The CSRC Steps In. Now What?
Summary: The strange trading pattern in index futures developed recently hints at selling pressure from unmet margin calls. Traders were shorting futures to hedge. It was a vicious cycle. The new CSRC rules to stop forced liquidation have hit the nail on the head, and will calm the market for now. But margins on small caps are not regulated by the CSRC. The urge to lock in the significant gains in these stocks and the style rotation from small to large caps will still induce market volatility. Beyond the short term, risk taking with leverage underwritten by the state plants seeds for even greater market peril in the future.
New CSRC rules should work for now; but plants seeds for longer-term crisis: The market makes history everyday these days. Just as traders breathed a sigh of relief, it was another epic plunge in the last hour of trading yesterday. Clearly, a rapid decline in margin trading, either from unmet margin calls and thus forced liquidation of margin accounts or from unwinding margin accounts to take profits, has led to the plunge (Focus Chart 1). To stem the free fall, unmet margin calls must be dealt with orderly so as not to create further selling stampede after ten o’clock and two o’clock on a bad day.
The CSRC has unleashed a flurry of new margin policies, including no more forced liquidation of margin accounts, stopping investigation of non-compliant margin lending practice, encouraging brokers to sell bonds to replenish capital and securitize margin loans. It has also lowered transaction fees, after PBoC’s twin cuts of interest rate and RRR. Sovereign money is ready to take the plunge as well. Such moves were only last seen during the 2008 Global Financial Crisis. Back then, similar policies had produced short-term technical reprieves, before the market eventually bottomed at a price that had priced in all bad news.
Market should gradually calm down; continue rotation to large blue chips with low valuation: Over the past few weeks, a strange trading pattern has developed: the market started to plunge after two o’clock, and index futures were heralding the free fall. When forced liquidation was triggered, stocks were limit stopped. For those traders with lower leverage who still had positions, they must sell futures to hedge. Unfortunately, such hedging tactics generated further selling pressure in the market, and conveyed a sense of desperation and panic.
Further, we note the plunge in A500 small-cap index futures has been more dramatic than the A50 large-cap index futures. Small-cap margins are mostly financed by non-brokerage channels and umbrella trusts, and they can buy stocks not stipulated by the CSRC’s list of marginable stocks. Large-cap margins are through brokers monitored by the CSRC. The new CSRC rules to stop forced liquidation will likely calm down the pressure on margin trades. But small caps and ChiNext have more than tripled in the past year and clearly are a bubble. As such, the urge to lock in gains in these stocks is still palpable. The new rules can facilitate a relatively more orderly exit of the small caps positions, compared with the havoc we experienced in the past two weeks when the market was plunging without these rules.
There is a possibility that since the state has shown its hands and underwritten risk taking with leverage, traders would pile back to small caps. We believe that such move will be fleeting, as the financers of margin loans will think twice before lending after the recent dramatic sell-offs, and the urge to lock in the substantial gains should gradually take hold. And money should start to rotate back into large blue chips. Such rotation, when it happens, will continue to induce market volatility.
Beyond the short term, we believe margin call is a necessary risk management mechanism for brokers. The premise of margin trades is that asset prices will rise perpetually. It simply cannot be true. Without proper risk management mechanism in place, brokers will go under when in the future market crisis looms again – just like Lehman.
Focus Chart 1: The fall in margin trades, probably from unmet margin calls, coincides with market plunge.
Hao Hong, CFA