A Crude Step in Chinas Long March toward Futures

By Daniel J. Boyle1

SUMMARY2
The Shanghai International Energy Exchange (INE) plans to launch a Chinese Yuan denominated
crude oil benchmark and futures contract. More than symbolic, this move is part of a longer ark
of government policy aimed at market reform and liberalization, including efforts to
internationalize the currency, to expand competition in the oil and gas sector, and to promote
transparency and reduce corruption. Seen in the context of this larger scheme of interrelated
efforts, long-term success seems as inevitable as Chinas continued rise in global significance and
power. Shorter term, this paper argues that the products anticipated launch in 2016 will expose
participants to market manipulation because it will pitch foreign oil traders against local teapot
refiners into an illiquid and thinly traded market in its early stages.

The two main arguments supported below are:

I. THE LEGAL AUTHORITIES AND REGULATORY REGIME GOVERNING

FUTURES TRADING IN CHINA SUPPORT MARKET DEVELOPMENT,
LONG TERM STABILITY AND RISK MANAGEMENT PRINCIPLES, BUT
II. IN THE SHORT TERM, INES PROPOSED CRUDE OIL FUTURES
CONTRACT WILL BE SUSCEPTIBLE TO MARKET MANIPULATION
DUE TO LACK OF LIQUIDITY AND THE LIKELY INTERACTION
BETWEEN LARGE AND SMALL PHYSICAL PLAYERS.

Susceptibility to manipulation has historically been associated with illiquid markets. As described,
the contracts require physical settlement, so liquidity will not be enhanced by speculators but only
by those hedging or trading around actual physical positions. Among these, Chinas so-called
teapot refiners seek access to crude supplies at the margin that are not controlled or constrained
by their erstwhile oligopoly-dominated domestic competitors, Sinopec, Petro China or CNPC, and

1
The views and comments contained in this paper are those of the author unless noted, but in no instance should
be attributed to any of the authors affiliations. The author is an executive LL.M. student in securities and financial
regulation at the Georgetown Law Center. He received a J.D. from the University of the Pacific McGeorge School
of Law and has been a member of the California Bar since 2010. He holds a Masters in Economics and a Bachelors
in Engineering Administration, both from the University of Delaware. He currently is a strategic planning advisor at
Saudi Aramco. Nothing in the article should be attributed to Saudi Aramcothe author is not responsible for
crude sales, pricing, or trading, and does not serve in the legal department of the company.
2
See infra for an explanation and analysis of the terms of the proposed crude futures contract and for references
which substantiate the facts underlying these two arguments.
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

CNOOC. Those state owned enterprises are only likely to sell into this market to balance their
supply and demand at the margin, and to their own competitive advantage. Beyond supply
diversification, the small refiners will be induced to use the future exchange to avoid currency risk.
These benefits of currency and supply risk mitigation to the smaller long participants could be
offset by large government interests that will dominate the balance of trade in crude supply
agreements, forward and spot markets, and by foreign traders with inherent asymmetric advantages
based on access to supplies and other currency risk mitigation tools. The likely foreign
counterparties to the long teapot refiners will be oil trading companies, who will use the
Exchanges free trade zone to establish local bulk storage and transshipment facilities, who can
hedge their currency exposure independently, and whose access to global supplies provide them
arbitrage opportunities.

Mitigation of these short term trading risks will be the bridge to long term success of the proposed
futures contract. As long as manipulation and attempted manipulation are detected and punished,
liquidity is likely to improve with time and with the development of competitive market dynamics.
In concert with parallel developments that reinforce currency liberalization and the prospect that
the product will allow exchange for physicals and eventually might evolve to cash settlement,3 the
product and the energy exchange are likely to succeed. In this sense, the crude futures contract is
part of a larger plan and typifies Chinas ability to take the long view on its managed economic
evolution. The proposed crude oil futures contract should be viewed in the context of this long
march.

PART I: THE LONG MARCH TOWARD FUTURES

Historical Context
Their troops surrounded and facing an economic blockade, the Red Army made a daring break out
from Jiangxi Province in 1934, shorting its position through a tactical retreat and exercising a real
option of deferring engagements until it could regroup in the north:

Thus was inaugurated the Long March, one of the central heroic sagas in Chinese
Communist history. Prompted by tactical defeats, the march ended as a strategic
victory after the remnants of the Communist forces reached Shaanxi province on
October 20, 1935, having trekked across almost 6,000 miles of hazardous country

3
Naturally China allows cash settlement of its financial futures. See e.g.,
http://www.cffex.com.cn/en_new/sspz/hs300zs/.

DANIEL BOYLE 2
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

in the span of 370 days.4 . . . Summing up the experience in December, 1935, Mao
wrote: The Long March is the first of its kind in the annals of History. It is a
manifesto, a propaganda force, a seeding machine.5
The Long March thus symbolizes the commitment of a people to take an arduous journey to a
better futureto pay a short term price to mitigate an existential risk.

In his book, CHINAS LONG MARCH TOWARD RULE OF LAW, Randall Peerenboom opens by
inviting the reader to put himself in the shoes of Deng Xiou Ping when he assumed the nations
leadership. Emerging in the late 1970s from the twin self-imposed tragedies of the Great Leap
Forward, followed by the Cultural Revolution, Peerenboom frames the situation for us:

The economy is in shambles. The legal system has been destroyed. The Ministry
of Justice was shut down, along with the Procuracy. Only a handful of law schools
ae open, though there are few professors around to teach, and no students. No one
wants to study law. There are only 2,000 lawyers, many of them trained before
1949. You have just ascended to power. What would you do?6
Jokes about lawyers in the U.S. would likely embrace the state of the legal profession, but the
reality of running a modern state, especially the worlds second largest economy on track to
become the largest, requires policies, rules, regulations, and enforcement in order to avoid chaos
and create opportunity. Peerenbooms central theme throughout the book is to contrast what he
terms a thin rule of law with a thick rule of law. Thin rule of law emphasizes formality and
instrumentalitythat laws be general, public, prospective, clear, consistent, capable of being
followed, stable, and enforced. Thick rule of law adds to thin by incorporating the particular
political and social aims and ethos of the society and form of government. While Chinas
governance is based on state centered rule of law, he found that the system was converging toward
a thick rule of law in terms of institutional arrangements and independent development of the legal
system when measured on its own societal terms, but that as ones focus narrows, the more
divergence one finds.7 This natural result echoes the comparative analysis that follows as the paper
considers the proposed crude futures. For instance, gradual expansion of derivatives trading
reflects the long-term view that Chinese leaders take as they navigate between state political

4
Johnathan D. Spence, THE SEARCH FOR MODERN CHINA, 405 (Norton, 1990).
5
Id. at 409.
6
Randall Peerenboom, CHINAS LONG MARCH TOWARD RULE OF LAW, ix (Cambridge University Press, 2002)
7
Id. at 3-20.

DANIEL BOYLE 3
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

control and market liberalization; while the crude oil futures contract diverges from expectations
by not allowing cash settlement, thereby minimizing its price discovery value.

Peerenboom described the status of the rule of law in China more than twenty years after Deng
assumed power. He found impressive advances across an array of institutions, legal frameworks
and infrastructure. Like Peerenboom, this paper fast forwards to the present and invites the reader
to analyze the current state of affairs, here limited to the rapidly emerging futures market in China
and in particular the attempt to create a crude oil benchmark and futures contract. The paper first
sets the stage by describing the immense economic gains over the past few decades and the
economic reform and liberalization processes that lend urgency to the development of the futures
market. After tracing the economic trajectory that gave rise to the need for a vibrant futures
market, the paper reviews legal authorities and regulations that underpin futures trading. It then
describes the proposed crude oil benchmark and futures product. This is followed by a policy
discussion of the product and a comparative legal analysis focused on the issue of the potential
involvement of U.S. persons and concerns over market manipulation. The paper concludes with a
few observations.

