The relentless downturn in China’s stock market is applying significant pressure to approximately $13 billion worth of snowball derivatives, raising concerns about heightened market volatility. Brokerages are increasingly compelled to liquidate hedge positions as structured products tied to the CSI 1000 Index approach levels that could trigger losses at maturity.
About 30 billion yuan ($4.2 billion) of these derivatives linked to the CSI 1000 Index are nearing levels that could result in losses, according to Guotai Junan Futures Co. Additionally, another 60 billion yuan of these derivatives are 5%-10% away from reaching their knock-in thresholds, the brokerage reported.
Snowball derivatives offer bond-like coupons as long as the underlying assets remain within a specified range. Despite being popular among China’s institutional and wealthy investors in recent years, the persistent decline in the stock market has exposed the risk of these derivatives reaching levels that trigger losses.
The ongoing equity slump in 2024 has intensified concerns regarding the risks associated with these securities. Brokerages are holding index futures to hedge the exposure from selling snowballs, and the triggering of knock-in levels has led to the closure of long positions in equity futures, as highlighted by Guotai analysts, including Yu Kan.
China’s CSI 300 benchmark has experienced a 4% decline in 2024, following last year’s 11% slide. The CSI 500 and CSI 1000 indexes, primarily tied to snowballs, closed at their lowest levels since April 2020 and April 2022, respectively.
Similar to autocallables in other markets, snowball investors face losses if the underlying index falls below a predetermined level and fails to rebound. The snowball derivatives market in China has grown to $27 billion, but regulators have implemented measures to prevent their marketing to retail investors as fixed-income products.
Losses from structured notes linked to Chinese stocks have also become a concern in South Korea, where regulators are intensifying efforts to address potential malpractices by brokers.
China International Capital Corp. (CICC) downplays concerns of a spillover effect to Chinese stocks. CICC analysts, including Zhou Xiaoxiao, note that the amount of snowball contracts facing knock-in levels has not increased, even as indicators fell below their previous lows in October.
While an extremely bearish scenario of 200 billion yuan of snowballs hitting knock-in levels within a week could trigger a selloff in futures, CICC suggests that this would represent about 2% of an average week’s turnover. Nonetheless, such an episode could deepen pessimism in the market, warns the brokerage.
Bearish sentiment prevails as market observers see few catalysts for China stocks. Economic data continue to indicate a weak economic recovery, geopolitical tensions persist, and the policy roadmap remains unclear. The market’s weakness is also attributed to selling and redemption pressures by mutual funds.
