China stocks rout exposes risk from US$30 billion of little-known leveraged ‘snowball’ derivatives

Snowball products have been gaining popularity among investors seeking high-yielding assets. As long as the underlying indices the products track trade above the predetermined level set in the prospectus, holders are paid bond-like coupons, typically around 10 per cent annually. But if the products breach the preset level, also known as knock-in, holders risk losing their entire principal because they only pay the margin on the full value of the snowball products.

“More triggering of knock-in on these derivative products has surfaced now,” said Zheng Xiaoxia, an analyst at Hua An Securities. “The unrelenting pullback in stocks has exposed the products tied to the likes of the CSI 500 Index to an increasing risk of liquidity.”

This has led some brokerages issuing these products to sell index-futures contracts for hedging, causing a negative feedback on the stock market, she added.

The structured products are one of the main reasons for the continuing losses on the onshore markets, according to investors. Other hurdles holding back stocks include the absence of more meaningful stimulus measures.

The benchmark CSI 300 Index has fallen almost 5 per cent this year after an unprecedented run of three straight annual losses. The CSI Smallcap 500 and the CSI 1000 have both made poorer starts to the year than the CSI 300, slumping more than 7 per cent and almost 10 per cent, respectively.

The risks involved with structured products were highlighted by a viral screenshot uploaded by a beleaguered investor. The leverage holder uploaded a notification by the product provider, which showed he had lost his entire 2 million yuan (US$279,000) investment after the underlying CSI 500 had fallen by 25 per cent since he bought the product.

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Every 100-point decline in the CSI 500 puts about 5 billion yuan of snowball products in the knock-in level, and 10 billion yuan for CSI 1000-linked products, according to Cinda Securities.

Of the 216 billion yuan worth of snowball products, 129.6 billion yuan is tied to the CSI 500 and the rest is linked to the CSI 1000, the brokerage said.

Derivatives may also be playing a part in fuelling the Hong Kong market’s worst annual start since 2016.

Unwinding of a similar structured product knowns as callable bull/bear contracts (CBBCs) may partially explain a 3.7 per cent slump in the Hang Seng Index on Wednesday, when China released a mixed bag of December economic data, according to Krane Funds Advisors, a manager of exchange-traded funds.

CBBCs are leveraged investments that track the underlying performance of assets, such as indices or individual stocks. They are issued either as bull or bear contracts usually by investment banks, allowing investors to make bullish or bearish bets on the underlying assets.

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“Using the Hang Seng Index as an example, a CBBC provider must sell their futures contracts when a level is hit,” according to a Krane Funds report. “In a normal market, this is fine, but, with no buyers, the forced selling only pushes the market down, which creates more selling.”

The saga underscores the fragility and volatility of an emerging market like China, particularly when leveraged financial products add fuel to ups and downs. In the 2015 boom-to-bust cycle, the CSI 300 tumbled more than 40 per cent within three months after the regulator began to crack down on over-the-counter margin trading, or buying stocks with borrowed money.

The spillover effect of the snowball products’ unwinding “will lead to selling from some investors who were still trying to figure out the direction of the market, thus intensifying the bearish mood on the market”, according to Guotai Junan Futures.