Hindsight is a wonderfully clear view. In terms of strategic performance of the economy under
the policies initiated by Deng as the opening-up, and continuing through a succession of five
year plans, more than half a billion people have been lifted from poverty.8 Chinas GDP per capita
in current prices grew from $307.75 in 1980 to $8,280.09 in 2015, an average annual growth rate
of nearly 10 percent.9 The nation has become the worlds second largest economy, the largest
exporter and the largest manufacturer. 10 Retrospective views of why China grew so fast point to:

[T]he potential advantages of backwardness. Under the opening-up policy,

China was able to borrow technology and models for social and economic
institutions from the more advanced countries and thereby innovate and upgrade its
industry at low cost and risk (Lin 2010).
A high initial level of distortions. The Chinese economy of 1978 was heavily
distorted by previous policies that played to the countrys comparative
disadvantages. To achieve its aim of developing large, heavy, and advanced

8
The World Bank and the Development Research Center of the State Council, the Peoples Republic of China, China
2030: Building a Modern, Harmonious, and Creative Society, xxi (2013). available at http://www-
wds.worldbank.org/external/default/WDSContentServer/WDSP/IB/2013/03/27/000350881_20130327163105/Re
ndered/PDF/762990PUB0china0Box374372B00PUBLIC0.pdf
9
International Monetary Fund, World Economic Outlook Database, October 2015.
10
Supra note 8, China 2030, at 5.

DANIEL BOYLE 4
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

industries, the government was forced to protect such activities through various
distortions, including suppressed interest rates, low input prices, and an overvalued
exchange rate (Lin 2010).
A supportive external setting. The global environment for much of this period
(Vincelette and others 2011) and the structural shift to more globalized forms of
industrial production (Yusuf and Nabeshima 2010) both worked in Chinas favor
as it pursued a strategy of opening to the rest of the world. This process included
Chinas accession to the World Trade Organization (WTO) in 2001 and associated
changes in tariffs and other policies, as well as a gradual opening to foreign
investment.11
Looking Ahead

But as 2015 closes, so does the era of Chinas rapid rise. GDP growth has slowed to under 7%,
and the country faces a daunting set of challenges to avoid the so-called middle income trap. 12
Among these are a broad set of political and market reforms, to include currency liberalization, all
the while fulfilling the rising energy needs of the growing economy.

The World Bank views the internationalization of the currency as an important step in the long
march:

The U.S. dollar will likely remain the worlds major international reserve currency,
especially given weaknesses in the Euro Area and Japan. But expansionary
monetary policies in the advanced countries, including the United States, will cause
instability in the international monetary system, and uncertainty in key exchange
rates will add to costs of international monetary and trade transactions. Chinas
growing weight in world trade, the size of its economy, and its role as the worlds
largest creditor will make the internationalization of Chinas renminbi inevitable,
but its acceptance as a major global reserve currency will depend on the pace and
success of financial sector reforms and the opening of its external capital account.13
Internationalizing Chinas currency will bring important long-term benefits for
China. The renminbi is already being used increasingly as the currency for cross-
border settlement. . . . If a substantial portion of Chinas assets and trade were
denominated in renminbi, then fluctuations in the dollar-renminbi exchange rate
would have few implications for domestic stability. But internationalizing the
renminbi requires opening the capital account, and that can be done only after China
has in place a stable financial sector with improved corporate governance in banks
and other financial institutions; well-functioning legal, supervisory, regulatory, and
crisis management frameworks; deep financial markets with credible indirect
monetary controls to manage liquidity; and an exchange rate that is made flexible

11
Id. at 140.
12
Id. at 12.
13
Id. at 7.

DANIEL BOYLE 5
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

over time. The many prerequisites for an open capital account was the main reason
why many European countries took nearly 20 years after the collapse of the Bretton
Woods system to achieve full capital account liberalization. In the case of China,
therefore, a relatively prudent approach, stretching over many years, is
recommended in transitioning safely to a more open and efficient financial and
exchange rate system.14
Currency liberalization goes hand-in-hand with a healthy derivatives market. U.S. regulatory
authorities have actively supported Chinas financial reforms and the development of robust and
sound derivatives and futures markets. In January 2002, the U.S. Commodity Futures Trading
Commission (CFTC) and the China Securities Regulatory Commission (CSRC) entered into a
Memorandum of Understanding Regarding Futures Regulatory Cooperation. The Agreement
covers consultation, information sharing, technical assistance, training, cooperation, and
operations. Delegations and exchanges have taken place since.15 U.S. Treasury officials also
consult with China on a broad range of related issues, including with the central bank, finance
ministry, CBRC, CSRC, and the exchanges themselves.16 Speaking before a CFTC Committee in
2005, Chicago Mercantile Exchange Official, Donohue, observed the need for patience; that he
felt bipolar and schizophrenic talking about China because despite its size and growth, its sort
of Pollyannaish to think that all they need from us is to understand how to successfully develop
derivative products, how to establish the critical market infrastructure for derivative trading, risk
management, and market regulation and supervision because the lessons learned in North
America and Europe point to need for very strong, well structured, well-regulated underlying
cash markets.17

Chinese authorities have responded to these challenges. By 2012, the International Monetary Fund
(IMF) noticed Chinas rise to become the most central economy in global trade, as well as its
development of currency swap lines with central banks and various countries between 2008 and
2012.18 On the currency front alone:

14
Id. at 63.
15
Memorandum of Understanding between the U.S. CFTC and the CSRC, available at
http://www.cftc.gov/idc/groups/public/@internationalaffairs/documents/file/ccsrc02.pdf. See also CFTC Sends
Delegation to China to Provide Technical Assistance to China Securities Regulatory Commission, available at
http://www.cftc.gov/PressRoom/PressReleases/pr5203-06.
16
CFTC, Global Markets Advisory Committee Meeting 31 (January 12, 2005).
17
Id. at 37-38.
18
Samar Maziad and Joong Shik Kang, RMB Internationalization: Onshore/Offshore Links 12, IMF Working Paper
WP/12/133 (May 2012).

DANIEL BOYLE 6
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

As of the end of May 2015, the Peoples Bank of China has signed bilateral
currency swap agreements with 32 central banks or monetary authorities of relevant
countries and regions, with a total size of more than 3.1 trillion Yuan. Use of such
agreements has increased significantly. By the end of 2014, the RMB had been
used in direct trading with currencies such as the euro, the yen, the pound, the
Australian dollar, the Singapore dollar, the Russian ruble, and the Malaysian
ringgit.19
On December 1, 2015, the IMF included China as one of five currencies included in its reserve
basket for Special Drawing Rights. The Fund saw this as an important milestone in the integration
of the Chinese economy into the global financial system. As a freely usable currency, its place
in the reserve basket at over 10% is above the Japanese Yen and the British Pound. 20

As to commodity trading, by the end of 2014, China had established four exchanges (Dalian and
Zhengzhou Commodity Exchanges and the China and Shanghai Financial Futures Exchanges);
participants had traded over two and half billion contracts across 38 commodity futures.
Furthermore, the CSRC announced rules to permit foreign entities access to hedge and speculate.21
While these levels may be small in relative terms to the United States and Europe, they are more
than symbolic and represent the states commitment to continued integration into the world
financial economy. This commitment is supported by an interlocking set of regulatory and legal
authorities, leading to Argument I:

I. THE LEGAL AUTHORITIES AND REGULATORY REGIME

GOVERNING FUTURES TRADING IN CHINA SUPPORT MARKET
DEVELOPMENT, LONG TERM STABILITY AND RISK MANAGEMENT
PRINCIPLES

Peerenboom and Chow remind us that the Rule of Law in China, as opposed to rule by people, is
a work in process. The one party system and parallel institutional structure of the Communist
Party leave observers with questions over the ultimate authority and independence of the
legislative and judicial functions from the executive functions controlled by the party leadership.22

19
International Monetary Fund and Peoples Band of China, Financial Liberalization, Innovation, and Stability
International Experience and Relevance for China 6 (Editors GUA Kai and Alfred Schipke, 2015).
20
See http://www.imf.org/external/pubs/ft/survey/so/2015/NEW120115A.htm.
21
Gary DeWaal, Chinas Futures Markets: The Door Opens Another Crack More, Futures Industry 32 (March 2015).
22
Supra CHINAS LONG MARCH TOWARD RULE OF LAW, note 1. See also Daniel C.K. Chow, THE LEGAL SYSTEM OF THE PEOPLES
REPUBLIC OF CHINA 69 (West Group, 2003) (The real power structure is created through a set of behind-the-scenes
practices and relationships that are embedded in the current political and legal culture of the PRC that are not

DANIEL BOYLE 7
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

Nonetheless, on technocratic matters, the hierarchy of authorities govern the institutional and
regulatory framework. A key factor in Chinas modern economy was the 1982 Constitution and
subsequent Amendments (1988, 1993, 1999, and 2004) which emphasize the authority of law, the
development of the market economy and private sectors.23 The Constitution describes the
ascendency of central level authorities, along with the organs and structure of state power: The
State Council, that is, the Central People's Government, of the People's Republic of China is the
executive body of the supreme organ of state power; it is the supreme organ of State
administration.24 Chow explains that the State Council is more powerful than the National
Peoples Congress (NPC) or the Standing Committee; that it serves as both legislature and
executive, acting as the source for the majority of administrative measures and law bills.25

