When the Hong Kong Exchanges & Clearing Ltd launched yuan futures trading last month, the market had great expectations for it as the yuan or renminbi is widely perceived to have great appreciation potential due to its demand in trading. However, after a month's operation, yuan futures trading is far from satisfactory.

The disappointment comes as the expected heavy trading in yuan futures hasn't happen due mainly to institutional difficulties faced by the yuan. Hence, the apparent yuan futures' unpopularity is not due to people's acceptance of yuan futures, but rather the lack of internationalization and trading of the yuan. These reasons are the main factors contributing to the disappointing yuan futures' performance.

Currency futures are financial derivatives designed for investors to hedge against exchange risks. Yuan futures are no exception. For other globally traded currency futures, the most popular ones all have underlying currencies that are being actively traded, and over 90percent of currency futures trading are speculative in nature. However, to speculators, an active market for the underlying asset is essential. In finance theories, the cash markets (i.e., the market for the underlying assets) and the futures markets are closely related. The two markets arbitrage against each other and their movements will provide important information to the price discovery process. From this perspective, an actively-traded cash market is crucial to the success of a futures market. Without an active cash market, the futures market simply cannot perform the arbitrage function.

In the case of Hong Kong's yuan futures market, the yuan futures are not actively traded because they cannot fulfill their roles. To investors, they simply will not trade the yuan futures because there is not a great need to do so. To speculators, when there are not enough real needs in the underlying asset, the speculative activities will be low. These factors definitely contribute to yuan futures' quiet environment.

The yuan futures' long run prospects remain optimistic for a simple reason: the yuan currency will attract more investors and speculators in the future. The current setback is the lack of investment opportunities in the yuan. Without a big demand on the yuan's investment function, the need to hedge yuan exposure will not be high, hence the poor yuan futures trading figures.

The slow yuan futures trading is actually a chicken-and-egg problem. Yuan futures are not actively traded because of the absence of active investment activities with yuan; and this absence in itself prohibits the development of such activities.

One thing Beijing can consider is to encourage more foreign countries to store their foreign exchange in yuan-denominated assets, and this will lead to more people holding the yuan, getting the currency to become more internationalized. This will lead to financial innovation in yuan products, which in turn will drive demand for hedging exchange risks of yuan. Beijing has made it clear that China wants to internationalize the yuan and the aforementioned direction is the way to go. This arrangement will give foreign countries a chance to diversify their foreign exchange holdings, while also allowing China to do so likewise. Once other countries have yuan assets on hand, they will demand for tools to hedge against yuan exchange risks, paving the way for yuan futures to become more attractive.

The author is dean, School of Business, Hang Seng Management College. The views expressed here are entirely his own.

(HK Edition 10/11/2012 page2)