The China Securities Regulatory Commission (CSRC) has revised the rules on margin trading and short selling in response to the current conditions surrounding China’s stock market. The new rules were released to the public on June 12, 2015 as a draft document for public comment.[1]  These new rules have the potential to ease investor concerns over the volatility of the market as well as bring about more favorable returns when closing out investor contracts.  Since the announcement of the new rules, the markets here in China have fluctuated in response with a 13% decline across the Shanghai Composite Index during the week following June 12th’s market peak.[2]  The new rules address the contract length for margin trading and would allow for an extension of contract terms beyond the current fixed period of six months.  Additionally, the new rules will ease barriers to enter the market and work with securities brokerages in China.

Current Regulatory System

Under current rules developed in 2011, the contract length for margin trading was determined by the stock exchanges according to the Measures for the Administration of Margin Trading and Short Selling by Securities Companies, Chapter 3, Article 13.[3]  Contracts are authorized by the stock exchanges for a fixed term of six months and were not allowed to be extended.  This mandatory sell off of investor holdings after six months causes short-term speculation of the market.  Furthermore, these forced sales affect an investor’s willingness to enter the market for fear they would have to sell off their holdings even if the market was not in their favor.  According to China Daily, several securities brokerages were penalized at the beginning of the year for extending contract terms for clients.[4]  The markets responded with a decline in market value, but this decline was temporary as the markets have risen steadily over the last twelve months.

New Regulatory System

The new regulations have not been translated into English by the Chinese Government because they are still in the drafting stage for public comment, but global news agencies have offered some insight into the changes.  According to Reuters, the new proposed rules would allow for the extension of contract terms for a “‘reasonable’ roll-over” in order to ease volatility and allow investors to sell their holdings when the market is more in their favor.[5]  A roll-over of contract terms for another six to twelve months would provide stability to investor’s concerns about short-term market volatility.  The Wall Street Journal notes that the rules are an attempt for the CSRC to promote “orderly development” of a margin trading business strategy for securities brokerages.[6]

In addition to the relaxation in contract terms, the new rules relax barriers to enter into margin trading as the markets become more reliant on margin financing.  The new rules also alter Chapter 3, Article 11 of the Measures for the Administration of Margin Trading and Short Selling by Securities Companies.[7]  Under the new rules, investors are no longer required to have trading accounts with securities brokerages for more than six months before they can begin leveraging their investments.  Additionally, investors no longer have to hold their investments in third-party escrow accounts.[8]  Brokerages, aware of the risks, have also begun to self-regulate by tightening lending requirements and restricting more volatile stocks from margin trading.  This creates a clear path for clients seeking entry into the market to take advantage of margin trading here in China.

Reasons for the Change and Impact

The Chinese stock exchanges are currently experiencing a seven year high; the new rules lessen the fear of margin calls triggering a sharp selloff of shares.  Since June 12th, there has already been a slight decline on the exchanges in response to the new rules.  According to news outlets, margin trading has been one of the primary drivers of the stock market to levels not seen since 2008.  If investors are forced to sell shares to meet margin calls, there is currently at least $364 billion (US Dollars) of leveraged money on the exchanges.  This amount of margin debt has the potential to magnify market declines.  Despite the increase in margin debt in recent months, analysts report China’s debt levels are manageable when the $8.8 trillion (US Dollars) stock market is taken into account.[9]

Despite the new regulations and tighter lending requirements, some analysts suggest investing now during the dip in the market to increase holdings and potential profits.  These analysts claim that now might be a more advantageous time to enter the market as they anticipate the Shanghai Composite Index to continue to rally upwards another 36 points, surpassing its all-time high.[10]  In the near-term, there is likely to be more consolidation among leveraged debt holders and HSBC has cautioned that the margin trading rally has cooled.[11]

Clients may find the next couple of weeks as an advantageous opportunity to increase their investment holdings in various sectors across China’s stock market.  Potential investors would benefit from assessing portfolio management tools within Chinese securities brokerages to analyze what self-regulation these brokerages are implementing.

John McDonough