The Law of the Peoples Republic of China on Securities derives its power from the State Council,
and governs derivatives: The regulatory measures for the issuing and trading of the derivative
varieties of securities shall be formulated by the State Council in adherence to the principles of
this Law.26 The law was effective January 1, 2006 and contains twelve Chapters covering:
General Provisions, Issuing of Securities, Trading of Securities, General Regulations, Listing of
Securities, Continuous Disclosure of Information, Prohibited Trading Activities, Acquisition of
Listed Companies, Stock Exchanges, Securities Companies, Securities Registrar and Clearance
Institutions, Securities Service Institutions, Securities Industry Association, Securities Regulatory
Authority, Legal Liability, and Supplementary Provisions.27 The State Council also promulgated
Order No. 489, Regulation on the Administration of Futures Trading (RAFT) on March 6, 2007,
amended via Order No. 627 on October 24, 2012. That set of regulations contains 87 articles
organized under Eight Chapters: General Provisions, Futures Exchanges, Futures Companies,
Basic Rules of Futures Trading, Associations of the Futures Industry, Legal Liabilities, and
Supplementary Provisions.28 The China Securities Regulatory Commission (CSRC) website

entirely accessible to outsiders. This distinction between an apparent government and legal structure and a real
behind-the scenes power structure is a basic and pervasive feature of the PRC state.)
23
Id. at 75-78. See also http://www.npc.gov.cn/englishnpc/Constitution/node_2825.htm.
24
Id.
25
Supra note 22, Daniel C.K. Chow, THE LEGAL SYSTEM OF THE PEOPLES REPUBLIC OF CHINA 96-101 (West Group, 2003).
26
http://www.npc.gov.cn/englishnpc/Law/2007-12/13/content_1384125.htm.
27
Id.
28
Regulation on the Administration of Futures Trading, China Securities Regulatory Commission, available at
http://www.csrc.gov.cn/pub/csrc_en/laws/rfdm/statelaws/201212/t20121221_219506.html.

DANIEL BOYLE 8
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

provides access to State Laws, Administrative Laws, Judicial Interpretations, Department Rules,
and Self-Regulatory Rules.29 Among the Department Rules of interest are the Interim Measures
for the Administration of Overseas Traders and Overseas Brokers Engagement in the Trading of
Specified Domestic Futures Products effective August 1, 2015.30

The RAFT is the main regulation affecting futures participants. The specific provisions are
diagrammed in Figure 1 below. The RAFT also has provisions governing trading, monitoring,
reporting, clearing and prohibitions against manipulative and abusive practices which are
discussed in more detail below. In 2007, the CSRC issued order number 42 under the Measures
for the Administration of Futures Exchanges, which further elaborates the rules and regulations
surrounding the exchanges in 114 articles organized in eight chapters (General Provisions;
Establishment, Change and Termination; Organizational Structure; Member Management;
General Business Rules; Supervision and Management; Legal Liabilities; and Supplementary
Provisions).31 In addition to the RAFT, each exchange, as well as the Self Regulating
Organization (SRO), the China Futures Association, has their own set of rules and regulations.32

29
http://www.csrc.gov.cn/pub/csrc_en/laws/rfdm/.
30
http://www.csrc.gov.cn/pub/csrc_en/laws/rfdm/DepartmentRules/201506/t20150626_279826.html.
31
http://www.csrc.gov.cn/pub/csrc_en/laws/overRule/Decrees/201507/t20150716_281129.html.
32
See e.g., Articles of Association and Rules of the Shanghai Futures Exchange
http://www.shfe.com.cn/upload/20141210/1418200411012.pdf; Rules and Regulations of the China Financial
Futures Exchange, http://www.cffex.com.cn/en_new/zywd/flfg/; and China Futures Association,
http://eng.cfachina.org/.

DANIEL BOYLE 9
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

These interlocking institutions, laws, rules and regulations demonstrate the level of sophistication
of development of the rule of law around futures trading in China. Around the time Peerenboom
was writing about the development of rule of law in China, the U.S. Congress passed the
Commodity Futures Modernization Act of 2000 (CFMA). The CFMA put forth a set of core
principles for the regulation Derivative Contract Markets (DCMs) and Designated Clearing
Organizations (DCOs).33 Table 1 below was prepared on the basis of principles, and using the
regulatory regime information provided above. Table 1 below compares the 23 core principles for
contract markets under the CEA against Chinese regulations in the RAFT as noted. Combining
Table 1 with the sketch of legal authorities above, along with specific rules and regulations
available at the exchange and SRO websites in China, one can conclude that many steps in the
long march are complete and available for scrutiny and comparison. On the regulatory front at
least, the markets and products appear to embed many of the protections sought by the U.S.
regulatory regime.

33
7 U.S.C. 7.

DANIEL BOYLE 10
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES
TABLE 1
Comparison of Core Principles for Contract Markets under U.S. and Chinese Law
7 U.S.C. 7 Designation of boards of trade as
contract markets34
(d) Core Principles for contract markets
(1) Designating a contract market: core
principles and rules
(2) Compliance with rules (access, terms &
conditions, prohibitions on abuse)
(3) Contracts not readily subject to
manipulation
(4) Prevention of market disruption with
methods of real time monitoring
(5) Position limitations or accountability
(6) Emergency authority (i.e., to liquidate
positions, suspend trade, meet margins)
(7) Availability of general information: terms
& conditions, rules, specifications
(8) Daily publication of trading information
34
Id.
35
Supra note 28 (RAFT).
DANIEL BOYLE
Related provisions under the Chinese
Regulation for the Administration of Futures
Trading (RAFT)35
Articles 4, 5, and 6 restrict futures trading to
places subject to the examination and
approval of the futures regulatory institution
of the State Council . . . in a centralized
manner.
Article 10 lays out the rules required of the
exchange to set up trading and contracts as
well as to supervise and administer its
members. RAFT Chapter VII, articles 65-81
describe a list of prohibited activities and
consequences of violations.
Articles 1 and 3
Article 28
Article 11
Article 12 states that for the occurrence of
any abnormal circumstance [defined later as
manipulation of futures trading prices,
emergencies caused by force majeure and
other circumstances prescribed by the futures
regulatory institution of the State Council] ,
the exchange shall have the power and
procedures to raise margins, adjust price
limits, limit positions, suspend transactions,
and take other measures. Articles 57 and
59 also stipulate emergency intervention
measures.
Articles 33 and 36
Articles 28 and 34
11
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

(9) Execution of transactions in a
competitive, open and efficient manner
(10) Trade information rules and
procedures to prevent violations
(11) Financial integrity of transactions
rules, procedures for FCMs and IBs on
protection of customer funds
(12) Protection of market participants
against abusive practices
(13) Disciplinary procedures
(14) Dispute resolutionADR
(15) Governance Fitness Standards
(Directors and Disciplinary Committees)
(16) Conflicts of Interesthow to
minimize and the process to resolve
(17) Composition of Governing Boards of
contract markets
(18) Record keeping5 years
(19) Antitrustno restraint of trade or
anticompetitive behavior
(20) System safeguardsrisk analysis,
oversight, mitigations, back up plans
(21) Financial resources
(22) Diversity of the Board of Directors
(23) Securities and Exchange Commission
equivalent to swap records for inspection
Articles 10, 27, 39, 47, 60, 67, and 68
Articles 28, 36, 47, 60 and 76
Articles 15-18, 22-23, 25, 29-31, 37-38, 41,
52-53, 60, 65, and 68
Articles 1, 3, 8, 22, 25, 27, 29, 30, 47, 48, 57,
62, 65-67, 69, 70-72, 74-77
Articles 8, 21, 44, 47-48, 51, 56, 63, 65-66,
68-81
Articles 73 and 83; Required under separate
legislation as well36
Articles 7, 9, 10, 19, 20, 24, 45, 54, 67, 69
Articles 10, 14, 17, 19, 67, 68
Articles 7, 8, 10, 26, 46, 84
Perhaps a separate law or in Exchange Rules
Separate National Anti-Monopoly Law
Articles 11-13, 22, 32, 35, 38, 42, 43, 48, 49,
55, 61, 63, 67
Articles 16, 29, 35, 38
Article 26; possibly an exchange rule?
CSRC

In conclusion, China has established the necessary foundational steps to for long term stability and
to accrue the risk management benefits of futures trading. Of course, laws do not prevent
misbehavior of participants, nor do they guarantee the policy and business success of the proposed
crude oil futures product. However, the legal regime surrounding futures appears positioned to
support the policy objectives.

