SHANGHAI Last January, China's Pure Heart Asset Management Co took a radical step to guard itself against a possible crash in China's domestic A-share market, liquidating all of its five domestic funds.
But the privately managed firm took a different tack with its Hong Kong-based hedge fund, choosing to keep the operation open. The reason, said a company spokesman, was partly because it was able to use financial instruments unavailable on the mainland.
The firm has since opened a second fund in Hong Kong and has shifted its headquarters to the former British colony.
Pure Heart's move underlines one of the factors behind Hong Kong's strength as an international financial hub -- the availability of risk-mitigating derivatives. Shanghai, for the most part, lacks these tools, a major shortcoming as sophisticated investors seek to manage risks in the country's increasingly open and volatile financial markets.
"If you're building a wooden house, simple tools are enough," said Joseph Ho with French bank Societe Generale (SocGen) in Hong Kong. "But if you construct a skyscraper, you need more advanced equipment."
China's central government vowed in March to make Shanghai a global financial centre by 2020, sending a clear signal that there's little time to lose in deregulating the country's capital markets.
"China should introduce a basic set of derivatives by 2015, and spend the next five years increasing liquidity, sorting out problems and improving rules and regulations," said John Tan, China head of Global Markets at Standard Chartered.
Those derivatives include options and swaps in bond and foreign exchange markets and margin trading and short selling in the stock market.
For a graphic on the derivatives gap between Hong Kong and Shanghai: here
The global financial crisis is one reason market participants haven't seen such products yet. The role of complex derivatives in last year's financial train wreck has made Beijing wary.
Street protests by Chinese investors who lost money on a Shanghai-listed warrant product last year also triggered fears that fast-paced innovation would lead to social unrest.
"The financial crisis has stopped a lot of things, because China is rethinking its model after the Western systems in the U.S. and Europe probably failed in many aspects," said Pascal Sefrin, China head of corporate and investment banking at SocGen.
Until such changes come through, however, many aspects of Shanghai's financial markets won't develop quickly.
Consider the importance of index futures.
Shanghai set up the China Financial Futures Exchange three years ago to prepare for the introduction of index futures, cash-settled futures contracts on the value of stock market indexes. The plan has been held back, though, along with proposals for margin trading and short selling.
"These are very fundamental tools, without which the only thing you can do when stock prices are excessively high is to sell," said Gao Zijian, analyst at Oriental Securities Co. "Long-term investors such as funds need such tools to hedge risks, especially in China's volatile market."
In addition to helping the market price securities more efficiently, the change would help create a domestic hedge fund industry that could be worth trillions of yuan, said Tang Xuan, an analyst at the Shanghai Stock Exchange.
In a sign that investors welcome such innovations, China's stock market rose more than 3 percent on Nov 30 after a senior Shanghai Stock Exchange official said that time is ripe for the launch of index futures.
China's interbank market also lacks financial tools to help companies manage foreign exchange risks. That matters because as Chinese companies venture abroad, their currency risk increases. Those risks could be better managed with yuan options, which would give companies the right to buy foreign currencies at a pre-agreed exchange rate on a specific date.
In the bond market, China could help develop derivatives by easing government control on interest rates, thus giving market players more incentive to hedge risks, Standard Chartered's Tan said.
Despite efforts to liberalise interest rates, loans are still priced according to benchmark rates set by the central bank, rather than by the interbank market, which partly explains sluggish trading in the domestic interest rate swap (IRS) market.
"One doesn't need to hedge risks if interest rates are set by the government, so you need to give more power back to the market to develop IRS," Tan said.
Richard Wu, Hong Kong-based portfolio manager of RCM, a unit of Allianz Global Investors, agrees.
"If you look at financial centres such as Hong Kong or Singapore, really successful innovations and derivative products are not directed by the government," Wu said.
"The government's role is to build a good infrastructure, but the last thing it should do is to tell people what to do and when to do it." (US$1=6.832 Yuan)