As outlined earlier today, Chinese equities re-plunged on Wednesday, retracing Tuesday’s bounce and returning stocks to their post-PBoC crash levels, hit on Monday after a desperation dual rate cut failed to trump margin jitters and ATM lines in Greece.
As tipped in “The Biggest Threat To Chinese Stocks: Shadow Lending Crackdown”, margin trading above and beyond officially sanctioned broker limits has likely added somewhere between CNY500 billion and CNY1 trillion to the official (and already stratospheric) CNY2.2 trillion in margin lending that’s poured into the market since last summer. Here’s BofAML on shadow lending and why it’s important going forward.
Based on limited available data, we estimate that SHCOMP could drop to the 2,500 range (some 40% down from the current level) for large-scale margin call to be triggered at the broker-run margin financing facilities (MFs). However, this doesn't mean that margin call is not a serious risk right now. In our view, the selling pressure so far has mainly come from stock-related borrowings via various unofficial channels where the leverage is much higher.
Besides MFs, there are many forms of leverage for stock purchases, including umbrella trust, financing companies, P2P platforms, stock-collateralized loans, wealth management products tied to stocks' performance, and even some personal, SME and corporate loans might have been diverted to buy stocks. The size of the other forms of leverage can easily be double or triple of that of MFs’ by our estimate (A-share fund flows analysis, Jun 8). In our view, these leverages are more risky than MFs because they are less transparent and lightly regulated, if at all - for example, anecdotally, we saw many cases of 10x leverage vs. less than 1x at MFs; and also unlike MFs, the other borrowings are often used to buy small caps which tend to be more speculative.
The “umbrella trusts” mentioned above are a particularly noxious vehicle that effectively allows retail investors to borrow from unsuspecting depositors to make leveraged bets on stocks. As a reminder, here’s how they work: Brokerages are only allowed to facilitate margin trading for investors whose account balances total at least CNY500K, and even then, traders can only lever up 2X. Clearly that’s no fun, so brokerages naturally looked for ways to skirt the rules. Umbrella trusts offered a way around the restrictions and while the mechanics can be made to sound complex, the idea is actually quite simple. An umbrella trust is set up like a CDO. The senior tranche is sold by banks to clients who receive a fixed payout (like a coupon payment), only instead of CDS premiums (in the case of a synthetic structure) or cash flows (from a cash structure), the ‘coupon’ payments are generated by equity investments in the subordinated tranches, which are used by brokerages to skirt margin restrictions. In other words, the guys holding the senior tranches are financing the stock trades of the guys in the junior tranches.
Late last year, the South China Morning Post described the products as follows:
This is how it begins. A trust company sets up an umbrella structured trust to cater to various stock speculators who want more than what the official margin finance limits will allow.
Under the trust are different units that are nothing but stock "pools" managed by the speculators. He or she puts up 40 yuan and gets 100 yuan from some so-called preferred investors to make the bet. That is 250 per cent gearing; it varies with different units.
The unit is then distributed to the man in the street through the banks. An unsuspecting you will become the preferred investor. Your return is capped at 6 per cent and the rest is for the speculator.
The only "protection" you have is the margin call made by the trust company on the speculator in the event of a market fall. He or she is solely responsible for topping up the margin. The so-called protection is, however, false. The product's documentation provides zero information on the identity of the speculator or his financial strength in case of a margin call. Neither does it detail the stock portfolio nor its liquidity in case of forced sale.
If the market goes south, one will end up with nothing. "I couldn't even begin to call it a high or low-risk product, as all necessary information is missing," a private banker in Hong Kong said.
But umbrella trusts and structured funds aren't the only way investors can skirt official margin trading restrictions in China. As Bloomberg reports, P2P loans — which have exploded in popularity in the US and are now being securitized — have also become popular among Chinese traders looking to "amplify" their bets.
As more Chinese jumped into the market in the hope of instant wealth, peer-to-peer websites offering loans for stock investing have mushroomed. They are among a multitude of sources of leverage outside of traditional margin financing that threaten to complicate any efforts to prevent an unruly reversal of China’s stock market boom, which is already faltering.
“While we can regulate margin finance within a brokerage, for those financing activities which are not within the securities houses, it’s very difficult to regulate,” said Ronald Wan, the chief executive officer of Partners Capital International, an investment bank in Hong Kong.
The perils of debt-fueled trading were underscored in past weeks, as the unwinding of margin loans helped drive China’s benchmark index into a bear market.
Online peer-to-peer, or P2P, lending accounts for just a small part of total leverage, yet it has expanded rapidly and attracted the type of investors who can least afford losses -- those that don’t qualify for traditional margin loans.
About 40 online lenders helped arrange more than 7 billion yuan of loans for stock purchases in the first five months of 2015, according to Shanghai-based Yingcan Group, which tracks China’s more than 1,500 such credit providers. Lending volumes surged 44 percent in May from April, Yingcan estimates.
The sites are popular because they allow high levels of leverage, and lack the restrictions brokers impose on margin finance accounts, such as high deposits and limits on the types of stocks against which clients can borrow.
“The threshold for lending on peer-to-peer websites is lower, this suggests that investors who borrow through these sites tend to be weaker financially,” said Shen Meng, a Beijing-based director at Chanson & Co., an investment bank.
Zhang the investor says he can borrow up to five times his capital using P2P sites, while brokers only allow leverage of up to three times. He can also take positions in an almost unlimited number of stocks, while brokers only extend margin finance for 900 of the shares traded in Shanghai and Shenzhen.
As should be abundantly clear from the above, China's equity miracle is in large part attributable to the leverage employed by retail investors who have used a bewildering variety of unofficial channels to avoid margin restrictions. As the market cracks and as the media shines new light on the shadowy vehicles investors use to pyramid risk, the unwind appears to have begun. In a testament to just how determined China is to keep the bottom from falling out, the China Securities Regulatory Commission is now racing to implement new margin trading rules and cut fees. From Bloomberg again:
China announced additional steps aimed at boosting equity markets, including speeding up the introduction of new margin-trading rules and cutting stock-transaction fees, after markets tumbled again on Wednesday.
The China Securities Regulatory Commission will no longer require brokerages to force the sale of stock held by clients with insufficient collateral, and will allow “reasonable rollover” in margin trading, it said on its microblog on Wednesday. China’s two bourses will reduce the fees by 30 percent starting Aug. 1, the Shanghai Stock Exchange said on its microblog the same day.
“While the reduction in transaction fee is symbolically supportive, easing margin requirements is more significant potentially as it may reduce the level of margin calls and forced selling,” Tony Hann, who manages $350 million as head of emerging markets at Blackfriars Asset Management Ltd. in London, said by e-mail.
Brokerages can securitize the right to profit from margin trading and short selling operations, the CSRC said. The regulator also said it will also let all brokerages sell short-term bonds, expanding a pilot program.
China Securities Depository & Clearing Co. will trim transaction fees by 33 percent on Aug. 1, it said in a statement on its website.
So, Beijing is set to "rollover" margin trading much as it does NPLs, which is simply another attempt on the part of the Politburo to forestall the deleveraging process, only this time the kick-the-can approach is being applied to brokerages as opposed to bank balance sheets.
Meanwhile, it appears as though the country's securities regulator is set to support the issuance of what amount to brokerage fee-backed securities, a structured credit abomination insane enough to make even the most corrupt Wall Street trading desks cringe.
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