Index Futures Trading Restrictions and Spot Market Quality: Evidence from the Recent Chinese Stock Market Crash

• Author: Qian Han,Jufang Liang
• Date: 01 April 2017
• Published date: 01 April 2017
• DOI: http://doi.org/10.1002/fut.21825

Index Futures Trading Restrictions and

Spot Market Quality: Evidence from the

Recent Chinese Stock Market Crash

Qian Han and Jufang Liang*

Using a difference-in-difference approach, we find that restrictions placed on the CSI 300 and

CSI 500 index futures trading during the recent Chinese stock market crisis deteriorated spot

market quality, particularly the September trade restrictions. Our results can be explained by

the sudden risk exposure faced by alpha-strategy traders who stop trading spots after the index

futures trading restrictions are introduced, thus worsening the spot market quality. ©2016

Wiley Periodicals, Inc. Jrl Fut Mark 37:411–428, 2017

1. INTRODUCTION

In a frictionless market, derivatives trading that provides exposure to the same source of risk as

the underlying asset will not affect the underlying market. When frictions do exist, however,

the trading of even simple derivatives such as index futures may affect the underlying asset’s

market quality. On the positive side, Silber (1985) argues that index futures trading may

induce a low cost for market makers to hedge their inventory risk, thereby narrowing the

spread in the spot market. Grossman and Miller (1988) and Grossman (1989) state that the

index arbitrage between the spot and futures markets may improve spot market depth. Froot

and Perold (1995) build an information model to show that market depth can be increased

through a more rapid dissemination of market-wide information due to the introduction of

index futures. In a more recent study,Banerjee and Graveline (2014) show theoretically that

when an underlying asset is scarce due to market frictions, derivatives trading can reduce

the underlying asset scarcity and alleviate the spot price distortion. On the negative side,

according to informed trader theory (Gorton & Pennacchi, 1993; Subrahmanyam, 1991),

Qian Han is an Associate Professor at Wang Yanan Institute for Studies in Economics (WISE) and School

of Economics, MOE Key Lab of Econometrics and Fujian Key Lab of Statistics, Xiamen University. Han’s

research is supported by the China Natural Science Foundation (CNSF project no. 714437 and key project

no. 71631004). Jufang Liang is an Assistant Professor at Department of Financial Engineering, College of

Finance and Statistics, Hunan University.Liang’s research is supported by the Fundamental Research Funds

for the Central Universities. Wethank participants at the 1st China Derivatives Markets Conference (CDMC)

at Suzhou, and the 2016 China Financial Research Conference(CFRC) at PBC School of Finance, Tsinghua

University for their helpful comments. We thank Yi Hong (discussant), Grace Xin Hu (discussant), Warren

Bailey, Xiaoyan Zhang, Liyuan Cui , Zhonghao Fu and Xuehui He for their valuable suggestions. Comments

from an anonymous referee and Robert I. Webb (editor) are also appreciated. Standard disclaimers apply.

JEL Classification: G13

*Correspondence author,Department of Financial Engineering, College of Finance and Statistics, Hunan

University, 109 Shijiachong Road, Yuelu District, Changsha, Hunan 410079, China. Tel: +86-731-88684772,

Fax: +86-731-88684772, e-mail: ljufang@hnu.edu.cn

Received August 2016; Accepted September 2016

The Journal of Futures Markets, Vol. 37, No.4, 411–428 (2017)

©2016 Wiley Periodicals, Inc.

Published online 9 November 2016 in Wiley Online Library (wileyonlinelibrary.com).

DOI: 10.1002/fut.21825

412 Han and Liang

index futures markets provide market-wide risk exposure with a lower cost than spot markets;

therefore, the introduction of a futures market may draw uninformed traders with well-

diversified portfolios away from a spot market. As a result, the proportion of informed traders

in the spot market increases, which causes market makers to face a higher adverse selection

cost, reducing spot liquidity after the introduction of index futures. Clearly, the effect of

index futures trading on spot market quality is worth empirical tests because theories have

different perspectives and diverge on this important issue.

This article is an empirical test along this line. Existing empirical evidence is limited and

inconclusive. Bessembinder and Seguin (1992) examine the effect of index futures trading

activities on spot market volatility and attribute the reduction of volatility to increased liquid-

ity from futures trading. Roll, Schwartz, and Subrahmanyam, (2007) find that spot market

liquidity and the futures-spot basis can Granger-cause each other. In contrast, Jegadeesh

and Subrahmanyam (1993) test the direct effect of index futures trading on average bid-ask

spreads. They find a 3.7% increase in spread upon the introduction of index futures trad-

ing. However, contrary to informed trading theory, they fail to find a significant increase in

the adverse selection component of the spread. Contradicting results are also found in the

voluminous literature on the relationship between index futures trading and spot market

volatility (see Chen, Han, Li, and Wu (2013) for the latest review).

One important reason for these empirical inconsistencies could be the existence of

confounding factors that may also affect spot market quality upon the introduction of fu-

tures trading. As such, conventional event study methods such as using dummy variables in

a regression model, may not be suitable for such analyses. Another important reason is that

studies using index futures introduction as an event are joint tests of futures market efficiency

and the role of futures trading in spot market quality. As shown in Figlewski (1984), dise-

quilibrium price discounts exist in early index futures trading, possibly due to “unfamiliarity

with the new markets and institutional inertia in developing systems ....” Yang, Yang, and

Zhou (2012) also show that soon after the introduction of Chinese CSI 300 index futures

trading, the futures market did not function well in terms of information transmission and

price discovery.

This article provides additional empirical evidence on the effect of index futures trading

on spot market quality using the 2015 summer Chinese stock market crash as a quasi-

natural experiment. Critics of the role of index futures in the crash argue that the index

futures market serves as a venue of speculative trading and that huge profits are made by

few market “manipulators” or “short sellers” through simultaneously dumping stocks and

accelerating the spot market crash. In late August 2015, under intense social pressure,

the China Financial Futures Exchange (CFFEX) adopted a series of harsh restrictions on

the scale of non-hedging open positions and effectively terminated index futures trading in

China. We consider this event a unique opportunity to re-examine the effect of index futures

trading on spot market quality because previous literature has mainly examined the issue

by looking at the introduction, not the termination, of index futures trading. As the futures

market shifts from a well-functioning state to a nearly full stop, our study avoids the joint

test problem discussed earlier.

To eliminate the effect of confounding factors and to identify the role of futures trading

in market quality,we adopt a difference-in-difference (DID) approach using index component

stocks as the treatment group and non-component stocks as the control group. This is the

same approach as the one used by Harris (1989), Kumar, Sarin, and Shastri (1995), Laatsch

(1991), and, more recently, Xie and Mo (2014). Note that a critical assumption underlying

the DID approach in our context is that investors can not cross-hedge, that is, restrictions

on index futures trading should not affect the trading of non-component stocks. If this

assumption does not hold, then estimates based on the DID approach might be misleading,