The shadowy world of high-frequency futures trading in China

High-frequency traders are a mystery power at work in China’s futures market.

They are reportedly working in China undercover as trade companies that buy and sell tangible goods, keeping a low profile while making significant profits. However, they are linked to well-known high-frequency gamers outside of China.

Yue Shen Industrial (Shanghai), a company that frequently has the biggest trading volumes of specific contracts on the Dalian Commodity Exchange, is one example of this. Jump Trading Group, a well-known proprietary trading company with a concentration on algorithmic and high-frequency trading tactics, effectively controls Yue Shen. The firm’s name includes “Yue” and “Shen” both: Ye – “Jump” in Chinese, and “Shen” –  another name for Shanghai.

According to industry experts, approximately 60% of the profits made by high-frequency trading in China’s futures market were taken by foreign companies. This profit total was estimated to be 5 billion yuan ($725 million) in 2019. The top three high-frequency traders with the most cutting-edge technology each took at least 2 billion yuan.

A futures broker in Shanghai ascribed the success of international companies to their cutting-edge technologies. “Futures trading is a zero-sum game, ” he continued, adding that “we are at least three to five years behind them in terms of techniques, hardware, and technologies. We are unsatisfied that they are utilizing their special powers to generate such a large amount of revenue.”

It raises the question of whether there is a legal exception that would allow these very successful overseas high-frequency trading businesses to participate in China’s futures market in this manner. Before 2018, foreigners were actually not allowed to trade on China’s domestic commodity futures market. The first commodity futures in China that were accessible to foreign investors were crude oil futures, which were introduced in March 2018. Investors in the Qualified Foreign Institutional Investor (QFII) programme and its yuan-denominated brother, the Renminbi Qualified Foreign Institutional Investor (RQFII) programme, were not permitted to trade commodity futures and options until November 2021.

However, it was more than ten years ago when foreign high-frequency traders first began to trade on the Chinese futures market. Before engaging in some transactions involving tangible products, they would either form a fully foreign-owned firm (WFOE) or join forces with another party. They would be eligible to trade on China’s futures market as a result.

When China’s stock market crashed in 2015, some of them gained notoriety. A few years later, Citadel Securities, the American trading behemoth that was generally believed to be one of the crash’s perpetrators, eventually paid a 670 million yuan administrative settlement fee to the China Securities Regulatory Commission (CSRC), the country’s main stock market watchdog. However, there was no mention of high-frequency trading in the case.

A WFOE has been established on the Chinese mainland by more than a dozen well-known foreign high-frequency trading businesses. Some of them have also requested a QFII license or established management firms for privately provided investment funds that are registered with the Asset Management Association of China in partnership with regional Chinese institutions. However, those private fund managers hardly ever introduce new products. Instead of trading on behalf of clients, some claim to engage in proprietary trading.

In essence, the so-called products trading companies that foreign high-frequency trading firms established on the Chinese mainland have been engaging in non-hedging futures trading without getting permission from financial regulators. Overseas high-frequency traders have been able to operate in China in this manner for years without a valid financial license due to the lack of clear restrictions in this gray area.

The “goods trading companies'” stooge

Jump Trading, established in 1999, operates in the futures, options, and equity markets all over the world with more than 700 staff members.

The corporation, which has its headquarters in Chicago, is well known for making substantial expenditures on infrastructure that can give it a competitive edge in high-frequency trading. According to Bloomberg, it purchased a microwave tower in Belgium in 2013 that NATO had previously used. Jump Trading invested in an undersea cable linking Chicago and Tokyo a few years ago, along with numerous other high-frequency trading companies, including Citadel, to receive data from various financial markets more quickly. Shanghai is currently linked to this cable. According to Zheng Yao, a founding partner of Shanghai Wenbo Investment Management, “the significance of this cable is that it will enable you to know what’s happening out there a little earlier than others.” According to the speaker, even a few milliseconds faster will make a significant difference.

Jump Trading is regarded as one of the most enigmatic high-frequency trading behemoths in the world and is well known for keeping a low public profile despite its widespread recognition within the industry. According to someone with inside knowledge of the business, Jump Trading “understands extremely well the Chinese mentality of generating a fortune quietly.”

According to public documents, Yue Shen is the sole Jump Trading business operating on the Chinese mainland. Quantitative developers, software engineers, and other positions are available in Shanghai, according to Jump Trading’s official website’s “careers” section. Yue Shen is one of the many non-financial organizations registered with a Shanghai Stock Exchange affiliate and given permission to access Level-2 data, a kind of electronic order book for listed stocks. Everything about the company indicates that it deals with financial markets.

According to established sources, Yue Shen made 1 billion yuan in earnings from the Chinese futures market in 2019 and 2 billion yuan in 2020. However, because futures exchanges withhold such data, it isn’t easy to find publicly available information regarding the company’s trading volumes.

In terms of total turnover, which exceeded 6.5 trillion yuan in 2020, Jump Trading Pacific, a subsidiary firm of Yue Shen, was the major constituent of the Shanghai Gold Exchange, according to data from the more open spot market. That was greater than the combined trading volume of the two “Big Four” banks in the nation, Industrial and Commercial Bank of China and Bank of China.

Massive trading volume

Another professional investment firm that poses as a firm that deals in tangible items is Optiver (Shanghai) Trading, which is controlled by the Dutch high-frequency trading firm Optiver. It had a close working relationship with China’s Haitong Futures, and in 2015 it paid Haitong Futures futures brokerage commissions totaling up to 109 million yuan, which represented around 5% of the futures company’s revenue in this area. In 2015, Optiver (Shanghai) may have traded more than 1 trillion yuan through Haitong Futures, if commission fees were assessed at a rate of one ten-thousandth.