36
See e.g., supra Note 22 (Chow) at 304-308.

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 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

PART II: THE CRUDE STEP

INEs Proposed Crude Oil Benchmark and Futures Contract
As a result of its population and economic growth, China is the worlds largest producer and
consumer of energy.37 In 2014, China became the worlds largest importer of crude oil.38 For a
variety of energy policy, market reform, and currency convertibility reasons, in 2012 China
proposed a new crude oil benchmark based on six Middle east grades and one Chinese grade,
which would be Yuan denominated, and whose futures would trade on the Shanghai Exchange.39
Since then, the launch date and the exchange have changedthe product was expected to launch
in October 2015 by the Shanghai International Energy Exchange (INE), a new exchange in a free
trade zone, funded by Shanghai Futures Exchange and the Shanghai Futures Information
Technology Company.40 Although approved by the banking, customs, and foreign exchange
authorities, the launch was again delayed until next year (2016), possibly related to the issues with
the product itself, recent stock market volatility, and perhaps even anti-corruption investigations
ongoing throughout the industry and its chief regulator, the China Securities Regulatory
Commission (CSRC).41 Even more recently, Platts said the contract had hit a roadblock. The
contract will be further delayed into 2016 because of concerns over adequate liquidity of the
grades, the need to expand the grades beyond the Middle East, and the need for more storage space
in the free trade zone.42

Despite these setbacks, the policy direction and commitment are clear from INEs objectives:

In the principles of internationalization, market-orientation, institutionalization and

specialization, INE will establish an international energy derivatives market
platform in an open, fair and equitable manner to objectively reflect the energy
supply-demand equilibrium of the Asian-Pacific region, make the regional energy
market more effective in the global market system, provide instruments in price

37
U.S. Energy Information Agency, http://www.eia.gov/beta/international/country.cfm?iso=CHN (last viewed on
30 October 2015).
38
Id.
39
Fabian Weber, Eastward Shifting of Oil Markets and the Future of Middle Eastern Benchmarks, The Oxford
Institute for Energy Studies (July 2015).
40
Id. See also http://www.ine.cn/English/aboutus.html (last viewed on 30 October 2015).
41
Chen Aizhu, China oil contract launch to be delayed to next year-sources, Reuters (Nov. 5, 2015), available at
http://www.reuters.com/article/2015/11/05/china-oil-futures-idUSL3N12Y33G20151105 (last viewed on 7
November 2015).
42
Platts, Analysis: Chinas Crude Oil Futures Contract Hits Roadblock, (26 Nov 2015); available at
http://www.platts.com/latest-news/oil/singapore/analysis-chinas-crude-oil-futures-contract-hits-27994512.

DANIEL BOYLE 13
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

discovery, risk management and asset management for the oil industry and global
participants and optimize the allocation of energy resources.43
As of late 2015, the INE website only shows a crude oil futures contract among its products.44 The
product is still under development and the proposed rule set and details are provided for public
consultation. Based on those proposed rules, the contract underlying is a reference synthetic
benchmark of medium and sour crude with 32.0 degree API, and sulfur content by weight of 1.5%,
is Yuan denominated, 100 barrels per lot, for physical delivery only (although there are conflicting
provisions that allow for Exchange for Physicals), with monthly settlement within one year, and
quarterly settlement dates for another two years.45 Trading will cease on the last trading day of
the month preceding delivery, with delivery five days later. A minimum trading margin of 5% is
required, with a minimum price fluctuation of 0.1 RMB per barrel, and a maximum daily price
fluctuation of +/- 4% of the previous day settlement price. Trading will occur from 0900 to 1130
hours, and from 1330 to 1500 hours, Beijing time.46

This proposed contract has been criticized by industry observers due to concerns over potential
manipulation because the state owned oil companies dominate crude importation through a license
system only recently liberalized, the product relies on a new benchmark whose liquidity is
untested, the product blends currency and oil price risk due to its Yuan denomination, the lot sizes
are small (100 barrels), and the margins low (5%).47 These criticisms raise policy concerns and
questions that can only be properly addressed based on a deeper understanding of the contract.

Contract Issues and Analysis

Unlike the Commodity Exchange Act (CEA) in the United States, Chinas Regulation on the
Administration of Futures Trading (hereinafter referred to as RAFT), defines a futures contract:

43
Supra, note 22.
44
http://www.ine.cn/English/products.html (last viewed on 30 October 2015).
45
http://www.ine.cn/English/laws_regulations_rule17.html (last viewed on 30 October 2015). See also infra, note
38.
46
Id.
47
See e.g. Fabian Weber, Eastern Shifting Oil Markets and Future of Middle East Benchmarks, The Oxford Institute
for energy Studies (July 2015); China: INE Contract Faces Obstacles, 4 Argus Global Media Vol. XLV, 37 (25 Sept.
2015); Henning Gloystein, Like it or not, Chinas crude oil futures will be a global benchmark, Reuters Markets (20
Sept. 2015); Reuters, China heads for record crude buying year (19 Oct. 2015)
http://www.cnbc.com/2015/10/19/china-in-record-crude-oil-buying-year-on-teapot-demand-stockpiling.html. For
a detailed discussion of crude oil pricing, the role of benchmarks and price reporting agencies, and the interaction
between physical and financial markets, see Bassam Fattouh, An Anatomy of the Crude Oil Pricing System, The
Oxford Institute for Energy Studies, WPM 40 (2011).

DANIEL BOYLE 14
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

For the purposes of this Regulation, futures contract means a standard contract
uniformly prepared by a futures trading place under which a certain quantity of the
subject matter shall be delivered on a given date at a specified location. Futures
contracts include commodity futures contracts, financial futures contracts and other
futures contracts.48
INEs proposed Standard Crude Oil Futures Contract of the Shanghai International Exchange
defines the underlying as medium and sour crude with benchmark specifications in 100 barrels per
lot contract sizes, with defined delivery dates to designated warehouses.49 The proposed contract
specifically calls for physical delivery. Applying the RAFT definition, the contract meets each
element of subject matter, quantity, date and location of delivery. The title calls it a crude oil
futures contract and it meets the statutory definition.

INEs stand-alone contract explanation only lists physical delivery. This interpretation raises the
issue as to whether the Chinese product is a futures contract or some kind of hybrid, exchange
traded forward contract. A confusing counter indication to the apparent clarity of the contract
description on the INE website, separate rules describing delivery contain a series of articles under
Chapter 3 Exchange of Futures for Physicals.50 There, articles 19-33 describe a process whereby
parties can use standard (exchange cleared) or non-standard (party cleared) warrants to negotiate
a bilateral agreement to exchange obligations under the futures contract. Chapter VIII, Article 82,
of the RAFT contains definitions that also leave room for doubt on whether physical settlement is
strictly required:

(5) delivery means the procedure by which, on the maturity of a futures contract,
both trading parties settle the contract having not yet closed out on the maturity by
transferring the ownership of goods stipulated in the futures contract in accordance
with the rules and procedures of the futures exchange, or settle the difference in
cash at a settlement price as prescribed. [Emphasis added.]51
These provisions create doubts about the nature of the futures contract itself for several reasons.
First, it is not clear if these provisions apply because the contract description only mentions the
physical delivery method. However, this alternative settlement mechanism still requires physical

48
China Securities Regulatory Commission, Regulation on the Administration of Futures Trading, Chapter 1, Article
2.
49
http://www.ine.cn/English/laws_regulations_rule17.html (last viewed on 13 November 2015).
50
http://www.ine.cn/English/laws_regulations_rule16.html (last viewed on 15 November 2015).
51
http://www.csrc.gov.cn/pub/csrc_en/laws/rfdm/statelaws/201212/t20121221_219506.html (last viewed on 5
December 2015).

DANIEL BOYLE 15
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

delivery but appears to allow trading around those positions. In the final analysis, if the product
can only be settled through physical delivery, it has limited speculative appeal because speculative
traders are not likely to control the physical capacity to handle product delivery. Further, as a
hedge for physical participants only, if the product were governed by U.S. regulations, it might be
exempt from a range of swap and futures settlement and clearing rules. However, if the articles
and provisions on EFP do apply, this embedded optionality has characteristics of a forward
contract and could be considered a swap. In the comparative analysis with U.S. rules, that could
invoke rules related to swaps and swap participants in addition to those governing futures.

