China’s tightening rules put foreign high-frequency futures traders in limbo
HIGH-FREQUENCY futures traders in China have seen the viability of algorithmic strategies come under pressure as costs have ballooned.
Some were set up as goods trade companies by big-name foreign firms to evade restrictions on overseas investment in the country’s commodities futures market, and have operated in a regulatory gray area for years.
They earned huge returns with advanced algorithms that enable them to execute vast numbers of transactions in the blink of an eye.
Industry experts estimate that total profits generated by high-frequency trading in China’s futures market amounted to about five billion yuan (S$913.2 million) in 2019, and about 60 per cent of that money was taken by foreign firms.
Those returns were aided by low costs, which are increasingly becoming a thing of the past.
Policies implemented over the past two years not only disqualify high-frequency traders from receiving commission rebates from futures firms, but also increase their overall costs by allowing futures exchanges to charge additional fees based on the number of orders submitted and cancelled.
BT in your inbox
Start and end each day with the latest news stories and analyses delivered straight to your inbox.
“Our good days are long gone,” an employee at a foreign-controlled high-frequency trading firm recently told Caixin. “Trading costs skyrocketed, and all high-frequency strategies lost their edges.” The person said that layoffs may be imminent.
To put themselves on a firmer regulatory footing, some foreign high-frequency traders have sought to register investment fund managers in China. But only one made it — and the registration was later revoked.
“We strongly support a regulatory approach that fosters good enterprises and reins in the bad apples,” the employee with the foreign-backed firm said. “But in terms of implementation, we may need a clearer idea of what to expect.”
Rising costs
Early this year, futures exchanges issued new rules for commission rebates to futures firms. Under these rules, rebates are no longer available for transactions deemed to be carried out by programme traders – investors who rely on computer programmes to execute their trades.
The rules updated a policy where futures exchanges return part of the fees they collect to futures firms. The firms then pass on some of the rebates to their clients, which included high-frequency traders before the new rules took effect.
Initially introduced as a temporary measure to help futures firms cope with operational difficulties, the policy has been retained to energise the market.
High-frequency traders used to be major beneficiaries of the rebate policy. The strategies of high-frequency futures traders involve submitting and cancelling massive numbers of orders, so they are highly sensitive to changes in transaction fee rules, Huatai Futures researchers wrote in January.
Costs for some types of transactions are now 10 times higher, a high-frequency trader told Caixin.
Multiple high-frequency traders told Caixin that under the new rules, their strategies no longer work in China’s futures market.
Leading institutions with top-shelf tools and strategies can still make money, though nowhere near as much as before, while mid-size traders may quit the game altogether, a high-frequency trader at an institution with a European background told Caixin.
The trader said that if operating costs remain high, some firms may look for opportunities for high-frequency trading elsewhere, such as India.
The latest rule changes are not the first regulatory moves that have impaired the profits and strategies of high-frequency futures traders in China.
In August 2022, futures exchanges started levying additional fees on certain futures and options traders whose total number of order submissions and cancellations, and requests for quotes exceed specific thresholds. Different accounts controlled by the same trader have since been counted as a single entity for calculating the fees.
Then, in November last year, several exchanges imposed daily trading limits on the most actively traded contracts.
The slew of measures not only affects high-frequency traders but also futures firms and exchanges, as the overall trading volume in the futures market may have declined, some industry insiders said. But in the long term, it will weed out firms that overly rely on high-frequency clients and lead to a more stable market, they said.
Lucrative business
For overseas institutions to invest in China’s futures market, the compliant pathway involves trading contracts of a limited number of approved commodities – such as crude oil and iron ore – or becoming a Qualified Foreign Institutional Investor (QFII), which allows them to trade dozens of commodity and financial futures and options.
To gain greater market access without the headache of becoming a QFII, some big-name foreign high-frequency traders have set up goods trading companies in China. But their opaque practices have raised concerns.
A paper penned by two officials at the State Taxation Administration published in February 2023 revealed how a trade company set up by an offshore high-frequency investment institution was able to pay minimal taxes on their billions of yuan of investment returns.
