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A potential 10% decline in a key Chinese equity benchmark could set off a chain reaction of selling in index futures connected to structured products, heightening risks for the struggling stock market.
Investors could face losses in intricate “snowball” derivatives if a benchmark falls below a designated knock-in level upon maturity. For those linked to the CSI Smallcap 500 Index, the average threshold stands at 4,865, as estimated by China International Capital Corp. As of 9:52 a.m. on Friday, the index was trading near 5,417.
The relentless downtrend in Chinese stocks has highlighted the risks associated with these derivatives. Snowballs, akin to autocallables in other markets, gained popularity in 2021 among institutional and affluent investors in China, growing into a market worth $27 billion. Brokers might rush to unwind hedging positions when the knock-in level is breached.
South Korean investors, who also have a significant stake in structured notes, are exposed to billions of dollars in products tied to the Hang Seng China Enterprises Index that could be at risk.
Snowball notes linked to the CSI 1000 index have an average knock-in barrier of 4,997, according to CICC estimates, which is approximately 14% below Friday’s morning levels.
Chinese stocks have faced a turbulent year, with numerous rounds of policy stimulus failing to halt the market’s decline. Lingering property concerns, geopolitical tensions, and a muted economic outlook have all weighed on sentiment toward China’s assets.
The CSI 500 and CSI 1000, the two most popular underlying indexes for snowball derivatives, have each seen declines of over 7% this year, even after a recent rebound following a mid-year budget expansion. In 2022, both indexes plunged more than 20%.
Regulators have heightened oversight of these exotic derivatives to prevent them from being marketed to retail investors as fixed-income products. The outstanding size of onshore snowball derivatives was 200 billion yuan ($27 billion) at the end of July, according to CICC’s note, based on data from the Securities Association of China.
While any index futures selling triggered by the breach of knock-in levels might impact market sentiment or result in the liquidation of long stock positions, Yu Yingbo, a fund manager at Shenzhen Qianhai United Fortune Fund Management Co. Ltd., believes regulators should be less concerned due to recent tighter oversight. CICC estimates that the impact on the spot stock market from futures selling will be limited, as traders will reduce their positions in a diversified manner, and the volume will be small compared to the total futures market.
