Drastic fluctuations in China’s stock market in recent months have grabbed international headlines, mainly for two reasons. The market experienced a sharp upsurge before going into a free fall within a mere few months. It began with a bang in early August 2014, driving daily trading volume to RMB 2 trillion in May 2015. Within just nine months the stock index doubled, setting a new global record. The crash thereafter was equally drastic. From June 15, 2015, the stock market plunged from over 5,100 points to less than 3,500 points within 20 days, causing widespread panic in the market and significantly weakening investors’ confidence.
In the second half of June, when the market nosedived, the government seemed to have gone out in full force to sustain the market regardless of costs and risks, leaving many puzzled about the intention behind such moves. An interpretation is that the government planned to prop up the stock market in order to further develop and restructure China’s financial sector. As China’s economy is highly dependent on indirect financing, a healthy and strong stock market is essential for firms to obtain financing through initial public offerings (IPOs).
Several new factors underlie the 2015 crash, including the use of leverage trading and the introduction of stock index futures. In leverage trading, both officially-approved margin trading and those through unofficial channels (changwaipeizi) were used.
Let’s first examine how leverage trading contributed to China’s drastic stock market fluctuations in mid-2015. Securities margin trading was launched on March 31, 2010, and in early 2014, the aggregate balance of margin trading was only less than RMB 500 billion. It exceeded RMB 1 trillion for the first time in late 2014, and, on June 18, 2015, it peaked at RMB 2.27 trillion (Figure 1).
Margin trading has been good business for security brokerage firms, which may have contributed over 10 percent of their total profits in 2014. Therefore they have little incentive to rein in margin trading. Commercial banks are also more than happy to lend to brokerage firms as they are perceived as relatively high quality firms with little risks due to the system of “forced liquidation.” In addition, these companies are regulated by the China Securities Regulatory Commission (CSRC).
Figure 1. Balance of Margin Trading (official, in billion RMB), January 2014 to September 2015
Besides firms which are officially sanctioned to conduct margin trading, there are also companies that provide credit for leveraged share purchases, known as changwaipeizi firms or peizi firms in short, which means “unofficial fund matching” firms. Such lenders offer borrowers much higher credit than the official lending limits. Under the official limits, lenders can give only as much credit as the value of the shares pledged as collateral or the money in the margin account.
Peizi firms receive their capital from two platforms: the peer-to-peer (P2P) platforms and the Umbrella Trusts. P2P lending services consist of online platforms that directly link potential borrowers with potential lenders. These “middleman services” for loans secured with pledged shares as collateral by P2P platforms constitute a huge grey-market for funding, very much like commercial banks but unregulated.
Another source of capital for the peizi firms are the Umbrella Trusts. Trust companies obtain money from commercial banks and subsequently loan them to peizi firms; peizi firms then retail these funds to borrowers. The peizi firms operate mainly via a technology called HOMS, a cloud-computing-based system used by P2P lenders to reach brokers. HOMS provides borrowers of peizi firms the access to brokerages by dividing one account into multiple sub-accounts. On the surface, HOMS merely develops a new function that allows more than one person to operate a single official security account. However it is this “simple” function that has generated serious problems.
These easily created multiple sub-accounts require no formal registration procedure and leave no transaction records. This feature creates huge obstacles for CSRC to implement ex ante regulation and ex post investigation. In a nutshell, HOMS performs all the functions of a security brokerage firm, while bypassing official supervision (Figure 2). By the end of June 2015, the aggregate scale of changwaipeizi reached RMB 1.4 trillion.
At the beginning of the stock market crash in mid-June 2015, peizi clients began to sell their stocks as these had been bought with borrowed money and hence they faced the constraint of margin calls.1 HOMS thus began to sell off intensively. As a result, the prices of peizi stock investments plummeted beyond their allowable limits.
