Highlights:
- Fourth week trading of DCE Hog Futures saw upticks with modest volume;
- Market rebounded Monday in response to report of ASF cases in Henan and Shandong;
- DCE announced new rules to empower the development of OTC markets;
- Ecosystems to support ferrous metal, petrochemical, grain, oilseed, egg and hog industries;
- Warehouse receipt, basis trading and commodity swap are the focus of OTC markets
[Greene County IL, Feb 8] – China’s Hog Futures ended the first week of February trending up. The front month September contract LH2109 closed at 26,170 on Friday, February 5th, up 2.8% from Thursday and +3.8% from prior week. November contract gained 2.3% for the day and +4.2% for the week. January contract was up 2.2% daily and 1.3% weekly. (Note: DCE hog futures price unit is RMB yuan per metric ton, US$1≈6.5 yuan.)
Trading volume has remained low. Since a record volume of 99,271 contracts was logged on January 8th at debut, average daily volume for the following four weeks has declined steadily, from 27,899 lots to just 8,408 lots for the latest week. Open interest paints a better picture. OI at Friday close was 23,655, up 5,588 lots or +31% from January 8th.
In a twist of fate, Hog Futures rebounded 4% with increased volume on Monday February 8th. Over the weekend, one FCM issued an investigative report showing severe African Swine Fever infections in Henan and Shandong provinces, both key hog production regions. This may be the main reason behind the sudden drop of sow inventory in December, after steady growth in the past eight months. Market repriced the futures contracts. January 2022 saw the biggest gain at 6.39%. The contract relates to the next Chinese New Year, a peak season for pork consumption.
As hog price is a politically sensitive matter in China, DCE installed strict rules to ensure hog futures not to fall victims to rampage speculation. Initial margin is set at 15% of notional value per contract for speculator accounts. At Friday’s closing price of 26,170 per ton, it amounted to RMB 62,808 for the 16-ton contract, or US$9,663. In comparison, CME requires only $1,800 for margin, even though Lean Hog is a bigger contract at 18 metric tons.
Transaction fee is also very expensive. At 2 basis point of Notional, it costs 84 yuan, or $12.9, to trade one lot. CME charges 51 cents for members, and $2.03 for nonmembers, for all agricultural commodities futures including lean hog and pork cutout.
Traders engaged in calendar spread find themselves being charged for full margins and transaction fees for both legs of the trade. To execute a long JAN short NOV strategy today, you will need to put up over US$19,000 for margins. This exceeds annual salary of a midlevel staffer in a typical Chinese city. It’s no surprise that retail speculators are priced out of the DCE hog futures market.
So, what happened to commercial interest?
On February 3rd, DCE amends its Administrative Measures for OTC members. Detailed rules governing ferrous metal, petrochemical, grain, oilseed, egg and hog OTC markets are announced.
In China, OTC commodities are regulated markets. Futures Exchanges views OTC as an important bridge linking futures market and the cash market. Fostering the OTC marketplace is a mean to increase commercial participation in futures contracts, and help cement the role of futures market as a venue for risk management, rather than a gambling house for speculators. Trading firms and commercial entities need to apply for an OTC membership from Exchanges in order to conduct trading business. FCMs may also apply, but need to do so through a subsidiary separate from its brokerage business.
DCE currently lists 28 contracts, including 12 agricultural commodities futures, 9 industrial commodities futures, and 7 options on futures. Wednesday’s amendment is the first time to issue rules on hog OTC market.
Since setting up an OTC division five years ago, DCE finds its role evolving over time. A unique feature is its encouragement of other entities to be stakeholders and taking bigger responsibility to build the new marketplace, which DCE calls an Ecosystem. The Exchange sets up rules, invests in infrastructure, and foster activities benefiting market growth. Guidelines for each of the six industries differ according to the current state of the cash market.
In general, four types of OTC products are supported by the Exchange: Standard Warehouse Receipt, Non-standard Warehouse Receipt, Basis Trading and Commodities Swap.
Standard Warehouse Receipt is approved and certified by DCE for the purpose of physical delivery of a commodities contract at its expiration. It can be used as collateral in financing where there is an active market to trade it. Therefore, making a market for warehouse receipts is an important way to help firms in the industry.
Non-standard Warehouse Receipt is one not meeting the strict requirement of futures delivery, and priced at a discount to standard warehouse receipt. For many industries, liquid cash markets deals with commodities at quality below Exchange standard. Making them tradable with the full faith backing of DCE lends credibility to the OTC market. It in turns makes it more accessible to a wider range of commercial firms, and brings the futures market so much closer to the cash market.
Basis is the difference between cash price and futures price. Futures hedging reduces the risk of price volatility, but the existence of basis risk impacts the effectiveness of hedging strategy. An active basis OTC market will certainly complement the futures contract.
Commodities Swap bridges the price movement of a single standardized commodities with dozens of cash market variants. In the case of Hog, the futures contract is Live Hog, where the cash market also actively trades hog carcass and many types of pork cutout, including sparerib, pork belly, loin, ham, shoulder, picnic, neck bone, pig feet, jowl and tail, etc.
In addition to the above four OTC products, the Exchange also promotes OTC options in conjunction with insurance companies. There is a main reason behind this setup: government subsidies.
For agricultural subsidies, there are established government policies subsidizing farmers for insurance premium and interest on bank loans. Option premium is not one of them. Therefore, a practical way to encourage farmers to hedge price volatility is to buy a government subsidized price insurance.
In China, insurance companies are not active participants in the futures market. In order for them to offer price insurance, they will need to buy OTC options to offset the price risk.
In my view, the “price insurance + OTC options” is hardly a success as broadcast. Insurance companies only offer price insurance if and when there is government subsidy. If the subsidy only covers premium for 1,000 hogs, you will not be able to buy price insurance for 1,100.
Farmers won’t buy it unless government pays for 80% of the premium. OTC options providers also rely on subsidy from the Exchange. After a few years, this scheme is still on a trial basis. Those who participate are really doing it for a “political correct” purpose. With the ever changing policy and the unpredictable nature of subsidy, it is not a sustainable market without life support.
In closing of today’s writing, I see huge potential in hog OTC market in China. Hog futures just started a month ago, and will takes years for China’s hog industry to fully take part in it. The OTC market is really an untapped market for the RME 3 trillion yuan hog industry. US FCMs and market makers would have a competitive edge with decades of experience and expertise in this field.
About the author: Jim W. Huang, CFA is chief executive of China-America Commodity Data Analytics, Inc., an independent agricultural commodity market consultancy and publisher of China Hog Market Intelligence Dashboard. Mr. Huang is a leading voice on China’s livestock and poultry markets, and frequently quoted by Bloomberg, Reuters and the Wall Street Journal. Prior to starting CACDA in 2012, he was an Associate Director of Product Strategy at CME Group, the world’s largest derivative Exchange holding company. You may contact the author by email at jimwenhuang@gmail.com.
