The Shanghai Stock Exchange has applied to the China Securities Regulatory Commission (CSRC) for approval to launch the nation's first exchange-traded fund. Exchange officials say they hope to launch an ETF based on its recent Shanghai180 Index by the end of this year.

The move is part of the exchange's broad programme to broaden its product offerings and increase trading volumes. It also hopes to attract foreign portfolio investors as part of China's emerging qualified foreign institutional investors scheme. Says one exchange official: "Foreign investors aren't familiar with Chinese stocks, and may want to invest in an ETF initially."

The exchange has been studying how an ETF might work in China for over a year. It now believes it has the capacity to create one, despite the lack of a futures market. Contrary to conventional wisdom, a Chinese ETF may be easier to launch than derivatives: an experiment in dealing interest-rate futures ended in flames with the destruction of Shanghai International Securities in 1995, an incident that regulators are not going to forget.

The exchange requires cooperation from brokers, fund managers, the China Securities Depositary Clearing Corporation and, most important, the Chinese Securities Regulatory Commission (CSRC).

ETFs are units of a basket of securities representing an index that trade on an exchange like a stock, in which units are subscribed and redeemed in kind, not in cash. The ETF's price must reflect the NAV of the underlying index, which is accomplished by arbitrage involving short selling or futures trading - which are banned in China. Moreover, there are no regulations permitting swapping baskets of securities for ETF units. The Shanghai Stock Exchange's lobbying the CSRC to make the necessary changes hit a lull amid the country's leadership changes, which saw chairman Zhou Xiaochuan depart from the CSRC for the central bank. But that effort may intensify now that Shang Fulin has taken charge at the CSRC.

To get around the lack of futures, the exchange will have to use the cash markets, in which arbitrageurs could buy an ETF, swap it for the underlying basket of constituent stocks and then sell the basket in the same day. Outsiders familiar with the idea say it is feasible, if the CSRC amends certain rules to allow same-day trades, but are sceptical because it is costly. ETFs are supposed to be cheap.

There are other hurdles the exchange must overcome. ETFs are a type of fund, and all funds require at least 20% be held in bonds. This could complicate the notion of the underlying basket. Second, fund management companies are restricted from owning more than 10% of any stock, so they will need better risk management systems to avoid breaching the rule when trading ETFs. Third, many stocks in the index are illiquid, so creating optimized baskets won't be easy.

The Shanghai Stock Exchange may be able to successfully launch an ETF, but it is not going to look much like Hong Kong's Tracker Fund.