As too many stocks reached their limits, all market participants, including security brokerage firms, funds and peizi firms, had no choice but to sell on the stock market. They were then forced to short on stock index futures (e.g., IC1507) in the futures market to hedge against further declines in stock prices. As the price of stock index futures reflects the expectations of the spot market, a decline in prices in the futures market caused by shorting will drag down prices in the spot market as well, causing a vicious cycle. The massive avalanche effect drove the stock market to rock bottom from over 5,100 points in June to less than 3,000 points in mid-September.
Figure 2. Relationship between Commercial Bank, P2P, Umbrella Trust, Margin Trading, HOMS and Stock Market
We can now turn our attention to stock index futures. Many believe that if leverage trading resulted in the first stage of the 2015 stock crash, stock index futures led to the second phase of the crash. The participants in the stock index futures market include two groups, one that holds stocks but shorts on futures to hedge risks and the other that engages in pure speculation without holding real stocks, an activity termed “naked short selling.”
In principle, prices of futures have a guiding effect on spot prices, that is, they are closely related to expected spot prices. For the speculators, the goal is to manipulate the price of futures to maneuver investors’ expectations. Successful speculation is mainly due to two reasons: the very fragile market confidence and the low cost of short selling. Before the market crash, the cash deposit for naked short selling was only 10 percent which is considered quite low. Having recognized the damage and potential contagion risks from the futures market to the spot market, the government issued a series of new regulations between June 8 and September 2, 2015 to restrain naked short selling activities. Under the new regulations, commission fees will be gradually increased and cash deposits will be required.2
The 2015 stock market crash and the government’s poor response have exposed serious weaknesses in China’s regulatory institutions. In the stock market, those with cash in hand and are buying are usually called “bulls” (long position) and those with stocks in hand and are selling are called “bears” (short position). Investors without leverage trading can hold on to stocks and wait for the next recovery, so the real bears are those who are heavily engaged in leverage trading. During the first half of 2015, leverage trading was widespread among individual investors, brokerage firms, public offering funds, private equity funds and trust companies.
Conceptually, the stock market is a zero sum game where one person’s gain is another person’s loss, regardless of the market’s direction. There are six groups of people are believed to have benefited from the market turmoil. The first are those in IPO financing. Indeed, the aggregate amount of financing from IPOs in A shares amounted to RMB 146.1 billion for the first half of 2015. The second are the top management of some publicly listed companies. The reduction of shares of managerial ownership was about RMB 500 billion for the first half of 2015.
The government also benefited as stamp tax on stock trading totalled about RMB 138 billion in 2015, an increase of 545 percent from that of 2014. Security brokerage companies and trust companies are also beneficiaries, making huge earnings through commission fees and interest payments from margin trading activities. In the first quarter of 2015, revenue from commission fees surpassed RMB 58 billion. Peizi firms were also believed to have reaped huge profits as the rate of interest they charged was extremely high compared to that of official margin trading. The last group comprised cautious investors who cashed out early and left the market.
In 2015, margin trading and peizi activities were allowed to flourish, as the government seemed confident it could manage the risks. Most seriously, the banking system is the one and only source of money. The involvement of the commercial banks was thus too much and too deep, reflected by the very high pledges of stock rights,3 which reached RMB 2 trillion in June 2015. After the crash, loans for stocks could not be repaid and banks ended up with massive holdings of junk stocks.
The gargantuan effort to uphold the sliding market ultimately did not succeed. There are however positive implications. First, the crash has given the government a valuable lesson before it rushes further into financial reform. It has also exposed risks and regulatory loopholes in China’s financial sector. The banking system should not be too deeply involved in the capital market. The crash demonstrated to the government the power of the market and the futility of its efforts to go against or manipulate such forces.
1. A "margin call" occurs when the equity in an account falls below the maintenance margin. It forces the investor to either liquidate his/her position in the stock or top up the account.
2. Currently, cash deposit has been increased to 40 percent for naked short selling.
3. A pledge of stock is a form of collateral given to a lender to secure a loan. More specifically, the lender holds the shares of a public company until the loan is paid off.