Because the contract specifically calls for physical delivery, an analysis of the product on that basis
under U.S. definitions creates some ambiguity as to the legal consequences. Under a U.S.
framework, since the CEA does not define the term futures contract, the analysis uses the
elements of contracts for future delivery based on standard contracts to purchase or sell a
commodity in the future: a price determined at the outset of the contract, to obligate each party to
fulfill at the specified price, used to assume or shift price risk, and that may be satisfied by delivery
or offset or trade out. [emphasis added].52

Resolution of the issue depends on whether the use of or in the final element requires the option
to settle by offset, or only allows the option. To paraphrase former U.S. President Bill Clinton, it
depends of what the definition of or is. Under U.S. law, this question is important because the
answer determines the applicable regulatory regime. If exclusive physical delivery were to render
the contract more like a forward contract used solely for hedging purposes, it would be exempt
from jurisdiction of the Commodities Futures Trading Commission (CFTC).53 7 USCS
2(a)(1)(A), which grants the CFTC exclusive jurisdiction over a range of agreements and

52
Peter Y. Malyshev, Class 10, Summary Introduction to OTC Markets, Slide 50 (November 5, 2015). See also
Gracey v. J.P. Morgan Chase & Co. (In re Amaranth Natural Gas Commodities Litig.), 730 F.3d 170, 173-174, 2013
U.S. App. LEXIS 19444, *4-6, 2013 WL 5302678 (2d Cir. N.Y. 2013) (It is the rare case when buyers and sellers
settle their obligations under futures contracts by actually delivering the commodity. Rather, they routinely take a
short or long position in order to speculate on the future price of the commodity. Then, sometime before delivery
is due, they offset or liquidate their positions by entering the market again and purchasing an equal number of
opposite contracts, i.e., a short buys long, a long buys short. In this way their obligations under the original
liquidating contracts offset each other. The difference in price between the original contract and the offsetting
contract determines the amount of money made or lost.)
53
7 USCS 2.

DANIEL BOYLE 16
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

transactions, including transactions involving swaps or contracts of sale of a commodity for future
delivery (including significant price discovery contracts)54

U.S. courts have struggled with these distinctions. In 1982, the Ninth Circuit Court in Commodity
Futures Trading Comm. V. Co Petro Marketing Group, Inc. said [t]he ability to form offsetting
contracts is essential55 to a finding that a contract is a forward contract and excluded from
treatment as a futures contract. Transnor echoed Petro Marketing by pointing out that the
legislative purpose of the exclusion was when the narrow purpose was to facilitate commodity
transactions within the commercial supply chain. If so, the contracts are treated like forwards
and excluded from regulation under the Commodities Exchange Act (CEA).56 However, even
forward contracts are subject to the anti-manipulation provisions of the CEA, per 7 U.S.C. 9, and
anti-fraud and insider trading prohibitions of 7 U.S.C. 13.57

Here, if the contracts are limited to physical delivery, despite their standardized nature and fact
they are to be traded on an exchange in China, they may be excluded under U.S. law because the
only parties likely to trade would be those with exposure to physical crude oil, like refiners. The
ambiguity introduced by the parallel articles describing the Exchange for Physicals (EFP) could
be material in how the CFTC might treat U.S. persons who wish to trade this contract because an
EFP is likely to be interpreted as a SWAP and regulated accordingly. . The paper returns to this
point below as part of a discussion of the contracts policy objectives and prospects.

Policy Discussion and Implications

The RAFT opens with a policy declaration:

Chapter I General Provisions

Article 1 This Regulation is formulated for the purposes of regulating futures
trading, intensifying the supervision and administration over futures trading,
maintaining the futures market order, preventing risks, protecting the legitimate
rights and interests of all parties to futures trading as well as the public interests,
and promoting the vigorous but stable development of the futures market.

54
Id.
55
CFTC v. Co Petro Mktg. Group, 680 F.2d 573, 580 (9th Cir. Cal. 1982).
56
Transnor (Bermuda), Ltd. V. BP North America Petroleum, 738 F. Supp. 1472, 1490 (S.D.N.Y. 1990)
57
7 U.S.C. 9, Prohibition regarding manipulation and false information; and 7 U.S.C. 13, Violations generally;
punishment; costs of prosecution. See also In the Matter of Ecoval Dairy Trade, Inc., 2011 CFTC Lexis 44 (C.F.T.C.
2011).

DANIEL BOYLE 17
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

Article 2 All entities and individuals engaging in futures trading and relevant
activities shall comply with this Regulation.58
In the United States, the CEA is similarly premised but more specific:

5. Findings and purpose59

(a) Findings. The transactions subject to this Act [7 USCS 1 et seq.] are entered
into regularly in interstate and international commerce and are affected with a
national public interest by providing a means for managing and assuming price
risks, discovering prices, or disseminating pricing information through trading in
liquid, fair and financially secure trading facilities.
(b) Purpose. It is the purpose of this Act [7 USCS 1 et seq.] to serve the public
interests described in subsection (a) through a system of effective self-regulation of
trading facilities, clearing systems, market participants and market professionals
under the oversight of the Commission. To foster these public interests, it is further
the purpose of this Act [7 USCS 1 et seq.] to deter and prevent price
manipulation or any other disruptions to market integrity; to ensure the financial
integrity of all transactions subject to this Act [7 USCS 1 et seq.] and the
avoidance of systemic risk; to protect all market participants from fraudulent or
other abusive sales practices and misuses of customer assets; and to promote
responsible innovation and fair competition among boards of trade, other markets
and market participants.
Thus we see a range of policy objectives in promoting and regulating the development of a vibrant
futures market, to include promoting competitive markets, improving market efficiency and
performance through: risk management (hedging); price discovery; and increasing market
liquidity; but also in protecting market participants, mitigating against systemic risk, and avoiding
market manipulation, fraud and abuse. These are all consistent with the argument and conclusions
derived in Part I above.

But the achievement of these policy objectives may be hindered by features of the proposed crude
futures contract and competing policies:

Competition: China adopted an Anti-Monopoly Law in 2007 aimed at eliminating anti-

competitive practices, including dividing the sales market or the raw material procurement

58
http://english.gov.cn/services/investment/2014/08/23/content_281474982978061.htm (last viewed on 13
November 2015).
59
7 USCS 5

DANIEL BOYLE 18
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

market.60 However the energy sector has always enjoyed special state privileges on the
grounds of state security. Refineries are the only purchasers and users of physical crude
oil. In China, there are two dominant state owned oil companies that share over 70% of
the refining market (Sinopec and CNPC/Petro China). The remaining share is split among
a number of independent refineries, called teapots which are often associated with local
governments. In 2015, the government allowed the independents to import crude for the
first time, but with conditions aimed to incentivize them to improve scale and
productivity.61 Most oil is sold through longer-term crude oil sales agreements (COSAs)
which are essentially forward contracts whose price is determined either by a price
benchmark (like the one proposed) and reported by a price reporting agency, or by an
Official Sales Price (OSP) set by the seller, such as those set by many of the Middle East
producers who represent the majority of Chinas oil imports.62 The World Bank cites
Administrative Monopoly as market power artificially created by the government, such
as the mandatory use of import licenses and preferential treatment of local refiners.63 The
concern is that among state control, oligopoly buying practices, and limited volumes
available for physical settlement, the proposed benchmark and futures will not promote
competition without additional sector reform.64 In other words, without the speculative
trade volume, the product will suffer limited liquidity and will not achieve the price
discovery and efficiency objectives.
Physical Settlement: The proposed contract on the INE website calls for physical
settlement as the only delivery mechanism, as noted above. But the benchmark is not an
actual crude sold in the market but a hybrid whose characteristics (32 API, 1.5% sulfur
content) represent the center of gravity of the nations demand. Thus all actually settled
crudes will be referenced to the benchmark, assuming it succeeds. As noted above, this
discussion is made even more confusing based on the ambiguity over whether parties can

60
Anti-monopoly Law of the People's Republic of China, Chapter II, Article 13(3); available at
http://www.china.org.cn/government/laws/2009-02/10/content_17254169.htm (last viewed on 15 November
2015).
61
U.S. Energy Information Agency, China; available at
http://www.eia.gov/beta/international/analysis.cfm?iso=CHN (last viewed on 15 November 2015).
62
See e.g., Bassam Fattouh, An Anatomy of the Crude Oil Pricing System, The Oxford Institute for Energy Studies,
WPM 40 (2011).
63
Supra note 8 at 106.
64
Supra note 41.