Shanghai Dutch Connect International Trading, a “trade company” established by IMC Financial Markets, a further Dutch high-frequency trading firm, paid 2.36 million yuan in futures brokerage commissions to Shanghai Zhongqi Futures in 2015, suggesting that its trading volume there may have exceeded 20 billion yuan.

Through publicly accessible data, it is difficult to determine exactly how many tangible products they traded, but their counterparties may be able to provide some information. For instance, Dalian Dafu Enterprises Holdings once acknowledged, in answer to a query from the Shanghai Stock Exchange, that it had purchased actual zinc ingots from Chinatech (Shanghai) Transaction; however, the amount of trading was not made public. Israel’s Coral Reef Technologies, a high-frequency trading company, owns and controls Chinatech.

For many people outside the industry, the business concepts of these so-called trade corporations remain mysterious. According to a market analyst, these businesses typically purchase and sell some tangible goods before using the proceeds to engage in futures trading.

Another source with knowledge of the situation informed that such trading organizations may easily complete a few transactions involving physical commodities and that they typically employ a very skilled accountant to inflate the earnings that they can use to trade in the futures market. This commercial operation is already extremely developed.

Regulators did look into the methods used by a few foreign high-frequency trading businesses. Still, no violations in accounting or taxation were discovered. A source added, “Their compliance was quite professionally well done.”

According to Chinese legislation, anyone wishing to register a trading account with a futures company must be in possession of a domestic identification, such as a Chinese mainland ID card (for persons) or a status of legal personality (for organizations). Before being allowed to create an account with a futures company, international high-frequency trading firms frequently set up a local goods trading company to obtain domestic legal status.

This business strategy was developed by regional legal firms many years ago, and numerous high-frequency trading companies have tested it and found it to be effective. On the other hand, skeptics point out that this strategy, in fact, makes it possible for these trading corporations to acquire the Chinese yuan through fraudulent operations. It finally promoted the influx of “hot money.”

Yishidun’s lessons

When the stock market crashed in the summer of 2015, the public’s attention was drawn to Yishidun International Trade, a little-known high-frequency trading company founded in China in 2012 and then run by two Russian citizens. Following investigations, it was discovered that Yishidun traded 3.77 million futures contracts on the CSI 300 Index and CSI 500 Index between June 1 and July 6, 2015, making an illicit profit of 389 million yuan.

Accused of manipulating the market, Yishidun was put on trial in 2016. Attorneys revealed that Yishidun purposefully avoided a legally needed verification stage in order to trade more quickly. They also revealed that Yishidun illegally connected its own trading system to the China Financial Futures Exchange. Two of the company’s leaders received suspended jail terms and a 300 million yuan punishment from a Shanghai court in 2017 for manipulating the futures market in China.

Sources with knowledge of the situation earlier reported that Yishidun’s initial investment in China’s futures market may have been as little as 700,000 dollars of its registered capital plus 3.6 million yuan it raised in China. Later, it generated a profit of up to 2 billion yuan. But when it tried to transfer the earnings out of China, it ran into regulatory obstacles since it couldn’t comply with China’s regulations regarding foreign exchange controls, according to the sources.

The case of Yishidun, which involved “a new sort of manipulation” of the futures market, was recognised as one of the seven case studies of securities and futures offenses in 2020 by China’s Supreme People’s Court.

The best way to deal with “the elephant in the room”

According to a seasoned market participant, the lack of a license is the major problem for these foreign high-frequency trading organizations. They shouldn’t be acting in a way that is exclusively permitted for domestic institutions because they are professional financial investors.

At this time, there are no restrictions on foreign investors using the QFII and RQFII schemes to access the domestic futures market in China. The market, however, finds many administrative regulations to be inconvenient. For instance, QFII and RQFII investors need to identify a qualified domestic institution to serve as their custodian, who is then required by law to publish comprehensive information about their business activities, such as opening and closing accounts, transnational fund flows, and asset allocation. A market specialist who is acquainted with foreign institutions said, “QFIIs are not willing to do this.” It’s difficult to keep their high-frequency trading a secret once so much information is disclosed.

China’s  futures law draft passed its first and second readings and is likely to go into force in 2022 after passing its third reading. The draft stated that programme trading must adhere to CSRC rules, report to futures exchanges, and not compromise the bourses’ system security or regular market order.

Given that regulations frequently lag behind market practices and technological advancements, it is well accepted within the industry that creating rules governing high-frequency trading is technically challenging. When China’s regulators first released draft rules intended to regulate high-frequency trading, they later discovered that the requirements were so strict that they also effectively banned numerous non-high-frequency traders. The market informed the CSRC in October 2015 that the proposed regulations to better control programme trading were too harsh. That draft is still in the draft stage.

Others also raise concerns about high-frequency trading’s contribution to actual economic growth. A dealer declared, “In my opinion, it merely produces commission fees and enriches the exchanges.” It does not even remotely support the real economy.

The issue of money laundering is another concern. Although several academics noted that regulators are still unable to fully monitor or regulate how cross-border money ultimately winds up being utilized on the Chinese mainland, both the draft Futures Law and the Anti-Money Laundering Law have advocated enhancing controls over cross-border fund flows. The aim is to better monitor and manage cross-border funds involved in programme trading and lower the risks related to illicit programme trading.