(Bloomberg) – Chinese brokerages are nearing record profits as they lure investors back to the derivatives market that fueled a sell-off in domestic stocks earlier this year as the business’ profits fall further in the aftermath of the meltdown. ing.
Coupon interest rates on two “snowball” products issued last month exceeded 40%, a level not seen since at least 2022, according to data compiled by Galaxy Technologies. Five securities companies raised yields on products linked to the CSI1000 index from March levels. Six other companies, including CSC Financial Co., joined the fray, pushing the average price measured by GalaTech to an all-time high, according to the data.
Brokers are struggling to win back investors after a market crash earlier this year that sent most products below levels that could wipe out coupons or impose losses. Increasing price competition is increasing pressure on profitability as companies seek to revive sales to offset mounting hedging losses.
“The price war has begun,” said Liu Fucheng, co-founder of Shanghai-based Galatec, which also provides derivatives trading and risk management solutions to financial institutions. If companies continue to issue products like this, they will face significant profitability pressures. ”
As of November, an estimated 330 billion yuan ($46 billion) of snowballs had been issued, according to UBS Securities. These exotic products pay investors a bond-like coupon as long as the stock index they refer to stays within a predetermined range.
If the index rises above the range, a “knockout” is triggered, the contract is terminated and the investor receives the coupon for the previous period. If the index falls below the range, a “knock-in” occurs. In this case, unless the index recovers and reaches the knockout level before expiry, the holder will not receive the coupon and may lose some of their capital. The longer an investor holds a product, the greater the snowball-like return.
Coupon rates these days typically range from 10% to 20%. These products are profitable for brokerages, who use stock index futures to hedge their exposure and generate additional income by investing a portion of the proceeds. Index futures continue to be discounted in the Chinese market, often increasing profits further. Products are often distributed by hedge funds.
big setback
However, the business suffered a major setback in the first quarter as most of the underlying stock indexes of existing products fell below the knock-in level. This meant that brokerages had to significantly increase their purchases of stock index futures and then sell them to limit risk under so-called delta hedging. The process likely worsened the recession and imposed losses on brokerages, Liu said.
On top of that, just as the market began to rise in the weeks following unprecedented government intervention, companies were forced to switch up their hedging strategies against adverse contracts. Although this switch was a loss-making proposition, it required buying more index futures when prices rose and selling them when prices fell, in order to remain delta-neutral.
This is eroding business profits, which accounted for about 2.5% of China’s listed securities companies’ net profits last year, according to Kaiyuan Securities estimates. Other sources of snowballing profits will hardly make up for hedging losses, Liu said, and even if the index rebounds further and reaches the knockout level before expiry, there will still be enough money to pay the coupon. It is said that there are some left. The CSI1000 has risen 23% since its February 5th low.
As a result, brokerages are facing pressure to sell anew and initiate new “buy low, sell high” hedging positions, he said. “This is the best solution for them. So if a very popular product with a big coupon can snowball sales back up, even if that’s possible.” It’s a lot of pressure, but I’m sure they’ll be happy. ”
The Shanghai-based hedge fund manages two of the most profitable snowball products sold last month, raising about 110 million yuan. A spokesperson for the fund said the brokerage firm has expressed confidence in its ability to provide the hedge, with high first-year coupon rates of 41.2% and 42.2%. He asked that he not name or identify his company or brokerage firm, citing policies regarding such private placements.
Separately, CSC Financial did not respond to a request for comment.
Increasing overall sales is not an easy task, as some experienced investors have lost confidence. Sophie Yu, who works at a financial firm in Shanghai, said she plans to reduce her snowball holdings from 50% to 20% of her investments. Her two holdings were sold in February after negotiations with a brokerage firm to lower the trigger level failed.
Yu said the product is designed to be disadvantageous for investors because while the probability of a knockout is only given on one day each month, a knock-in can occur on any day when the index is low enough. said. It added that customers should be given more flexibility, including the option to waive the coupon and cancel the principal early, or extend the contract maturity by a year if necessary.
According to Garatec data, only seven new snowballs were issued in the chaotic week of February 5, just before the Lunar New Year holiday, near the lowest number of the year. According to the data, there were 133 new products in the first quarter, down from 383 in the same period last year.
risk appetite
Much of the hope lies with investors like Dora Zhong, who bought Snowball in January for 1 million yuan, thinking it was a safe time to earn a 12.5% return. The market fell further and her product was knocked out. Still, her rise in CSI 1000 puts her closer to a knockout, where she could benefit.
“The good thing about snowballs is that when market volatility is high, the nominal interest rate is much higher than bonds and they have a clear return profile. However, they can come with extreme tail risks,” Zhong said. Ta. Yes, even if you suffer a loss, it is acceptable. ”
Brokers are also offering revised product structures to respond to investors’ changing risk appetite. They issue snowball products with low knock-in thresholds and have recently focused on so-called phoenix products, which are highly liquid and pay monthly dividends unless a knock-in occurs.
When Yu Zheng, who works in the southern city of Guangzhou, bought a snowball with a descending knockout line in May, she thought it was safe. “She didn’t expect it to be such a hit in February,” she said, adding that she’s still settling in because she has more than a year to mature.
“We will continue to look at suitable products like the Phoenix structure. We don’t have the money anymore,” Yu said.
–With assistance from Amanda Wang.
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