DANIEL BOYLE 19
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

negotiate to exchange physicals under Chapter III of the Delivery Rules.65 These features
would only appeal to entities who buy or sell oil and need a hedge against their physical
exposure, or traders who invest in bulk facilities in the free trade zone.
Benchmark Adoption: Successful crude oil benchmarks depend on several things:
liquidity in trading of the underlying crudes, adoption of the benchmark by physical traders,
not being susceptible to manipulation, and accurate and timely reporting by the Price
Reporting Agencies.66 For instance, the Oxford Energy Institute criticized the Dubai
benchmark because of decline[s] in physical production, low trading liquidity,
domination of trading by a few players, and the non-participation of Key oil exporters;
as well as the complex and obscure interaction between the financial and physical layers.67
Indeed, Platts plans to add new crudes to its Dubai price marker to address dominance by
Chinese energy traders.68 This is in part a response to puzzling market behavior which
threw the market into backwardation in September even while other benchmarks remained
in Contangofueling speculation that the trading arms of the two large Chinese state
owned oil companies, Unipec and Chinaoil, were using their buying power to shift margins
between their upstream and downstream activities.69 Whether the proposed benchmark
serves to overcome these anomalies or suffer their repetition remains to be seen, but as
noted above, the contracts introduction has been delayed over concerns with liquidity and
physical storage capacity.
Target Market: Local refiners, especially the small ones, are likely to use the product as
a hedge. Larger refiners have more complex balance sheets and income statements with
global exposure, and although the product may help them hedge their net positions, it will
have to compete with a wide range of derivatives available to them through their
international operations and affiliates. The product is being offered to overseas participants
under a set of qualifying rules, and that may induce foreign traders to enter by investing in
bulk storage and processing facilities. Existing foreign importers and those with equity in

65
Supra note 50.
66
Supra notes 39 and 62.
67
Bassam Fattouh, The Dubai Benchmark and Its Role in the International Oil Pricing System, The Oxford Institute
for Energy Studies (March 2012).
68
Reuters, Platts to add new Mideast crudes to Dubai price marker in 2016, (17 Nov 2015).
69
Paul Tosetti, Dubai oil markers unusual behavior: Dubais frequent backwardation puzzles market, IHS Energy,
Global Crude Oil Markets (16 Sept 2015).

DANIEL BOYLE 20
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

Chinese refineries have COSAs and other tools to hedge their exposure. In the end, since
the product is priced in Yuan, it may be more about the currency risk than pure product
exposure, as noted next.
Currency Risk Internationalization of the RMB: Chinas longer-term ambition to
internationalize their currency have gone hand-in-hand with the development of
commodity trading and futures markets, and this product, denominated in Yuan, is clearly
a step in that long march. That said, the gradually adjusted peg is still in place, and between
volatility of crude prices and the possible peg movement, one can easily envision a situation
where arbitrage opportunities open up for traders due to the +/- 4% daily cap on price
movement, a level that has been exceeded in recent months as crude oil has suffered large
price swings over the past 18 months. If successful, this product will open up Yuan based
trade, and that will help with currency price discovery. However, if the government
decided to either float the Yuan, or even liberalize the band more dramatically, this product
could be seen as either a great hedge, or as an opportunity for regulatory arbitrage due to
the daily price movement limits. Meanwhile pre-float position holders could see dramatic
changes in the value of their positions if the Chinese government decides to float the
currency.
Ongoing Corruption Eradication Campaign: Chinas campaign to eradicate corruption
has focused on several large State Owned Enterprises (SOEs), and in particular, on the
major oil companies.70 In fact, Reuters has speculated that among the reasons the product
launch has been delayed is related to corruption investigations of CSRC officials. Speaking
to a group of Aramco officials in mid-November 2015 just after a recent trip to China,
Daniel Yergin, Pulitzer Prize winning author of THE PRIZE and considered one of the
worlds leading oil market experts, commented that corruption investigations are delaying
currency liberalization and the introduction of the new crude benchmark.71 The
anticorruption campaigns reach into high level officials and prominent state institutions
illustrate the tension between thin and thick rule of law, and Chinas gradual evolution

70
Jamil Anderlini, China corruption purge snares 115 SOE tigers, Financial Times (May 18, 2015), available at
http://www.ft.com/intl/cms/s/0/ad997d5c-fd3c-11e4-9e96-00144feabdc0.html#axzz3rfafRjll (last viewed 16
November 2015).
71
Remarks by Daniel C. Yergin to a group of executives and corporate planners at Saudi Aramco on 12 November
2015.

DANIEL BOYLE 21
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

toward the latter. At the same time, the ubiquitous presence of corruption, including at
regulatory authorities themselves, undermine confidence that mere regulations can prevent
abusive market practices and market manipulation, since these may be condoned by corrupt
officials with inside information.
Extraterritoriality vs. Sovereignty: Cross border cooperation could be seen as an
opportunity to enhance enforcement of the protective provisions of commodity trading
regulations both in China and outside. This would enhance the stability, safety and
soundness of the global financial system by reducing systemic risk. Despite the assumption
against extraterritoriality under U.S. Supreme Court decisions, U.S. efforts to apply its law
and regulations in other jurisdictions on economic issues like antitrust create conflicts with
other nations.72 Post Morrison,73 the Dodd Frank Act applies the CEA to swap activities
outside the United States where they have a direct and significant connection with
activities in, or effect on, commerce in the United States, or contravene such rules or
regulation as the Commission may prescribe or promulgate as are necessary or appropriate
to prevent the evasion of any provision of this Chapter . . . Coupled with the CFTC Cross
Border Guidance, this application of the doctrine of extraterritoriality has created a
regulatory storm.74 Especially when viewed in light of the geopolitical tensions and
relationship between the U.S. and China as strategic adversaries, this extraterritoriality flies
in the face of national sovereignty and pride. The notion that Chinese authorities would
agree that Chinese persons under their jurisdiction, conceivably including state owned
enterprises or banks, would be subject to U.S. registration and rules is difficult to imagine.
In fact, the situation could easily be spun into an irreconcilable conflict of laws and the
invocation of immunity doctrines.75 However, such a hypothetical analysis is beyond the
scope of this paper.

72
Malcolm N. Shaw, INTERNATIONAL LAW 688-696 (Cambridge 6th ed. 2008).
73
Morrison v. National Australian Bank, 561 U.S. 247 (2010) (holding that there is a presumption against
extraterritoriality in U.S. legislation unless explicit, and establishing restrictive rules for the application of Rule 10b-
5 of the Exchange Act only in connection with the purchase or sale of a security listed on an American stock
exchange, and the purchase and sale of any other security in the United States.) Dodd Franks provisions were a
response to that decision. See infra note 58 at 728.
74
Ronald H. Filler and Jerry W. Markham, REGULATION OF DERIVATIVE FINANCIAL INSTRUMENTS (SWAPS, OPTIONS AND
FUTURES): CASES AND MATERIALS, 735 (West 2014). (Citing Section 722 of the Dodd Frank Act adding section 2(i) to the
CEA, codified as 7 U.S.C. 2(i)).
75
Supra Shaw, note 72 at 697-750.

DANIEL BOYLE 22
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

U.S. Regulatory Perspective

The proposed crude oil futures on INE is available for overseas participation under its own set of
rules; requiring registration and demonstration of compliance with financial and fitness rules as
well as ongoing reporting compliance.76 Assuming arguendo that the geopolitical concerns and
tensions between extraterritoriality and sovereignty were not at play, and that the product when
launched would appeal to U.S. persons, the issue would be how the exchange or its associated
FCMs could reach and contract with the U.S. persons.

A direct access path for U.S. based FCMs is through registration of the Shanghai International
Energy Exchange (INE) as a Foreign Board of Trade with the CFTC. Direct access to trades on
the foreign exchange requires the Foreign Board of Trade to register. The CFTC published the
eligibility standards in 2011:

(b) Foreign board of trade eligible to be registered. A foreign board of trade eligible
to be registered means a foreign board of trade that satisfies the requirements for
registration specified in 48.7 and:
(1) Possesses the attributes of an established, organized exchange,
(2) Adheres to appropriate rules prohibiting abusive trading practices,
(3) Enforces appropriate rules to maintain market and financial integrity,
(4) Has been authorized by a regulatory process that examines customer and market
protections, and
(5) Is subject to continued oversight by a regulator that has power to intervene in
the market and the authority to share information with the Commission.77

The CFTC website has no indication this has happened, nor were the industry experts gathered in
Baltimore in April aware of such registration.78 An alternative would be for the Board to petition
for a no action relief letter, or for FCMs who are linked to INE to petition for exemptive relief
pursuant to CFTC Regulation 30.10. In either case, the application contains a specific set of
requirements and documentation that serve to demonstrate that the regulatory regime in its home
country is comparable to the U.S. regulatory regime.79 The CFTC seeks information from

76
http://www.ine.cn/English/laws_regulations_rule8.html.
77
17 CFR 48.2
78
2015 FIA Law & Compliance Division Annual Program, Master Answer Sheet: CRF (Compliance Rapid Fire)
Baltimore 97-98 (April 29, 2015)
79
U.S. C.F.T.C., Petitions for Exemptive Relief Pursuant to CFTC Regulation 30.10DCIO Information and Guidance
on Materials Required and Questions to Be Answered by Petitioners, Division of Clearing and Intermediary
Oversight.

