If you want a graphic illustration of just how serious Chinese merchants and manufacturers are about the cotton business, all you have to do is look at cotton futures trading on the Zhengzhou Commodity Exchange.
Daily volume in Zhengzhou cotton futures, which will complete their first year of trading on June 1, is now running about 50,000 contracts. Open interest at the ZCE has been running between 60,000 and 80,000 contracts per day since last November.
“What's important about these numbers — 70,000 contracts per day open interest — is that the New York Cotton Exchange only reached this level after 120 years of trading and a record U.S. cotton crop,” says Ed Jernigan, chairman and CEO of Nashville, Tenn.-based Globecot, Inc. “The ZCE did it in less than a year.”
Jernigan, who has made numerous trips to the Far East and China on behalf of Globecot in recent years, spoke on the debut of the Zhengzhou Futures Market at the USDA Agricultural Outlook Forum in Arlington, Va.
What's behind the success of China's still-new cotton futures contract? Some critics would say it's because the contract size in China is small.
“That's the reason, they say; they trade so many contracts,” says Jernigan. “I say that's not the case at all. The size of the contract doesn't matter — it's what people think of the contract.”
There are five reasons the Zhengzhou futures market already rivals trading on the New York Board of Trade, according to Jernigan, who admits he is a frequent critic of the NYBOT's trading rules. (Jernigan has served on the New York Cotton Exchange board.)
One is that the base quality of the contract more closely mirrors the domestic use and production in China, which the Chinese are happy to point out, is typically higher than that in the United States.
“The Chinese did a lot of research on this,” he said. “I asked the chairman of the Exchange when we might be able to deliver non-Chinese cotton on the ZCE. He pointed out that New York had been trading for 100-plus years, and you still can't deliver non-U.S. cotton against its contracts.
‘Know their facts’
“So I think they know their facts and understand what they are doing.”
The base quality for the ZCE contract is the Chinese Type 328 cotton, which Jernigan says is the equivalent of a U.S. middling, 1-3/32-inch grade and staple. Currently, more than 80 percent of the Chinese crop is middling, 1-3/32-inch.
Other quality factors include a micronaire range of 3.5 to 4.9. Chinese traders can also tender a Type 129 cotton, which is a strict middling, 1-1/8-inch, down to a lower quality Type 429 cotton with premiums and discounts.
Zhengzhou Commodity Exchange officials also designed their cotton futures contracts to have “very, high integrity,” as far as the quality of the cotton. In contrast to the NYBOT, the contracts make it relatively easy for the buyer to take delivery of the cotton, according to Jernigan.
“If you go back and look at the number of cotton futures contracts that have been introduced outside of New York over the last 25 years, each and every one of them failed, and one of the reasons they failed was the delivery mechanism.”
In the ZCE contracts, China's Fiber Inspection Bureau inspects all cotton before it is placed in a deliverable warehouse, and the Fiber Inspection Bureau classes it again when delivery takes place.
“This has created strong integrity in the quality of the cotton received by the buyer and prevents dumping by the seller,” Jernigan notes. “ZCE futures trade at a premium to general physical prices for that reason.”
All cotton is delivered in 20-ton lots — the contract size is 5 tons or 11,000 pounds or 22.9 480-pound bales. The Exchange recognizes 13 approved delivery warehouses in East China.
Jernigan says the third reason for the ZCE's success is that cash cotton prices have been highly volatile, encouraging merchants and manufacturers to hedge using the exchange's future contracts.
“The first contract traded when the ZCE began its cotton futures market was the November. China had a shortage of cotton going into the fall months and the spread between November and December futures widened out to more than 2,000 riminbi,” he said.
“Since then, prices have become more stable with the March/April 2005 spread trading at a more normal 50 to 100 riminbi under, reflecting the discount for the later month.”
Despite the government's tight rein on most aspects of Chinese life, China's physical price movement of cotton occurs in a free market, he said. “Chinese prices have significant volatility, and prices are less influenced by the government than in the United States.”
Against that backdrop of strong volatility, the ZCE has put strong regulatory procedures in place, including those for delivery integrity, position limits, daily price limits and strong margin rules.
“They have very strong position limits, but the position limits do change as they get closer to the delivery months,” says Jernigan. “The limits change when they get two months out and they change again at one month out, depending on the stocks levels.”
All trading is done by computer, he notes. There are no open-outcry pits at the ZCE.
The final reason for the early success of the Zhengzhou cotton futures, he says, is the widespread familiarity with futures and their uses on the part of the Chinese cotton community.
Although the New York and Chicago Boards of Trade pre-date the current futures exchanges in China, futures trading is an Asian invention. The first trading was done with rice in Japan.
The modern era of commodity trading in China began with the first grain wholesale spot market, which opened in October 1990. Chinese merchants began trading aluminum futures in Shenzen in September 1991, and the first futures brokerage firm opened in 1992.
The Zhengzhou Commodity Exchange transferred its grain-selling business to futures in 1993, and the government approved 11 futures contracts for trading on a trial basis in 1994. But government officials began getting cold feet in April 1994 and banned futures trading in steel, sugar and coal. Bans on rice and rapeseed futures followed in September 1994.
In 1998, the 14 futures exchanges in China were consolidated into three — the Shanghai Futures Exchange, the Zhengzhou Commodity Exchange and the Dalian Commodity Exchange. All futures trading now occurs on those exchanges.
The ZCE began trading wheat, corn, soybeans, green beans and sesame futures in 1993 with green beans being its most active contract until 1999 when wheat took over the top position. In 2003, daily volume in ZCE wheat futures reached a record 887,446 contracts.
Big zce volume
“The volume in many of the ZCE grain contracts exceeds that on the Chicago Board of Trade,” says Jernigan. “It probably helps that commodity markets have been much more attractive than the domestic equity and bond markets. The latter are in a three-year bear market.”
“ZCE cotton has to be the most successful new cotton futures contract ever introduced,” he notes. “It has enjoyed liquidity from opening day, and the daily volume now averages two to three times that of the NYBOT.”
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