In part three of their collaboration focussing on the Chinese Gold market, Jan Skoyles and Koos Jansen delve into the key elements of the gold contract on the Shanghai Futures Exchange and present what they believe is a growing cog in the international gold market. For more great analysis of China's gold news don't miss Koos' blog.
This year volumes and deliveries on the Shanghai Gold Exchange have begun to appear with some regularity in gold market updates, alongside COMEX gold futures volumes and London prices.
But the Shanghai Futures Exchange is where we believe the Chinese authorities wish to use their influence on the international gold price.
Background to the Shanghai Futures Exchange
As we have highlighted in an earlier infographic, China's gold market has undergone radical changes in the last two decades. From preventing gold ownership to publically encouraging it, the State Council is ensuring that China's gold market is the one to watch as the nature of the global economy changes.
There are only two State Council approved gold trading exchanges in China; the Shanghai Gold Exchange and the Shanghai Futures Exchange.
On January 9 2008 the SHFE launched a 1kg gold futures contracts in response to both domestic and hedging demand. Originally there was a debate over who would have the gold futures contract, the SHFE or the SGE. In 2006, when the issue was discussed the SHFE traded 58% of China's futures volume and its copper and aluminium trading volume was second to the LME. It seemed a clear choice who would introduce China's first gold futures contract.
Shortly after launch the gold futures contract quickly gained a dominant share of China's gold product market and was seen as 'a major force in its own right' within the gold futures market. Despite trading only being available to domestic customers, the SHFE's gold contract became the fourth most traded futures contract in the world within two years of launch (in terms of size).
Reportedly the size of the contract was originally contested, and a 300 gram contract was originally considered. However the 1000g contract enabled the SHFE to present a gold contract which is line with others on the international market, namely TOCOM, India and Dubai futures markets.
It seems to us that there are two main aims of the State Council when it comes to offering access to gold markets. The first is to facilitate gold ownership, the second is to play a significant role in price discovery.
We believe the SGE is to facilitate gold ownership whilst the SHFE is a vehicle for China to influence the international gold price.
Despite its relative infancy to the market, it is the second largest gold futures exchange in the world.
Volumes traded in gold futures
Previously market commentators have stated that Chinese gold investors traditionally buy gold when the price is climbing. However this was questioned earlier this year when record amounts of activity was seen on both the SGE and SHFE and reflected in the import figures from Hong Kong, following the fall in the gold price.
One could speculate that this explains that the dip in volume in 2012 but the surge so far this year suggests that Chinese investors are attracted to the low gold price and are perhaps changing their gold buying behaviour.
It is also important to note the introduction of night trading in July this year, when the exchange is open at 9pm (1pm London, 8am New York) for five-and-a-half hours. Upon the launch of the additional hours, record volumes for both gold and silver were traded as investors embraced the exchange's opening hours covering those of the two largest gold markets in the world, COMEX and London.
The popularity of night trading has remained, although it is declining somewhat. The SHFE are no doubt hoping for the same success as the SGE who introduced night trading a few years ago and accounts for one-third of gold trading activity.
Compared to its contemporary, the SGE's Au (T+D) contract (also 1kg) which accounts for 75% of activity on the gold exchange, the SHFE contract has significantly higher volume.
However, compared to COMEX, China's gold futures market is practically non-existent. Trading activity does however mirror COMEX more closely than the SGE does. This suggests that participants are using it for the same means, suggesting it is in good stead to eventually become area centre of price discovery.
Open interest
In July 2013, open interest on the SHFE reached a record level of 163,592 lots. Since January 2009 (the earliest records are available at the time of writing) open interest on the SHFE has increased nearly four-fold from 34,168 lots.
When the contract first launched in 2008, it is reported to have received 'tepid interest'. Since April 2012 OI has remained consistently above 100,000 lots and in 2013, with the exception of April and May, it has remained above120,000.
Whilst the SHFE gold contract is the second largest in the world, it remains significantly smaller than COMEX in terms of open interest.
Physical gold
Whenever we discuss gold futures the inevitable discussion of how much gold is really backing the exchange quickly begins.
Unlike for its other contracts the SHFE only publishes on-warrant data for its gold stock. The SHFE has confrimed that 'on-warrant' refers to the amount of gold which is good for delivery.
One can see an erratic climb in the increase of the amount of gold on stock,rapidly reaching a peak of 2655 kilos in December 2012.
A steady depreciation in 2013 in gold on warrant is visible, in May the gold stock fell from 588 kilos to 393 kilos before the warehouses received further stock giving them 1173 kgs in total. However this was quickly drawn down over the following fortnight during prompting the gold stock to fall from 1173 kilosto just 390 kilos.
June and December are consistently high delivery months for the futures exchange. Prior to December 2012 there had been a steady increase in delivery volumes in these months. In December 2012 a record 2,064 kilos was delivered.
Given the news coverage of the record amounts of gold being delivered by the SGE, this has clearly also been reflected on the SHFE. However, what is most interesting is the higher than average deliveries seen in the earlier monthsof 2013.
Already in 2013 (January - September) the exchange has delivered 2.25 times more gold than it had in the same period in 2012. Therefore, should December delivery continue to top previous years, as it has consistently done so, thenthis will be another record year for gold deliveries on the SHFE.
Unusually for a futures exchange, individuals are not allowed to take delivery, insititutions can only take delivery of the gold. Therefore individuals mustliquidate or roll their positions.
China's State Administration of Taxation (SAT) announced that investors who conduct physical delivery of SHFE gold contracts are not required to pay value-added tax (VAT).
