(Bloomberg) — The Chinese stock market faces potential risks if a major equity gauge experiences another 10% decline, which could lead to selling in index futures tied to structured products. This development adds fresh challenges to an already slumping stock market.
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Complex “snowball” derivatives, which offer bond-like coupons when underlying assets stay within a specific range, may result in losses for investors if a benchmark falls below a designated knock-in level. For structured products linked to the CSI Smallcap 500 Index, the average knock-in level is estimated to be 4,865, as reported by China International Capital Corp. As of 9:52 a.m. Friday, the gauge was trading around 5,417.
The derivatives, known as snowballs, gained popularity in China during 2021 and have grown into a $27 billion market. However, the ongoing decline in Chinese stocks has highlighted the risks associated with these derivatives. Brokers may rush to liquidate hedging positions once the knock-in level is breached.
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Investors in South Korea, another significant market for structured notes, have also placed billions of dollars’ worth of bets on products tied to the Hang Seng China Enterprises Index, which are susceptible to these risks.
According to CICC estimates, snowball notes with the CSI 1000 as the underlying index have an average knock-in barrier at 4,997, which is approximately 14% below Friday morning levels.
Chinese stocks have faced a turbulent year, with various rounds of policy stimulus failing to stabilize the market. Factors such as persistent property issues, geopolitical tensions, and a subdued economic outlook have all contributed to negative sentiment towards Chinese assets.
The most popular underlying indexes for snowball derivatives, the CSI 500 and CSI 1000, have both experienced over a 7% decline this year, despite a recent rebound following a mid-year budget expansion. In 2022, these indexes plummeted by more than 20% each.
Regulators have increased their oversight on these exotic derivatives to prevent retail investors from considering them as fixed-income products. As of the end of July, the outstanding size of snowball derivatives in China was 200 billion yuan ($27 billion), according to the CICC note, based on data from the Securities Association of China.
“If there is forced selling of index futures, the impact could spill over as the drop in derivatives will hit sentiment or could force closing of long stock positions,” said Yu Yingbo, fund manager at Shenzhen Qianhai United Fortune Fund Management Co. Ltd. However, Yu added that regulators should be less concerned due to stricter oversight in recent years.
CICC estimates that any selling of index futures triggered by breaching knock-in levels will have limited impact on the spot stock market. Traders are expected to reduce positions in a diversified manner, and the volume will be relatively small compared to the total futures market.
(Updates prices throughout)
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