Hong Kong warrants: this time it’s different

There’s a sense of déjà vu in the world of Hong Kong warrants. For the first time since an exodus a decade ago, banks and securities houses are dipping their toes back into the $2 billion-a-day market.

Entrants including Morgan Stanley and Citigroup are braving the narrowest of spreads as they return to a listed structured products market, jam-packed with high-frequency predators hunting for arbitrage opportunities.

Their return begs a question: what happens if we see a repeat of the 2007–08 equity slump that sent investors – and eventually issuers – fleeing for the exits last time round?

The current state of Asian equity markets has drawn parallels with the financial crisis era. If history is any guide, how the events unfolded back then should be at the forefront of warrant issuers’ minds given an uncertain market outlook amid escalating trade tensions between the US and China.

In the years leading up to the financial crisis, retail investors piled into the highly leveraged investments as a bet on a seemingly never-ending bull run. By 2007, there were 20 active issuers in the market. Three years later, after equity markets crashed and investors fled in their droves, the number of issuers almost halved.

Those taking the plunge again say it’s different this time round. They point to new defences in the form of a broader array of products listed on the Hong Kong Stock Exchange compared with a decade ago.

While warrants are built for bullish sentiment, new-found structural diversity means investors can express views in any and all market conditions – in bull markets, in bear markets and in range-bound markets.

If history is any guide, how the events unfolded back then should be at the forefront of warrant issuers’ minds given an uncertain market outlook amid escalating trade tensions between the US and China

In July, so-called inline warrants will become available for the first time on HKEX. Similar to a digital option, the instruments offer investors the opportunity to benefit from the stability of the index. Investors receive a fixed amount at expiry if the price of the underlying instrument has not breached a specified corridor during the contract’s term.

Investors can also now be compensated for any loss in warrants revenue through callable bull and bear contracts. Unlike warrants, CBBC prices are not affected by movements in implied volatility. Last year’s sell-off on the Hang Seng Index is a case in point.

Roughly HK$4.5 trillion ($576 billion) in market capitalisation was wiped from the HSI over the course of 2018 as the index shed 13% – its worst performance in seven years. Despite a wretched year for Hong Kong stocks, the average daily turnover of CBBCs increased to $7.5 billion, up from $4.8 billion in 2017.

Product diversity may be helpful in preventing an investor stampede at the first time of trouble, but it does not guard against other dangers.

Compared with warrants markets in Europe or the US, Hong Kong is notorious for its paper-thin spreads, often quoted as tight as one tick. As a result, it has become a playground for high-frequency trading firms scouting for every arbitrage opportunity available. In this ‘seller beware’ market, issuers must be on their guard at all times and need to develop sophisticated, low latency in-house trading systems.

Providing that investment is forthcoming, it could be possible for the new entrants to build a profitable and sustainable listed product franchise, whatever direction the stock market heads in next.

This time it really is different. But then again, it probably was last time too.