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Bearish Chinese bets fuel iron ore rout as China's pricing clout grows

A halving in the price of iron ore this year has been fueled in part by Chinese speculators who built up huge short positions on the one-year-old futures contract on the Dalian exchange, in the process giving China the pricing power it has long craved.

As the largest consumer of many commodities from iron ore to gold, China has pushed hard to have a bigger say in pricing. Analysts say its clout on iron ore could become even greater if, as proposed, it lets foreigners including the big producers trade in the Dalian futures.

The contract, launched in October 2013, gave many Chinese investors their first real chance to play in the iron ore futures market, especially as Beijing has kept a tight rein on overseas derivatives trading by state-owned firms since some lost billions of dollars in offshore futures in the global financial crisis from 2008.

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A sharp fall and big volume in Dalian futures, the world's first iron ore futures contract backed by physical delivery, helped drag down global spot prices as well as derivatives on other exchanges as sentiment soured in a market hit by a big supply glut just as China's economy was slowing.

"The more investor-heavy customer base of the Dalian Commodity Exchange has continued to short sell for some time now on Chinese economic concern," said Jamie Pearce, head of SSY Futures Singapore.

Open interest, or open contracts, on the benchmark iron ore contract surged nearly eight-fold from July to more than 1 million lots in November and prices tumbled 25 percent during that period, according to Reuters data.

Volume traded on the bourse reached 67.6 million contracts in its first year to Oct. 17, exchange data showed. In comparison, volume for swaps and swap futures on the Singapore Exchange, the dominant marketplace for swaps, was just above 2 million lots in roughly the same period.

China has about 700 private funds managing about 300 billion yuan ($49 billion), data from fund research firm Z-Ben Advisors shows.

Some of these funds, which invest in commodities futures and equities markets, took huge short positions that led to copper hitting a four-year low in March. Fresh short positions in Shanghai may have helped push it to a 4-1/2-year low this week.

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"Many short positions were built up as a hedging strategy between the equity index and iron ore or rebar (a steel product), which is also new to me," said an iron ore trader in Singapore, adding that the funds had tended to buy equity index futures and short one or two other futures contracts.

Big impact

The Dalian contract was China's third attempt in two years to have more say in pricing iron ore and it has proved more successful than previous efforts involving its own price index and a physical trading platform.

"Futures markets in China are key indicators of sentiment, so daily movements can have a big impact on buying behaviour for iron ore," said a representative for The Steel Index (TSI), one of three providers of global iron ore prices.

Dalian futures affect the pricing of spot cargoes in China, which providers such as TSI compile daily to come up with spot market reference prices. Other price providers are Platts, a unit of McGraw-Hill Financial and which also owns TSI, and Metal Bulletin.

The benchmark indexes of TSI and Metal Bulletin have moved in lock step with Dalian futures, Reuters data showed.

At around $70 a tonne on both TSI and Metal Bulletin's price gauges, iron ore has fallen 47 percent this year. On the Dalian exchange, the benchmark contract has dropped 43 percent.

The indexes are published well after futures trading has finished each day.

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As iron ore's decline deepened in recent months, Dalian futures had got "an increased focus from physical buyers because it's the only real visible intraday price", said Daniel Hynes, senior commodity strategist at Australia and New Zealand Banking Group in Sydney.

To cement Dalian's influence, Chinese authorities may have to let foreign players participate.

"If China wants to be a price maker, clearly they would need producers to support Dalian futures and the contract dollar-denominated to attract international investors," said Hynes.

The Dalian exchange seems to be aware of this.

In a bid to develop a futures product with global pricing power, it said in a recent statement, it "will introduce qualified foreign investors to increase its global influence through bonded delivery of iron ore".