China, Japan Futures Markets Cooperate on Weather Derivatives

By Maria Trombly | Securities Industry News | July 10, 2006

The Dalian Commodity Exchange (DCE), China's largest agricultural commodities futures exchange, and the Tokyo Financial Exchange (TFX), Japan's only financial futures exchange, have agreed to jointly develop weather derivative products for trading on both markets.

The TFX deal is the latest of 12 memorandums of understanding (MOUs) that DCE has with foreign derivatives markets and the first that involves developing new products. It comes at a time when the DCE is pressuring the Beijing government for wider latitude in launching products.

"Researching and promoting an innovative product is unprecedented" for the DCE, said Lihong Zhu, a senior analyst at the exchange. "All of our existing alliances are based on how to manage price risk for a traditional commodity." She said DCE and TFX might cooperate on developing derivatives for rainfall, snow, wind speed and humidity.

DCE also has agreements with the Chicago Mercantile Exchange, Chicago Board of Trade, Chicago Board Options Exchange, Tokyo Commodities Exchange, Central Japan Commodity Exchange and the Tokyo Grain Exchange, as well as futures exchanges in Brazil, Argentina, India and Malaysia.

DCE chief executive Yucheng Zhu told Beijing newspaper Futures Daily: "We are pleased to sign the MOU with the Tokyo Financial Exchange, and we are looking forward to further cooperation between the two exchanges, which will benefit both markets. We will take this opportunity to make a number of cooperative moves in several areas." The MOU was announced on June 9 while the CEO was on his third official trip to Japan in the past year.

Temperature derivatives have become important for hedging weather risk in global markets, and over-the-counter trading of U.S. dollar-denominated temperature contracts accounts for more than half of the worldwide volume in weather derivatives. Japan launched an OTC weather derivatives market in 1999, and by 2005 daily trading volume was averaging JPY60 billion ($521 million). TFX spokesperson Ryoji Iketani said there is currently no trading of weather derivatives on a Japanese exchange. While TFX is working on initiating floor trading for temperature index futures, it has not set a launch date.

Chinese officials have sought for years to mitigate risk in the agricultural sector, where bad weather causes hardship for most of the nation's farmers, says Shouhong Huang, director at the Rural Department of the Research Office under the State Council in Beijing. DCE's entry into weather derivatives is taking place as the government is attempting to ease volatility in the rural economy.

According to DCE's Lihong Zhu, the exchange and the national weather center have designed index futures that will be traded on both TFX and DCE. The latter has sought approval for the contracts from the China Securities Regulatory Commission (CSRC) and is waiting for the legislative and regulatory changes it will need to begin trading.

Since 1999, CSRC rules have required physical delivery when a futures contract matures. Yongjun Feng, the DCE's manager of research, said: "There is an obvious advantage of cash delivery, and it means more convenience for investors. It will also help with deliveries of large contracts and bulk goods like crude oil. With a new delivery system, product innovation will definitely speed up."