News of the volatile Chinese stock market has dominated international headlines over the past couple of months, and the spotlight has been on the Chinese authorities’ reaction to these developments. Their wide-reaching policy response has implications for fund managers both inside and outside of China.
Until the recent market turbulence, China’s stock markets had been inclined towards increased liberalization, with foreign investors being given access via Stock Connect, and greater numbers of investors gaining access to both futures and shorts. The prospect of being able to run long-short strategies within China or to hedge Chinese equity exposure cost-effectively appeared on the horizon.
But since the market correction began, Chinese authorities have taken assertive measures to curb market volatility. Such measures include:
- suspending (or allowing the suspension of) the trading of more than 1,400 companies;
- temporarily banning insiders (including 5%+ shareholders) from selling their shareholding within six months;
- increasing scrutiny of “malicious” short selling (although there has been little clarity as to what types of shorting would be regarded as “malicious”) and other market behavior that may affect the Chinese stock market, including police action against several firms;
- suspending initial public offerings;
- reducing access to the Chinese futures market and the availability of lending for short sales;
- making available to China Securities Finance Corporation more than US$480 billion of borrowed funds to finance equity purchases, and encouraging other market participants to make purchases;
- arresting brokerage and investment bank employees for insider trading apparently related to the correction; and
selling U.S. Treasuries to support the devaluation of the yuan.
There will be more to come. Chinese authorities are now re-considering market “circuit breakers.” The proposed system would suspend trading on the Shanghai and Shenzhen stock exchanges for 30 minutes if the CSI 300 rises or falls 5% in a single trading session, or for the remainder of the day if the index rises or falls at least 7%.
Foreign fund managers have been directly affected by these measures. Dozens of trading accounts, including those of both domestic and foreign market participants, were frozen by the Shenzhen exchange, and Chinese authorities have been investigating whether algorithmic trading has contributed to the disruption of the Chinese stock market. Prior to the crisis, managers, brokers and other trading firms had begun to explore a variety of creative approaches to accessing the Chinese market. However, it is now clear that managers must evaluate their operations in China against both published rules and unwritten policy, and need to exercise great caution with respect to new approaches to trading in China. Of course, unwritten policy, and indeed published rules, may further evolve as the market turbulence continues.
Market volatility has also focused fund managers’ attention on existing market regulation in China. In particular, Chinese securities regulation requires the disclosure of positions of 5% or more in listed companies, and certain subsequent changes in such positions must be disclosed within three business days. Similarly, the short-swing profits rule affects 5% holders. Managers with affiliates who also invest in Chinese equities must consider whether their own positions must be aggregated with the positions of their affiliates – both for disclosure and short-swing purposes, as well as the six-month ban on “insider” sales mentioned above. Official guidance on aggregation arises from a patchwork of regulatory and judicial sources; answers regarding aggregation are not always clear. But the lack of clarity has real consequences. As with other jurisdictions, violations of the short-swing profits rule trigger a requirement to disgorge any trading profits back to the issuer. In an up-and-down market, managers are much more likely to trip over these rules, and authorities are under considerable pressure to detect such sales. As a result, it is prudent to comprehensively review compliance functions having oversight over investments in China.
Many of these measures are only stop-gap responses to volatility. China’s top leadership has stated that they remain committed to fundamental market reform. Managers should expect that China’s cycles of regulation and de-regulation – and the opportunities such cycles provide for managers – will continue.