Hong Kong Small Caps Crash Amid Marketwide Margin Call: "It's A Domino Effect"

A few weeks ago, we reported that in a bizarre development - and the latest in a long series of red flags involving Chinese and HK stocks - various Chinese small and micro cap companies had asked employees to buy their stock while promising to cover losses" amid rising margin call pressures as the underlying stocks had been drifting lower. As we also noted, China has a broader issue with collateral that could endanger the health of its financial system, such as fraudulent or "ghost" collateral, where pledged products either don't exist or are already sold or pledged to multiple lenders.

This in turn led BofA strategist David Cui warned that a potential "vicious selling circle" could lead to a replay of China's mid-2015 market crash. "As the 2015 experience shows, with high leverage, a vicious selling circle can quickly develop," he said, noting a "moderate" risk of broad-based financial instability. To which we concluded that "at that point either Beijing will have to step in with another bailout, or scenes such as this one which emerged during the 2015 market rout, will become the norm once again."

Less than three weeks later we got a vivid example of just how dire the impact of a coordinated margin calls on Chinese markets could be, when overnight dozens of Hong Kong microcap stocks plunged amid what started as a rumor that the local exchange will force all "zombie companies"to delist (since denied)... 

... but not before triggering banks to promptly demand their margin, which in turn led to a sudden plunge in over a dozen names on Tuesday as 'traders pointing to links between some of the companies and a brokerage that’s under regulatory investigation" according to Bloomberg.

In total, seventeen firms tumbled by more than 40% at the close, losing a combined $6.1 billion in market value. Among the names plunging were China Jicheng Holdings, an umbrella maker, and GreaterChina Professional Services which sank more 90% .

Quoted by Bloomberg, Francis Lun, the CEO of HK's Geo Securities said “we’re seeing a domino effect; all the companies in the same network got cut. These shares are owned by the same group of people so they must be experiencing a liquidity crunch and they don’t have the money to support the share prices,” he said.

In other words, a market-wide margin call, which led to a self-reinforcing avalanche of selling, and as 

There were other red flags which investors conveiently ignored as long as everything was going up. Here's Bloomberg

The stocks that saw large price drops on Tuesday tended to have characteristics that can be conducive to extreme volatility and to market misconduct: multiple relationships between different companies and listed brokerage firms, high shareholding concentrations, thin turnover and small public floats, Ernest Kong, a spokesman at the Securities & Futures Commission, said in an emailed statement. The regulator won’t comment on whether it has been or will be pursuing investigations into specific individuals or related companies, he said.

The selloff, which sent Hong Kong's Growth Enterprise Market, or S&P/HKEX GEM Index crashing by 10%, the most since 2015, has reinforced concerns about risks in the world’s fourth-largest equity market after a series of spectacular plunges. While Hong Kong’s benchmark index is among the best performers this year, declines in companies such as China Huishan Dairy Holdings Co., which in March plunged 85%  after a Muddy Waters research report, have blown up more than one investor.

Meanwhile, despite the crash in HK's small capps, the broader market remained resilient to the declines on Tuesday, with the Hang Seng Index losing only 0.1% and the Hang Seng Composite Small Cap Index sliding 0.4%.

To be sure, anyone seeking an explanation for what happened would be disappointed: Hong Kong Exchanges & Clearing Ltd. said it wasn’t in a position to explain the share price declines.

However, as noted above, the explanation was simple: a market-wide margin call which promptly made all the recent buyers into aggressive lilquidators:

“Obviously there’s been some margin calls and forced liquidation of shares among these companies,” said Hao Hong, Hong Kong based strategist with Bocom International.