Delivery can only take place into SHFE approved warehouses. In 2007, the Industrial Commercial Bank of China (ICBC) and the Bank of Communications (both state-owned banks) announced they were to become the first two licensed physical delivery warehouses for the SHFE's gold futures trade.
The SHFE Chairman said in a speech at the 10th Shanghai Derivatives Market Forum in May 2013 that "The SHFE is also working to open up to foreign investors ... to allow overseas firms to participate in the physical delivery of goods in both tariff-free and non-tariff-free zones," however in October it was announced that the ban preventing overseas exchanges from opening warehouses in the Shanghai Freezone would be upheld.
56 refineries are published on the 'Gold Refiners' list whose bars are constituted as Good Delivery. Bars are available in 3kg or 1kg bars.
Sustainability
One way we can measure the sustainability of the SHFE is to measure the ratio of contracts standing for delivery versus open interest, i.e. the percentage of futures delivered as physical gold.
For future research it would be interesting to look at the number of institutional investors versus individuals as this would place the delivery ratio in a better perspective.
The delivery ratio on the SHFE is significantly less than we found earlierin the year when we examined COMEX.
The only time when the SHFE's delivery ratio is higher than that of COMEX is in December 2012. This was when the exchange saw record volumes and delivered2,064 kilos of gold.
This was still not as high as COMEX's previous delivery record in 2006, when the delivery ratio was 11%. Since this point peaks have been less than half of this. Whilst the SHFE's peak was just 1.9%.
Cover ratio
As can be seen from the graph below the number of owners per kilo has declined since the end of 2011, suggesting the exchange is more sustainable.
If we use the Owners per Kilo calculation (as done by Nick Laird for COMEX) and invert it (as originally suggested by Bron Sucheki) then we can see the cover ratio, this shows what percentage of the SHFE's obligations are backedby physical gold.
On average, the cover ratio since 2009 has been 0.37%. This is a stark contrast to COMEX where the cover ratio fell to its lowest level since August 2011,to 4.8% in May .
In previous work we have looked at the difference between the cover ratio and the delivery ratio as this can provide a more accurate indication of the sustainability of an exchange. In this instance we have not been able to accurately calculate this on account of stock changing on a weekly basis. It is clear looking at the figures that stock is brought in, in order to meet expected delivery requests rather than gold being held to cover future contracts.
For instance, 2064 kilos were delivered in December 2012 and in the same month stock was increased to 2655 kilos.
One must question the sustainability of this method, but given the efforts the Chinese authorities are making to import and mine physical gold one could argue this is a more manageable method than that on COMEX.
Opportunity for price discovery?
In previous commentary we have discussed where the centre of price discovery lies. We looked at academic research carried out by Professor Brian Lucey etal and concluded that it swings between the London Gold Market and COMEX.
When the gold futures contract was launched in January 2009 the question on everyone's lips was how the SHFE price would compare to the international gold price. It launched with a reference price of about $898/oz, COMEX settlement was $859.60. This sent a shock through market participants and the COMEX price climbed $20 higher in the following session.
According to William Purpura, the June contract was the most nearby listing and was, in the opening days, around $100 higher than the COMEX price. This was thanks to the biased response of the Chinese in the buy-side of the market, unsurprising given Chinese were unable to trade on international markets. And, of course foreign investors were unable to trade and sell the bid.
In the beginning the presence of Chinese investors along with the lack of international presence meant that there were few sellers, creating the arbitrage opportunity, to later be exploited to bring prices in line.
Without looking at second by second tick data it is impossible to tell whether or not there is a signifcant price discrepancy.
The Shanghai Gold Exchange is the other exchange approved for gold trading by the State Council. Founded in 2002 it is now the largest spot gold exchange in the world. In regard to its relationship with the SHFE in terms of pricing, hedge and arbitrage a 2010 paper found that 'the SHFE gold futures contract are well suited for hedging the SGE spot gold products.' The authors found that using the gold futures as a hedge meant traders were able 'to reduce the daily variance of a hedged spot gold position by almost 80% in [2008] and by almost 90% in [2009]'.
The launch of night-trading hours and the gradual introduction of foreign institutions will both bring prices on the SHFE in line with those found on COMEX and the London gold market. Once liquidity increases, on the SHFE there is little doubt of the growing influence China's futures exchange will have on the gold price.
Conclusion
We believe that the Shanghai Futures Exchange gold contract is not there to facilitate gold ownership, the success of the Shanghai Gold Exchange is evidence enough of this.
Like the SGE, volumes on the SHFE have reached record levels this year with delivery numbers to match. However, compared to COMEX, the current centre of price discovery, there is little evidence of China's gold futures market becoming as significant a player as China has become in the physical market.
In regard to sustainability it is, potentially, less sutainable than COMEX, given the relationship between the delivery and cover ratios. In order to assess this fully however one needs to look more closely at the nature of participants on the exchange, i.e. if they are individuals or institutions.
However, looking at weekly evidence we can see that gold stocks are rapidly filled in order to facilitate delivery. Given the amount of gold that is mined and imported into China, this may be a more manageable approach than that of COMEX where there is little evidence of a sustainable gold supply to match large requests for delivery.
Despite the current low levels of liquidity in comparison with COMEX, we believe that with the introduction of night-trading and the further opening up of access to the exchange, the SHFE has the potential to become a dominant hub for gold price discovery.
For now the SHFE continues to show great promise as part of China playing her trump cards in the currency wars. Dominance might take a while yet to arrive.
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