The IMF Working Paper, written by Zhongxia Jin, Yue Zhao, and Haobin Wang, analyses the importance and urgency of setting up a foreign exchange (FX) futures market in China…

The IMF Working Paper, written by Zhongxia Jin, Yue Zhao, and Haobin Wang, analyses the importance and urgency of setting up a foreign exchange (FX) futures market in China. It also examines the impact of FX futures markets on the volatility of spot markets. Additionally, the authors suggest that regulatory design changes are necessary for the establishment of a well-functioning FX futures market in China.

Currently, China’s OTC FX derivatives market is mainly an interbank market that offers customised products to large companies and institutional clients. An FX futures market is needed to encourage a broader participation of market participants with hedging needs, such as small and medium-sized enterprises.

The onshore FX futures market can also help resolve regulatory challenges associated with an oversized offshore market. Finally, the establishment of an onshore FX futures market will enable cross-border investors to better manage FX risk.

The paper examines whether the establishment of FX futures in emerging markets increases the volatility of the underlying spot FX markets. The authors demonstrate that FX futures markets do not increase the volatility of the spot market, and, in some cases, volatility decreases.

The authors suggest that China should phase out the underlying exposure documentation requirement for derivatives traders. This regulatory approach can impede the development of China’s derivatives markets. Instead, regulators should allow for a more market-based approach to ensure stability of the FX futures market.

Click here to read the whole working paper