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Fish futures can provide new financial tool for China

Exchanges ponder hedging of seafood risks

| China

China saw an influx of speculative capital into commodities exchanges in 2016. Such hot-money rushes are caused by a dearth of alternative investment options. But if the central government were to allow sensible speculation, a planned Chinese seafood futures contract for trade on the Dalian Commodity Exchange could provide a new asset class for investors and a hedging tool for the industry.

The current investment environment is uninspiring. Savings in commercial banks earn less than inflation, and the housing market is bubbling over as closed capital accounts prevent convertibility to foreign currency. Investors are left with the casino-like securities markets and the trusty mattress.

However, if Beijing approves plans for a regulated fish futures market, it would allow the standardization of production and processing of an important commodity. Major producers would adhere to price benchmarks, and minor producers would be forced into regulated markets.

The benefits of futures contracts in agricultural commodities are well established, allowing price formation and the hedging of risk. However, while futures contracts derived from underlying assets in agricultural commodities are widely traded on exchanges, futures derived from seafood commodities have usually failed to attract the necessary liquidity to function as a price formation mechanism.

A futures contract is a standardized financial contract traded openly on a public exchange. It is simply a promise to buy or sell a good at a predetermined price at a specified time in the future. Standardized exchange of futures contracts can occur either on a cash or physical delivery basis.

The principal benefit of well-functioning futures exchanges is that responsibility for price-formation and uncertainty bearing is effectively transferred to speculators, freeing suppliers and distributors to focus on supply-side and demand-side pressures respectively.

Agricultural commodities markets are usually centered on grains and oilseeds -- rice, wheat, corn, soybean and rapeseed. In order to function as an effective underlying asset class, a commodity must have uniform or standardized properties; for example, 100 tons of unbroken free-on-board Hom Mali Grade B rice needs to be of uniform quality. However, shipments of horticultural and seafood products are more difficult to standardize than grains and pulses because of their varied sizes and shapes.

Limited attempts in other countries to develop seafood-based futures have failed to take off because of a lack of liquidity. The Minneapolis Grain Exchange in the U.S. offered a shrimp futures contract for a few years, and Japan's Osaka Dojima Commodities Exchange still does. Norway's Fish Pool has standardized a salmon contract, but has struggled to become a price-setter in the market.

Unfamiliar risk

This is largely because not enough people know the market exists, while those who do may not understand it well enough to invest, or may consider the risks involved too high. However, in China, financial technology and shadow banking are combining to allow individual investors to take risks that might deter institutional buyers.

Dalian Commodity Exchange is currently exploring the possibility of a standardized contract for seafood. This is likely to result in it piloting a tilapia contract, as the fish -- widely reared in freshwater ponds throughout China's coastal provinces -- yields an easily standardized fillet, and has little variation in production quality or size.

In China, rural finance development faces an important institutional bottleneck. The state has an obligation based on historical governance legitimacy to support peasant incomes in grains. However, in seafood, the livelihoods of fishing villages are sociologically different to the patron-client relationship of land farmers.

China's fishing communities have traditionally dwelled on the fringes, and are isolated from centralized state power. Yet the economies of scale required for large-scale farming in grain-based agriculture already exist for seafood in the massive state-owned fisheries enterprises such as China National Fisheries, Dalian Zhangzidao Fishery Group, and Shanghai Fisheries General.

These large state-owned enterprises mostly collect seafood from small companies or fishermen. The fish is of varying quality and compliance with live-catch quotas. Historically, there is less planned-economy institutional control in primary producers in coastal areas, especially in the southern provinces of Zhejiang, Fujian and Guangdong. Therefore, reforming the financial institutions required for centralized and standardized seafood prices is easier because the production system is already more marketized than that for commodities such as grains and oilseeds, for which the state provides guarantees.

Since 2015, the government has been keen to push its "futures plus insurance" initiative as a financing mechanism to replace state procurement. Target prices have been introduced on soy and cotton. They will soon be introduced for rapeseed, and will eventually be extended to rice, corn and wheat. Allowing provinces to set target prices introduces an element of price variation as an interim measure, preparatory to full market trading and price-setting. And agricultural insurance provides a social safety net that replaces state procurement.

In seafood, there is less institutional baggage to overcome than in land-based agriculture. And with China's increasing protein demands being met by rising fish consumption, a seafood futures price-setting mechanism is likely to attract the liquidity it needs to function properly.

Currently, Zhengzhou Commodity Exchange offers contracts on cotton, sugar, rapeseed oil and meal, three types of rice and two types of wheat, while Dalian Commodity Exchange has contracts on corn and corn-starch, soy beans and soy oil, eggs and palm olein (liquid palm oil). Commodity futures markets are expected to be further liberalized, according to Fang Xinghai, vice-governor of the China Securities Regulatory Commission, which oversees Zhengzhou Commodity Exchange and Dalian Commodity Exchange.

Regulatory uncertainty

That said, the futures and spot markets face regulatory uncertainty because of the rise of financial technology. New central bank controls introduced in February 2017 limit finance and trading by microtraders (weipan). Such shadow microtrading platforms include CNGold and Baibei, which offer futures and spot trading on soybeans, gas, coal and precious metals via WeChat, a Chinese messaging app. The platforms partner with trading houses such as Harbin Precious Metals Exchange, Guangdong International Commodities Exchange and Heilongjiang COSCO Commodities.

These "exchanges" are really enterprises approved by provincial governments to promote price-formation in regional or specialized commodities such as jade in Guangdong or pine nuts in Heilongjiang. The provincial trading centers partner with third-party platforms to offer online trading using WeChat finance and Union Pay, a Chinese bank card service, to connect to user capital in the traditional banking system. Such platforms have flourished and their popularity with retail investors has worried the government, which has been cracking down on the wider shadow banking industry.

Apart from that, the central government is also struggling against two anti-market principles. China's communist legacy means that many people see speculation as a capitalist endeavor for personal profit, devoid of social functions such as the provision of market liquidity. The other legacy is central planning, which has left authorities terrified of the prospect of foreign capital controlling the means of food production.

However, change is occurring in both areas as China relaxes its food security fixation and seeks international legitimacy for its capital institutions. Reforms encouraging the use of futures markets were reiterated in an important announcement in January by the central committee of the Chinese Communist Party and the State Council, China's cabinet, which signaled the introduction of a price-setting mechanism into domestic agricultural production and the beginning of an increased reliance on foreign food to feed its population.

A seafood futures contract traded on the Dalian Commodity Exchange would be in line with broader developments in financial and agricultural markets, and would likely attract the liquidity necessary to make it sustainable. Reliable price-signals on seafood would also help policy-makers across the Asia-Pacific to better gauge China's likely demand for fish-based protein in the future.

Tristan Kenderdine is a lecturer in public administration at Dalian Maritime University and research director at consultancy Future Risk.

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