China stock sell-off will test securities firms’ risk managers

“Only when the tide goes out,” Warren Buffet famously observed, “do you discover who has been swimming naked.”

The tide has been heading out in China’s investment markets of late, and it’s put the mainland securities companies’ risk management capabilities to the test. They’ve not only had to navigate tumbling equity prices, but also ad hoc trading restrictions and government market interventions that complicate risk management efforts.

The vicious bear market in China stocks this past year – which has seen the mainland benchmark CSI 500 index fall 29% from the start of March 2023 to the lows on February 5 this year – has had a devastating impact upon the market-sensitive revenue sources of local securities firms, such as structured products. Sales of the products known as ‘snowballs’ have been down since last year, and with retail investors now nursing big losses, any near-term revival seems doubtful.

Supported by a steady stock rally that was sustained through the Covid-19 pandemic, these products became a key source of revenue for securities firms in recent years, alongside other derivatives brokerage services and proprietary trading.

It will be difficult for the securities firms to plug the gap with other types of derivatives products. The China Securities Regulatory Commission (CSRC) recently placed caps on outstanding volumes of single stock options and cross-border total return swaps, two products that also make a big contribution to firms’ revenues. To make matters worse, proprietary trading desks are likely to face mark-to-market losses on their portfolios as well, after the recent equities carnage.

The priority for securities firms now will be to ensure prop trading and structured products hedging positions do not further deteriorate so as to put a big dent in the bottom line.

The financial performance of China’s securities firms has always tracked the ups and downs of the markets closely. However, in a note published in March, Fitch Ratings said it believes “the strength of securities firms’ risk management frameworks and their capability to execute risk policies are increasingly differentiating their financial performance”.

The flurry of recent measures from the CSRC, including a curb on short-selling and an informal ban on net selling in the first and final 30 minutes of the trading day, appear to have achieved the objective of stabilising the market. From February 5 to March 1, the CSI 500 Index rallied by roughly 20%, helped too by the government instructing state-backed funds to buy stocks.

Credit rating agency Fitch, however, believes the bounce could be short-lived and that in the long term the key factor determining equity market performance will be the health of the real economy. If stocks take another tumble again in the near future, then the net selling ban and increasing frequency of window guidance on trading strategies will make the task of risk management all the trickier.

The losses quant funds suffered when China’s government stepped in to support the market in February highlight the various operational risks – execution risk, especially – that such measures can give rise to.

Nevertheless, Fitch says the largest securities firms it rates have robust risk management functions, and they should be able to contain the negative impact through hedging and active portfolio management. Falling interest rates might also help to offset equity trading losses by boosting the value of firms’ bond portfolios, Fitch writes.

Perhaps one of the biggest potential risks for securities firms in a further stock sell-off is that of being called upon by the CSRC to support the market by buying stocks. There is a precedent for this, with the regulator asking securities companies for help during the 2015 stock crash.

But in this latest sell-off, that responsibility has so far been limited to the large state-run funds. Should the regulator decide to also rope the securities firms into this effort at some point, it must do so only after a thorough assessment of individual firms’ financial capacity to provide such support.