The paper referred to the company only as Y Industrial. Sources with knowledge of the matter told Caixin that Y Industrial is actually Yue Shen Industrial (Shanghai), a trade company controlled by Jump Trading Group, a globally well-known high-frequency trading firm. Yue Shen is an active trader on the Dalian Commodity Exchange.
Y Industrial was registered as a wholesaler, but its invoices showed that the amount of transactions it conducted in the financial market far exceeded those involving physical commodities, the paper said.
The company reported investment income of 2.4 billion yuan and 2.7 billion yuan in 2020 and 2021, respectively, but the corporate income tax it paid for those two years amounted to only 59.8 million yuan and 33.7 million yuan, the paper showed.
Meanwhile, it not only paid nothing in value-added tax (VAT) in both years, but also received VAT rebates of 31.9 million yuan and 240 million yuan in 2020 and 2022, respectively.
The firm paid zero VAT on its transactions as many of the futures contracts it traded were not settled through goods deliveries, while the tax rebates it received were the result of paying royalty fees to related parties overseas, according to the paper.
Transferring profits earned from investing in China to overseas entities in the form of royalty payments means China is de facto missing out on corporate income tax revenue, the authors said, adding that while the practice complies with the letter of policies and regulations, its reasonableness remains open to question.
They also called for unifying the taxes collected on futures transactions regardless of whether goods deliveries are involved.
The tax officials’ examination of Yue Shen’s tax files adds to the existing controversies surrounding foreign-backed high-frequency traders.
Other investors have accused them of inflating trading volume without actually making the market more liquid, because high-frequency traders usually cancel some of the orders they submit as part of their strategy.
Failed transitions
Under pressure from the regulatory and public scrutiny, some foreign high-frequency traders have attempted to open private investment fund management companies in China.
Part of the rationale is that as stricter regulations limit the profits they can earn from investing with their own funds, they may be able to find new opportunities in managing portfolios on behalf of clients.
But traders’ attempts to transform have mostly failed.
Only one foreign high-frequency institution-backed firm, Optiver Private Fund Management (Shanghai), registered as a private fund manager with the Asset Management Association of China (AMAC). But the registration in 2021 was revoked about one-and-a-half years later due to the manager’s failure to register any fund products within the required timeframe.
The firm was associated with Dutch high-frequency trader Optiver, owner of Optiver (Shanghai) Trading.
Similar to Yue Shen, Optiver (Shanghai) is a high-frequency trader that operates under the guise of trading physical goods.
Founded in 2012, Optiver (Shanghai) paid 109 million yuan in commissions to Haitong Futures. in 2015, accounting for about 5 per cent of the latter’s revenue from futures brokerage commissions that year.
Sources with knowledge of the matter told Caixin that Optiver Private Fund Management tried to launch a private fund product, but the product was funded by Optiver itself. In other words, the trader was trying to continue operating a proprietary business in China instead of raising others’ funds to manage.
A private fund wouldn’t meet its regulatory definition if it doesn’t conduct external fundraising, according to Melody Yang, co-head of Shanghai Yaowang Law Offices and a former adviser to the AMAC’s International Partners Committee.
Two other firms backed by foreign high-frequency traders also applied to register with the AMAC as private fund managers. The foreign institutions behind them were Jump Trading and US-based quant trader Hudson River Trading. Both applications were terminated in November.
The AMAC did not disclose reasons for the termination. Some industry sources said it might be because Optiver’s failure to launch compliant products left a bad taste in Chinese regulators’ mouths.
“It seems that we are currently at an impasse, because when high-frequency traders operating under the guise of trade companies tried to comply with the rules, they found themselves stuck,” the source at the institution with a European background said.
A leading foreign institution-backed high-frequency futures trader set up a team in China to focus on spot trading in order to operate in compliance with regulations, the source said.
But the trader is concerned that one day there may be sudden regulatory changes, and it would be held accountable for previous transactions conducted in the gray area, according to the source. CAIXIN GLOBAL
Copyright SPH Media. All rights reserved.
