BEIJING - China will launch yuan options trading, the government said on Wednesday, a market that will help pave the way for a more flexible exchange rate but will be limited in scope at first.

The move is Beijing's boldest attempt yet to give firms more hedging tools to cope with steady yuan appreciation as well as uncertainties in global currency rates.

"This marks an important step in the development of the yuan derivatives market," said Zhao Xijun, a senior economist at Renmin University of China. "The exchange rate regime will become more market-oriented and the yuan will be more flexible."

The foreign exchange regulator said that onshore options trading will be restricted to firms and banks using it for hedging purposes rather than for speculation about currency fluctuations.

Yuan options are currently tradable in the offshore market, primarily in Hong Kong. Within the mainland, firms have been able to use forward contracts to hedge their foreign exchange exposure.

The State Administration of Foreign Exchange (SAFE) said that the yuan was now sufficiently flexible to merit onshore options. It added that its launch on April 1 would just be the first step in developing an onshore market.

The key purpose for the options is to eventually hand over the function of setting the yuan's exchange rate to the market," said a senior trader at a European bank in Shanghai.

The government keeps the yuan on a very tight leash and has allowed it to rise just 3.5 percent against the dollar since it was de-pegged in mid-2010.

The regulator said that the onshore options would be European-style, meaning that it would only be possible to exercise them when they mature and not beforehand.

A currency option is the right - but not the obligation - to buy or sell a set amount of one currency for another at a predetermined price at a predetermined time in the future.

A key provision in the new rules is that firms will only be permitted to trade call options, not put options, a defensive move that traders said was meant to prevent short-selling and keep the options business confined to genuine hedging.

Along with other restrictions such as strict vetting procedures for banks seeking licenses, traders expect that initial volumes will be low.

"With the yuan exchange rate becoming increasingly flexible, there is greater demand from banks and firms to hedge FX risks through derivative trading. This is the impetus for the launch of options trading," SAFE said.

"In the future, except for the appearance of some special situations, such as a global financial crisis, the yuan exchange rate will become increasingly flexible."

SAFE said at the end of December that it would let more banks sell currency forwards to their clients to further develop demand along with the nascent derivatives market.

It also published new rules at the end of last year classifying forex market makers into a number of categories, clarifying which can handle derivatives such as forwards and swaps, and opening up forex trading to some smaller banks that had not been able to participate before.

The National Association of Financial Market Institutional Investors (NAFMII), an industry association set up under the central bank, also said late last year there were plans to develop more forex-based derivatives to provide more opportunities to hedge risks.

Reuters

(China Daily 02/17/2011 page14)