China’s stock market crash exposes risks posed by little-known ‘snowball’ derivatives with $30 billion worth of leverage

Snowball products are gaining popularity among investors seeking high-yield assets. As long as the product’s underlying index tracks trades above a predetermined level set in the prospectus, holders are paid a bond-like coupon, typically around 10% annually. However, if the instrument violates a preset level (also known as a knock-in), the holder risks losing the entire principal, as the holder only pays the margin for the full amount of the snowballing instrument.

“Further triggering of knock-ins in these derivative products has now surfaced,” said Zheng Xiaoxia, an analyst at Hua’an Securities. “Due to the relentless decline in stock prices, products associated with the CSI 500 Index and others are exposed to increased liquidity risk.”

As a result, some brokerage firms issuing these products are selling index futures contracts for hedging purposes, negatively impacting the stock market, he added.

Investors say structured products are one of the main reasons for continued losses in the onshore market. Other obstacles holding down stock prices include the absence of more meaningful economic stimulus.

The benchmark CSI 300 index has fallen nearly 5% this year after an unprecedented third consecutive year of losses. The CSI Smallcap 500 and CSI 1000 have both had a worse start to the year than the CSI 300, falling more than 7% and almost 10%, respectively.

The risks associated with rigged products were highlighted by viral screenshots uploaded by confused investors. Leverage Holder has uploaded a notification from the product provider. The notice indicated that the underlying CSI 500 had fallen 25% since purchasing the product, resulting in a loss of the entire investment of RMB 2 million (US$279,000).

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According to Cinda Securities, for every 100 point decline in the CSI 500 index, about 5 billion yuan of products will snowball into the knock-in level, and 10 billion yuan of CSI 1000-related products will reach the knock-in level.

The brokerage firm said that of the 216 billion yuan worth of snowball products, 129.6 billion yuan is related to the CSI500 species, and the rest is related to the CSI1000 species.

Derivatives may also be playing a role in fueling Hong Kong’s worst start to the year since 2016.

The 3.7% decline in the Hang Seng Index on Wednesday, when China released mixed economic data for December, was due to an unwinding of a similar structured product known as a callable bullish-bearish contract (CBBC), according to Crane Funds Advisors. This may be partially explained. Exchange traded fund manager.

CBBC is a leveraged investment that tracks the fundamental performance of assets such as indexes and individual stocks. These are typically issued by investment banks as bullish or bearish contracts, allowing investors to place bullish or bearish bets on the underlying asset.

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“Taking the Hang Seng Index as an example, CBBC providers have to sell futures contracts when a certain level is reached,” according to the Crane Funds report. “In a normal market, this is fine, but if there are no buyers, forced selling will only push the market down, which creates more selling.”

The story highlights the fragility and instability of emerging markets like China, especially when leveraged financial products fuel their ups and downs. During the 2015 boom-bust cycle, the CSI300 index fell more than 40% within three months after regulators began cracking down on over-the-counter margin trading, the practice of buying stocks with borrowed money.

According to Guotai Kunan Futures Exchange, the ripple effect of the unwinding of the snowball product “leads to selling from some investors who were trying to gauge the direction of the market, reinforcing the bearish mood in the market.”