Here is the Hong Kong Stock Exchange Hang Seng China Enterprises Index, recently falling below 8,000—a crucial trigger point for a type of structured product known as an autocallable.
According to a Citigroup analysis, a "substantial amount of autocallables will be knocked in if the HSCEI falls below 8,000. In particular, these knock-in strikes are concentrated below 7,600 and 8,000 and then a larger concentration around 7,300."
The knocking-in of autocallables has the undesirable effect of producing losses for retail investors who bought the products to bet on the direction of Asian stocks and who now face losing a chunk of their principal. It also triggers a potential wave of turmoil at the banks that sold the products.
"The problem really comes about with the hedging of the products, especially around the knock-in as the issuer becomes short vol[atility] at the worst time," Citi says, meaning banks need to buy volatility just as markets are in turmoil, and doing so becomes more expensive.
"Even before then the issuers would need to buy vol as the market goes down and sell it as it goes up ... once the barrier is triggered, issuers would become even shorter vol causing them to bid up puts and skew and resort to selling even more futures as a dirty hedge. In what is likely to be an illiquid market, this would result in significant risk," the analysis adds, producing "tricky trading conditions in the HSCEI and Kospi futures."
Given the potential for autocallables to spread market risk, it's worth wondering (again) why regulators didn't clamp down on such products earlier and to a potentially greater degree. Sales of equity-linked structured notes reached a record 76.9 trillion won ($63 billion) in 2015, though issuance slowed after Korea's Financial Services Commission warned brokers and investors in August of potential concentration in stock exposures. Still, Citi estimates that at least $12 billion of HSCEI-related autocallables—potentially $30 billion—are still outstanding.
And it certainly wasn't as if the market was unaware of the risks. Here, for instance, is the HSCEI against the share prices of Korean brokerages (i.e. autocallable issuers).
"Since April 2015 there has been a 90 percent correlation between the HSCEI and the KOSPSEC index showing how the fate of these two seemingly different securities is inextricably joined together," Citi concludes. "It is unclear which of the brokers have the largest exposure."