DANIEL BOYLE 23
 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

applicants on the regulatory system governing the exchange, and for applicants to address specific
areas of concern, such as: (1) the qualifications of participants; (2) the minimum financial
requirements for FCMs to include risk-based capital and adjusted net capital for early warning; (3)
Provisions for safeguarding of customer funds; (4) Recordkeeping, reporting and notification; (5)
Sales practice standards; (6) Compliance; and (7) Information Sharing.80

Aside from the pride and sovereignty considerations, since the proposed crude oil futures contract
is not yet official and hence is not yet trading, it would be premature to attempt to compile a full
set of answers to these queries. For instance, questions over physical delivery provisions and the
Exchange for Physicals need clarification. As noted above, the introduction has been delayed and
is now expected in mid-2016.81 Nonetheless, given the momentum and history behind the
development of this product, the comparative legal analysis based on principles provided above
illustrates that if the INE were to apply for U.S. exemption, it would be able to demonstrate parallel
governance regulations, institutions, practices and procedures.82

The INE exchange is open to foreign participants that meet defined qualifications, become licensed
and subject to supervision.83 As to U.S. jurisdiction, even without foreign board approval or
exemption, U.S. persons could participate through intermediaries. From a business perspective,
the allure of participation in small lot sizes with physical delivery required would suit oil trading
companies that are accustomed to establishing terminals, bulk storage and transfer facilities. Many
companies base their business model profitably around these operations, such as Glencore, Vitol,
Shell Trading and others.84 Unlike large oil producers who prefer to sell through long-term crude
sales agreements and forward contracts, trading companies are likely to find the proposed contract
attractive as a hedging and arbitrage opportunity to expand their sales in China and to provide
regional storage and arbitrage opportunities throughout Asia. Whether or not the large domestic
State Owned Enterprises who dominate the China market for crude (Sinopec and CNOOC and

80
Id.
81
Supra note 42.
82
17 C.F.R. Part 30 contains the rules surrounding U.S Persons trading futures on a non-U.S. Exchange.
83
INE Rules, Overseas Special Participants Management Rules of the Shanghai International Energy Exchange (for
Public Consultation); available at http://www.ine.cn/English/laws_regulations_rule8.html (last viewed on 28
November 2015).
84
See e.g., http://www.glencore.com/who-we-are/what-we-do/energy-products/; http://www.vitol.com/;
http://www.shell.com/global/products-services/solutions-for-businesses/shipping-trading/about-shell-
trading.html.

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 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

Petro China) decide to participate at the margin remains to be seen, but will likely depend on their
need to balance the supply and demand requirements of their own refineries. This participation
may be accompanied by anticompetitive behavior due to their market power. In terms of liquidity,
industry observers have questioned whether the product and its associated proposed benchmark
can succeed, especially without the added price discovery value of speculative traders.85 For these
reasons and due to the asymmetric information between domestic refiners and their demand needs
and that of foreign traders and their access to alternate crude sources, argument II concludes:

II. IN THE SHORT TERM, INES PROPOSED CRUDE OIL FUTURES

CONTRACT WILL BE SUSCEPTIBLE TO MARKET MANIPULATION
DUE TO LACK OF LIQUIDITY AND THE LIKELY INTERACTION
BETWEEN LARGE AND SMALL PHYSICAL PLAYERS

Like other commodities, crude oil pricing involves the interaction of physical and financial layers
based on reference prices known as benchmarks. The current basis of crude oil pricing is formula
pricing referenced to the key oil benchmarks such as West Texas Intermediate (WTI), Brent, and
Dubai-Oman. The benchmarks are used by physically long and short participants to price long
term forward contracts and for spot transactions; exchanges use them for futures cash settlements;
banks, swap dealers and companies use them for settlement of swaps; governments use them for
tax determination. When there is limited production of the benchmark crude, the price reporting
agencies do not have sufficient information about arms-length deals to accurately assess prices,
leading to an increased exposure to squeezes and market distortions.86 Benchmarks are
constructed as blends of several physical crude streams to increase the underlying physical
production and thereby enhance the price discovery process. Actual crudes are then referenced to
the benchmark via price differentials, which themselves are traded to help participants manage
their risk exposure to time, location, and grade.87

The key to market efficiency is proper pricing signals. Accurate reporting of spot transactions is
required to price the closing of expiring futures contracts, and these in turn are used to price open
futures based on their future dates of settlement. In some forward and swap contracts, the futures
prices are used to settle the price term giving the system a circular nature and providing physical

85
Supra notes 41, 42, 47, 62, and 69.
86
Supra note 62 at 7 (Fattouh, Anatomy of Crude Oil Pricing); note 67.
87
Id. at 9.

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traders who have a combination of long and short exposure (i.e., most of the oil producers who
own refineries, or traders who have physical capacity for blending and storage), the incentive to
manipulate trading to their advantage.88 In the complex interaction in crude markets between the
physical layers related to volume, timing, location, and grade, and the financial layers of forward
contracts, futures, and swaps across the various benchmarks and differentials, susceptibility to
manipulation is high if narrow closing windows are used, such as the Platts Market on Close
(MOC) methodology, because there is insufficient liquidity and potential domination by one party
or another.89

U.S. case law and enforcement actions confirm these concerns over potential manipulation. For
instance, in 2006 the CFTC filed an enforcement action against Shell Trading US Company
("STUSCO"), Shell International Trading and Shipping Co. ("STASCO"), and an executive for
violating Section 4c(a) of the Commodity Exchange Act, as amended (the "Act"), 7 U.S.C.
6c(a)(2002), and Commission Regulation 1.38(a), 17 C.F.R. 1.38(a).90 The companies were
charged with pre arranging quantities and delivery months on at least five occasions over several
months and then clearing the pre-arranged deals on the exchange, thereby creating fictitious trades.
The Commission cited various authorities to sustain the position that this behavior was
anticompetitive and a violation of the Commodity Exchange Act, including Harold Collins, [b]y
determining trade information such as price and quantity outside the pit, and then using the market
mechanism to shield the private nature of the bargain from public scrutiny, both price competition
and market risk are eliminated.91

While the INE contract has not yet been traded, similar circumstances can be foreseen, where a
Chinese refiner in one region could either set terms with an importing trader or with one of the
Chinese producers of crude off-line and then clear the deal through the futures exchange to
artificially affect prices. Chinese regulatory authorities and data tracking software will need to be
alert to these possibilities. The RAFT and Exchange Rules call for prompt reporting of trading

88
Id. at 40-50 (discussing the interaction between Brent forward and futures contracts, and the exchange for
physicals to connect the actual crude traded in physical contracts to the reference benchmark Brent).
89
Id. at 30-35.
90
In the Matter of SHELL TRADING US COMPANY, SHELL INTERNATIONAL TRADING AND SHIPPING CO., and NIGEL
CATTERALL, Commodity Futures Trading Commission, January 04, 2006, CFTC Docket 06-02 (2006 CFTC LEXIS 2;
Comm. Fut. L. Rep. (CCH) P30,161).
91
Id.

