China stocks rout exposes risk from US$30 billion of little-known leveraged ‘snowball’ derivatives

A slow start to the year for Chinese stocks has exposed some obscure financial derivative products, which investors blame for exacerbating the slump.

Many of the so-called snowball products tracking the underlying CSI Smallcap 500 Index and the CSI 1000 Index have breached preset levels that trigger forced sales of futures contracts, amplifying the panic and fuelling sell-offs on the stock market.

Such structured products, similar to put options issued by brokerages to wealthy investors with a typical maturity of two years, are estimated at 216 billion yuan (US$30 billion), according to Cinda Securities.

Snowball products have been gaining popularity among investors seeking high-yielding assets. As long as the underlying indices the products track trade above the predetermined level set in the prospectus, holders are paid bond-like coupons, typically around 10 per cent annually. But if the products breach the preset level, also known as knock-in, holders risk losing their entire principal because they only pay the margin on the full value of the snowball products.

“More triggering of knock-in on these derivative products has surfaced now,” said Zheng Xiaoxia, an analyst at Hua An Securities. “The unrelenting pullback in stocks has exposed the products tied to the likes of the CSI 500 Index to an increasing risk of liquidity.”