Introduction
Since economic liberalization began in 1978, the People’s Republic of China has experienced unprecedented growth, driven, in large part, by domestic manufacturing and agriculture.
This growth, plus China’s interconnectedness in the Global economy, led to a structural underlying need for futures contracts. Historically, goods and products have been exported via long shipping routes to consumer economies in Europe and North America, but increasingly Chinese manufacturers, and the domestic population, rely on imports from equally far-off sources. As government price-regulation was slowly withdrawn - the need for, and opportunity therein, futures contracts markets has grown considerably.
Regulatory developments in China have since opened up these ever-growing marketplaces and in 2024 Chinese Futures Markets are an essential column of the international commodity economy. As a result, western firms are investing heavily in these markets - for example, a partnership including US high frequency trading firms Jump Trading and Citadel recently invested in a high-speed undersea cable reaching directly from Chicago all the way to Shanghai.
In this article, we’ll analyse an excerpt from our research into a direct application of our systematic trading model (TAD) to the Chinese domestic futures markets, without customization. The research shows that despite the idiosyncrasies of these specific markets, it’s certainly possible for CTAs and other investment management firms to successfully apply existing trend-following approaches in the Chinese futures marketplace.
Specifically, what are Chinese Domestic Futures?
To be precise, we are analysing a basket of liquid domestic Chinese futures contracts, the type traded on mainland Chinese venues such as the Zhengzhou Commodity Exchange. While the underlying assets are often the same as those found in western markets, importantly, these markets are affected by regional fundamental factors which differentiate them from similar products traded in other global venues.
At their establishment in the 1990s, Chinese futures markets were intentionally inaccessible to foreign investors. This began to change in 2018, when foreign investors were allowed to directly participate in the first Yuan-denominated oil futures contract[1], and this deregulating trend has continued to the present day where at least 45 different contracts are accessible to foreign investors[2].
In order to trade these contracts, a foreign firm will usually become a Qualified Foreign Institutional Investor (QFII) and must abide by a set of unique rules. For example, firms have extremely rigorous reporting requirements, are subject to quotas and are not allowed to participate in the physical delivery of their futures contracts[3].
Growth and International Position
Looking at the included charts we can see that, by volume of single contracts, the Chinese futures exchanges now make up a considerable part of the global futures picture and that this theme is amplified for agriculture contracts.
In figure 1, we can see how three of the Chinese futures exchanges have clearly now broken into the top ten, as measured by the total number of contracts traded.
Figure 2 shows how much of this activity is driven by China’s dominance in agricultural futures, where over 80% of global volume in agriculture futures contracts trading now occurs in China.
Figure 3 shows the rapid growth from the Chinese exchanges by measuring the percentage change in volume from 2020 to 2021. Whilst many of the global exchanges saw a reduction in volume in this period, all three of the main Chinese markets experienced considerable growth.
Opportunity
As a firm, we are led by our knowledge of the markets, the needs of our clients, and our curiosity. Our recent interest in Chinese futures (which led to this blog post) originates from these three sources.
In terms of recent developments, changes in regulation have somewhat liberalised the space and, as of 2024, there is a considerably longer list of futures contracts which can be traded by outsiders. This, alongside other factors, has caused liquidity to grow. Successful trend-following strategies usually require enough liquidity to trade without constriction (which is now the case with the majority of the larger Chinese contracts), but not such high liquidity that trend strengths are diluted, seen for example in many global FX markets.
Our Research
The 10Dynamics team recently undertook a research project to better understand the opportunities available from applying our existing systematic trading models, know-how and experience, in the developing Chinese futures markets.
Specifically, we applied the existing 10Dynamics’ trend-following model, which has been running on EU and US markets only, to a backtest of 55 Chinese futures contracts, non-optimized for the markets. It’s critical to note that market-agnosticism is a core pillar of 10Dynamics’ work and, as such, non-optimization was an elective but important restraint.
The backtest ran over a ten-year period and was modelled net of fees. We were principally investigating the returns profile, risk, diversification, factor exposure and correlation.
Figures 4 and 5 show the breakdown of the contracts used in the research. As expected, the majority of the contracts are in either the agricultural or metals complex, and the vast majority (82%) are traded on one of the three major Chinese exchanges.
Findings
For this research, we applied the exact same model as used in our EU/US strategies, and found that resultant factor exposure was lower, which traditionally indicates more differentiated alpha.
The research also showed that by combining the non-optimised Chinese domestic futures portfolio with the US and EU portfolios, it is possible to increase both the Sharpe Ratio and overall diversification of the model.
Professional investors receiving our monthly factsheets will have seen the detailed results of this test already. Contact us at enquiries@10dynamics.com to find out more.
Limits, Risks and Considerations
Beyond existing constraints of trend-following strategies, operating or investing in a Chinese domestic futures strategy would bring meaningful additional dimensions to consider.
Principally, firms examining this opportunity should consider that, depending on account size, some domestic Chinese markets may not be liquid enough to be traded efficiently. There are also region-specific tax considerations and the unusual cash management feature that all margins must be fully pre-funded when trading futures in China.
In addition, there are long-tail factors to evaluate including the possible difficulty of on-shoring cash (rather than using currency swaps), local reporting requirements, trade execution and other counterparty risks.
Finally, all investors and firms should always consider relevant geopolitical and country risks, especially when investing foreign capital in emerging markets.
Conclusion
For anyone operating or investing in trend-following strategies, the Chinese domestic futures markets provide a great opportunity to run truly out of sample tests, as chances are most Western firms are yet to trade these contracts.
By using a non-optimised, equal weight and price-data-only approach, managers can see if the key assumptions underlying their knowledge-based models can be independently validated in new, disparate and unconventional markets.
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