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information. Moreover, the rules on insider trading under article 70 are stricter than those
governing commodity trading in the U.S. and are similar to those for securities insider trading:

Article 70 For an insider of the inside information about futures trading or person
who illegally obtains the inside information about futures trading, prior to the
publicity of the information which may considerably affect the futures trading
price, if he conducts futures trading by taking advantage of the inside information,
or if he divulges the inside information to any other person so that such person
conducts futures trading by taking advantage of the inside information, the illegal
gains shall be confiscated and he shall be concurrently fined not less than one time
but not more than 5 times the illegal gains. If there are no illegal gains or if the
amount of illegal gains is less than 100, 000 yuan, he shall be fined not less than
100, 000 yuan but not more than 500, 000 yuan. Where an entity conducts any
inside transaction, the directly liable person-in-charge and other directly liable
persons shall be given a warning and fined not less than 30, 000 yuan but not more
than 300, 000 yuan.
Where any of the personnel of the futures regulatory institution of the State Council,
or of a futures exchange, or of an institution monitoring the safe custody of futures
margin conducts any inside transaction, he shall be given a heavier punishment.92
In the sense of collusion based on insider trading, Article 70 would prevent traders aware of a
refinery shut down or other event from trading on that information, whereas the U.S. considers
asymmetric information surrounding commodity supply and demand to be the nature of market
participation and not illegal. These stricter Chinese rules may provide regulators there with an
additional tool to prevent collusive trades, but their detection and monitoring are just as difficult.

BP was able to have a claim against them for market manipulation dismissed for failure to plead
fraud with particularity under Federal Rules of Civil Procedure, Rules 9(b) and 12(b)(6). There,
the court explained the dependence of the over-the-counter (OTC) forward contracts on the prices
of NYMEX traded futures contracts.93 Plaintiffs alleged seven methods of market manipulation
involving noncommercial behavior in leveraging their storage and pipeline facilities and masking
transactions through conspiring market participants to bid up the market and squeeze the market
in order to inflate the crude oil futures market.94 The court there explained the elements of market
manipulation under section 9(a) of the Commodity Exchange Act (CEA) as (1) the defendant
possessed an ability to influence market prices; (2) an artificial price existed; (3) the defendant

92
http://www.csrc.gov.cn/pub/csrc_en/laws/rfdm/statelaws/201212/t20121221_219506.html (last viewed on 5
December 2015).
93
In re Crude Oil Commodity Litig., 2007 U.S. Dist. LEXIS 47902; 2007 WL 1946553 (S.D.N.Y., June 28, 2007).
94
Id. at 3.

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 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

caused the artificial price; and (4) the defendant specifically intended to cause the artificial
price.95 The courts finding that the plaintiffs theory of market manipulation [was] insufficient
in specificity and detail to establish a strong inference of fraudulent behavior that caused the
market manipulation96 was in the context of a private claim of action, but illustrates the need for
data to show the price was artificial and that the defendant actor had the ability and intent, and did
indeed cause the artificial price.

Chinese rules address market manipulation issues in Article 71:

Article 71 Where any entity or individual commits any of the following acts
manipulating the futures trading prices, it shall be ordered to make a correction,
have its (his) illegal gains confiscated, and be concurrently fined not less than one
time but not more than five times the illegal gains. If there are no illegal gains or if
the amount of the illegal gains is less than 200, 000 yuan, it (he) shall be fined not
less than 200, 000 yuan but not more than 1 million yuan:
(1)Manipulating fixtures trading prices individually or in collusion by buying and
selling futures contracts by jointly or successively taking advantage of funds or
positions it holds or by taking its advantage in information;
(2)Deliberately colluding with another party to conduct futures transactions with
each other at a time, at a price and in a method agreed upon in advance so as to
influence the futures trading prices or the fixtures trading volume;
(3)Using oneself as the trading party, acting as the buyer and seller simultaneously
so as to influence the futures trading prices or the futures trading volume;
(4)Hoarding goods in order to influence futures market prices; or
(5)Committing other acts manipulating fixtures trading prices as prescribed by the
futures regulatory institution of the State Council.
Where an entity or individual commits any of the acts as specified in the preceding
paragraph, the directly liable person-in-charge and other directly liable persons
shall be given a disciplinary sanction and fined not less than 10,000 yuan but not
more than 100,000 yuan.97
Here, if the INE product does become dominated by foreign traders who create physical bulk
storage and transport facilities and use those to trade with smaller local players, they will possess
the ability to influence market prices and would have financial incentive to cause them. The recent
decision to postpone the contract introduction over liquidity and storage concerns illustrate that

95
Id. at 4.
96
Id. at 6-7.
97
Supra note 92.

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 A CRUDE STEP IN CHINAS LONG MARCH TOWARD FUTURES

these issues are not just hypothetical. What remains to be seen is how the Chinese regulations and
rules would be applied in different circumstances, and whether the authorities will be looking for
patterns in the data to infer such behavior and act to prevent it.

In re Crude Oil Commodity Futures Litig., a case involving a group of companies that traded in
futures contracts and calendar spreads brought a private claim of action against a group of
companies that held both physical and futures contracts in crude oil, plaintiffs claimed violations
of the CEA for price manipulation, and violations of the Sherman Act for monopolization.98 The
complaint survived a motion to dismiss based on allegations that defendants used a four step
manipulation scheme to exacerbate and profit from tightness in WTI supply.99 In essence the
scheme was about defendants leveraging a dominant market share in physical positions to create
the appearance of scarcity which impacted prices in the futures market. Defendants used a
combination of short and long positions in calendar spreads to drive the market from contango to
backwardation and profit from their actions. Plaintiffs claimed the defendants netted some $35
million through the manipulative scheme.100 In denying the motion to dismiss, the court cited
CFTC v. Parnon, a related action, where that court found it plausible that the calendar spread
prices did not reflect the basic forces of supply and demand when the complaint alleged that the
defendants conduct caused an abrupt shift from contango to backwardation. The court found that
plaintiffs allegations (taken as true under the standard of review for a motion to dismiss) that
defendant had intentionally acquired a 92% share of the next months deliverable supply in order
to cause the shift were neither bare nor conclusory.101

Under the proposed contract it is imaginable that similar fact patterns could arise in China. An
exercise in hypotheticals based on imagined specifics and an attempt to apply a Chinese rule set
against those would be of limited value. However the speculation surrounding manipulation of
the Dubai crude marker describe above highlights the importance of vigilance, and to the extent
the market perceives that such manipulation can occur, participants are likely to avoid purchasing
the futures contracts. In the short run this will exacerbate the problems of liquidity. Until the

98
In re Crude Oil Commodity Futures Litig., 913 F.Supp. 2d 41 (2012).
99
Id. at 49.
100
Id. at 49-50.
101
Id. at 52.

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authorities can demonstrate their ability to detect, deter and prevent manipulation, the product will
suffer.

Conclusions

For 300 years up until the Industrial Revolution, China had the largest economy in the world. 102
Its civilization spans 5,000 years and it has proven itself resilient and innovative over the past
several decades. That said, as CME official Donohue said at the CFTC hearing in 2005, one feels
bipolar and schizophrenic whenever talking about China. Peerenboom spoke to this duality of
thick versus thin rule of law. While admiring the progress in the legal system from 1978 to 2002,
he always knew that there were party apparatchiks behind the scenes, leaving the question of
whether the system had evolved to rule by law or by people. We are still faced with the same
conundrum today as we witness a party leadership that appears bent on eliminating corruption and
managing a massive economic transition, but without losing its monopoly grip on power.

The advanced development of futures contracts and exchanges are evidence of progress in
institutional reforms and integration. The Word Bank and others have pointed to considerable
remaining work to do, especially on improving the legal framework, enforcement of laws and
regulations, upgrading financial infrastructure, and imposing stringent rules on information
disclosure.103 The Bank went on to point out that Chinas integration in the international
financial system and the internationalization of the renminbi will put pressure on China to improve
its regulation and supervision. The government needs to seek institutional reforms to secure the
political independence of regulatory bodies to enable them to conduct arms-length regulation and
supervision, regardless whether it would remain the owner of financial institutions.104

So the progress over the past decade may represent crude steps in the long march indeed
however, when it comes to the futures market development at least, we are reminded of the ancient
Chinese proverb that a journey of a thousand miles begins with the first step.105 The steps taken
to date appear strong. Forged with Chinese patience and diligence, they will eventually be refined
into the instruments of market liberalization the economy needs to reach higher levels of

102
Supra note 8 at 3 (China 2030).
103
Supra note 8 at 120.
104
Id. at 121.
105
Or from my limited Chinese from living in Taiwan many years ago, Hao de kai shi, jiu shi cheng gong de yi ban
which means a good start takes one half way to success.

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performance. But as a colleague who is a strategist once advised when connecting long run plans
to short term actions, the long run is a succession of short runs. So for the INE crude futures
contract to succeed in the long run, it must address short run concerns over market manipulation.
If it does not, the product could fail and the reputation effects could deter others from attempting
to create a similar product in country. If they succeed, the contract is likely to evolve and grow
stronger over time, encouraging increased global participation.

DANIEL BOYLE 31