Despite the collapse in Chinese stocks, Bloomberg reports annual sales of Chinese equity-linked structured notes across AsiaPac rose to a record (prompting Korea's financial regulator to warn investors in August that their holdings had become too concentrated in notes tied to the China H-Shares index). When banks sell the structured products to investors, they take on an exposure that's similar to purchasing a put option on the index... which needs to be hedged via index futures; and if BofAML is right, Chinese stocks in Hong Kong are poised for a fresh wave of selling now that HSCEI has crossed 8,000 as banks are forced to hedge.
As Bloomberg details,
[The selling pressure] is because the benchmark Hang Seng China Enterprises Index is approaching a level that forces investment banks to pare back their bullish futures positions, according to William Chan, the head of Asia Pacific equity derivatives research at BofA’s Merrill Lynch unit in Hong Kong. The trades, tied to banks’ issuance of structured products, are likely to start unwinding when the index falls through 8,000, a level it briefly breached on Wednesday. The gauge dropped 1 percent to 7,932.24 at 1:05 p.m. local time on Thursday.
Banks have purchased futures on the gauge of so-called H shares to hedge exposure to structured products that they’ve sold to clients, according to Chan. Many of those products have a “knock-in” feature at the 8,000 level that will spur banks to cut futures positions to maintain the effectiveness of their hedges, he said. Additional pressure points may also come at lower levels, Chan said.
“As the market goes lower from here, the downward move may accelerate,” he said. “There will be a large amount of hedging in futures which dealers need to unwind.”
And it appears that has already begun as not only did stocks accelerate through the "pin" level of 8,000 but Chinese 'VIX' has surged as banks look for alternative ways to hedge their implied positions...
When banks sell the structured products to investors, they take on an exposure that’s similar to purchasing a put option on the index, Chan said.
To hedge against the possibility of a rally, the banks buy Hang Seng China index futures. If the stock gauge falls below knock-in levels for the structured products -- the price at which investors begin to lose their principal -- the sensitivity of the bank’s position to index swings gets smaller, and banks respond by selling futures to reduce their hedge.
"There will certainly be a build-up of pin risk at given strikes," said Andrew Scott, head of flow strategy and solutions for Asia Pacific at Societe Generale SA in Hong Kong. "But it is clearly very difficult to accurately identify specific key market trigger levels with a great deal of confidence."
Still, if Chan’s scenario plays out, the market could soon come under pressure. A notional $13.6 billion of structured products linked to the H-share measure will get knocked in between levels of 7,000 and 8,000 on the index, and $16.8 billion between 6,000 and 7,000, he said.
It was clear that is what happened yesterday, but how many more are to follow?