China, Explained series: How margin trading and short selling work in China
During the 2015 market collapse in China, regulators took measures to limit margin trading and short selling activities. The move came as a surprise to global investors who to this day, remain wary about the transparency of the country’s financial system. In this discussion with Head of Quantitative Investing at Invesco Great Wall, Haiwei Li, we examine how leverage and trading practices work in present-day China.
Q. Has taking leverage in China such as margin financing and short selling changed over the last few years?
The market regulator, the China Securities Regulatory Commission (CSRC) is becoming more receptive to margin trading and short selling activities in most cases, particularly those that are conducted on-exchange via the stock bourses. However, they remain vigilant about those activities that are less transparent and harder to monitor — those off-exchange leveraging activities done via commercial banks’ structured products. In 2018, the China Banking Regulatory Commission (CBRC) (which monitors the banking industry) and the China Insurance Regulatory Commission (CIRC) (which oversees insurance products) merged into a single regulatory body, making it easier for authorities to monitor off-exchange investment activities.
As China’s stock market becomes increasingly market-driven and rational, many of the restrictions on leveraging have been removed. Regulators have raised requirements and transaction fees on margin trading, making it difficult to engage in off-exchange margin financing. They have also increased short sale inventory which I believe will continue to rise over the next few years.
How does short selling and margin trading work in China?
There are two ways to conduct short selling in China:
- Regular short selling: For investors taking a bearish view on a stock, they will borrow the stock, sell it and buy it back at a lower price later. Brokerage firms will use their own capital to buy or acquire those shares in the market then lend it out to their clients. A broker typically hedges their position by buying the index future which is very costly given that the futures market remains in a backwardation-like situation (the future price is lower than spot price).
- Short sale refinancing: The brokerage firms find institutional investors to supply them with the shares and then lend it out to their clients. The brokerage firm acts as an intermediary without the need to take any position or do any hedging while charging service fees for the refinancing.
Every short sale transaction is reported to the central agency, the China Securities Finance Co., Ltd. (CSF) to record each party’s trading position, the fees charged, the contract terms agreed, etc.
The other form of leverage is margin trading where the investor borrows funds from a broker to purchase (long) a stock. All brokerages are required to report their margin positions to the CSF on a regular basis. The lending fees vary according to client account types and are regulated by the CSF to ensure an efficient, fair, honest and integrated process for investors1.
How effective have these measures been historically for limiting losses in the Chinese stock market? Do they lead to any overvaluation of securities or market inefficiencies?
Restrictions on short selling are unlikely to lead to a permanent overvaluation of the market, which is more due to limited equity supply. On the other hand, it may trigger a “burst” in the event of a stock market “bubble” and additional market volatility. For instance, if an investor thinks a stock is overvalued and short selling is banned, then the only way for him/her to offload the stock is to push its price higher, selling it at its peak. Short selling allows a stock position to be more balanced and investors can express their views via different positions, both long and short. By allowing the market to determine the real value of a stock, short selling in fact can improve market efficiency over time.
What kind of reforms is the Chinese regulator taking to improve market transparency?
I believe the CSRC is looking to be more liberal and transparent such as relaxing market restrictions, lowering entry barriers to the Chinese stock exchanges, removing QFII quotas and promoting renminbi (RMB) internationalization. Industry participants and fund managers are invited to visit and advise on market views in an open dialogue with the CSRC.
On the CSF and local stock exchange websites2, investors can read about the margin trading and short selling balances for each stock or news about penalties on companies violating shareholders’ rights. In China, Explained series: How to find quality corporate reporting in China?, regulators are strengthening governance on company disclosures.
How does your team hedge against market losses?
We believe diversification is important for generating sustainable returns, limiting exposure to extreme events or irrational market behavior.
With over 70 analysts and portfolio managers (fixed income, equity, quant, and traders) in China, we continuously refine our financial and risk models so that they are dynamic and responsive to new parameters. In China, the market is constantly facing challenges, risks and investment opportunities so good judgment and agility go a long way.
Having managed portfolios for more than 15 years in China- related markets (A and H shares, etc.), Haiwei sums up one key lesson learnt: market measures can only momentarily change the pace of the market, but it cannot change its direction. In the end, the true potential of a country’s stock market comes down to its core fundamentals.
1 China Securities Finance Co, Ltd. (CSF) website. http://www.csf.com.cn/publish/english/index.html
2 Shanghai Stock Exchange. Publications. Monthly Statistics. http://english.sse.com.cn/
Investment risks
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
When investing in less developed countries, you should be prepared to accept significantly large fluctuations in value.
Investment in certain securities listed in China can involve significant regulatory constraints that may affect liquidity and/or investment performance.
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C2020-11-157
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