China Stock Rout Seen Getting Uglier as Derivative Trigger Looms

China Chaos: What Would Stabilize the Markets?
  • Banks need to sell futures used to hedge products, BofA says
  • Hang Seng China Enterprises Index sinks toward key 8,000 level

If Bank of America Corp. is right, Chinese stocks in Hong Kong are poised for a fresh wave of selling.

That’s because the benchmark Hang Seng China Enterprises Index is trading at a level that forces investment banks to pare back their bullish futures positions, according to William Chan, the head of Asia Pacific equity derivatives research at BofA’s Merrill Lynch unit in Hong Kong. The trades, tied to banks’ issuance of structured products, are likely to start unwinding when the index falls through 8,000, a level it breached on a closing basis Thursday for the first time since 2009.

Banks have purchased futures on the gauge of so-called H shares to hedge exposure to structured products that they’ve sold to clients, according to Chan. Many of those products have a “knock-in” feature at the 8,000 level that will spur banks to cut futures positions to maintain the effectiveness of their hedges, he said. Additional pressure points may also come at lower levels, Chan said.

“As the market goes lower from here, the downward move may accelerate,” he said. “There will be a large amount of hedging in futures which dealers need to unwind.”

While the opaque nature of structured products makes it difficult to gauge how much money is riding on any particular level of the Hang Seng China index, Chan came to his conclusion by analyzing regulatory data from South Korea, one of the few countries that publicizes such figures. The nation is among the region’s biggest markets for structured products and there’s a notional value of more than $30 billion from Korea linked to the Hang Seng China measure, according to Chan.

When banks sell the structured products to investors, they take on an exposure that’s similar to purchasing a put option on the index, Chan said. To hedge against the possibility of a rally, the banks buy Hang Seng China index futures. If the stock gauge falls below knock-in levels for the structured products -- the price at which investors begin to lose their principal -- the sensitivity of the bank’s position to index swings gets smaller, and banks respond by selling futures to reduce their hedge. Those sales can filter through to the cash equities market as arbitragers unload shares to keep them closer in line with futures, Chan said.

The Hang Seng China index dropped 2.2 percent to 7,835.64 on Thursday.

Korea Sales

"There will certainly be a build-up of pin risk at given strikes," said Andrew Scott, head of flow strategy and solutions for Asia Pacific at Societe Generale SA in Hong Kong. "But it is clearly very difficult to accurately identify specific key market trigger levels with a great deal of confidence."

In Korea, annual sales of equity-linked structured notes rose to a record 76.9 trillion won ($63 billion) last year despite a slowdown in the second half as Chinese stocks dropped, according to Gyun Jun, Seoul-based head of derivatives research at Samsung Securities Co.

The plunge in H shares prompted Korea’s financial regulator to warn investors in August that their holdings had become too concentrated in notes tied to the index, Jun said, adding that authorities have put a cap on net issuance. The regulator said on Nov. 26 that it expects the outstanding balance of structured notes linked to the Hang Seng China index to decrease this year.

Chinese stocks have extended their tumble in 2016 as the weakest economic growth in a quarter century and a depreciating yuan fueled capital outflows. The Hang Seng China index and the Shanghai Composite Index of mainland shares have both lost more than 18 percent, versus an 11 percent drop in the MSCI All-Country World Index.

On some measures, the H-share gauge looks primed for a rebound. Its relative-strength index, which measures whether gains or losses have been too fast to sustain, fell to 23 on Thursday, a threshold indicating recovery. The stock gauge is valued at 5.9 times estimated earnings for the next 12 months, the lowest level since 2008.

Still, if Chan’s scenario plays out, the market could soon come under pressure. A notional $13.6 billion of structured products linked to the H-share measure will get knocked in between levels of 7,000 and 8,000 on the index, and $16.8 billion between 6,000 and 7,000, he said.

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