Chinese hedge funds were looking forward to a holiday break from the market turmoil when trouble started brewing last month. One manager had his short-selling orders abruptly rejected by brokers. Another was cut off from the stock market completely. Regulators turned up on trading floors at multiple funds to monitor transactions in person.
As one fund put it, three sessions of chaotic trading “felt like a whole year to us.”
The scenes, extraordinary even by the standards of a market that has long operated under the Communist Party’s shadow, played out in recent weeks in a clampdown that’s rewriting the rules of computer-driven trading in China. The country’s once-booming quant industry has become the latest casualty of Beijing’s campaign to stop a $4 trillion selloff in stocks.
While the measures have helped prop up share prices at least temporarily, they raise bigger questions of how far Xi Jinping’s government will go to meet short-term goals at the expense of maintaining some pretense of a free market that’s attracted billions of dollars from Wall Street firms in recent years.
For international investors becoming increasingly skittish about China, the sudden trading restrictions give them one more reason to stay away.
China saw a record six months of outflows from the equity market until this month, while foreign direct investment is at a 30-year low following unprecedented crackdowns on the tech and property sectors that have stifled growth. China risks losing out further to countries like India and Japan, which are enjoying a surge in investment.
“These seemingly panic actions by authorities risk undermining all the good work done in the past two decades to give China access to global pools of capital,” said Gary Dugan, chief investment officer at Dalma Capital Management Ltd. in Dubai. He said the moves will make “even the most battle-hardened investors” question whether China is worth the risk.
The new restrictions are sweeping. Quant funds, which rely on computer algorithms to carry out trades, will be scrutinized and new entrants will have to report their strategies to regulators before trading. Beijing will also expand the scope of reporting to offshore investors via a mainland-to-Hong Kong trading link.
China’s securities watchdog meantime set up a task force to monitor short selling and could issue warnings to firms that profit from the wagers, people familiar have said. It even took the extreme step of halting some major institutional investors from selling more shares than they buy during the first and last 30 minutes of trading, they added.
“Quant managers were hit by the biggest Black Swan in quant history,” Shanghai-based Semimartingale Private Fund Management LP wrote, recapping the wild market swings in a letter seen by Bloomberg.
The crackdown adds to a series of moves aimed at halting a multiyear plunge in equities, which have been slammed by the housing crisis, weak economic growth and lingering tensions with the US. It also echoes the heavy-handed approach that has been used to clamp down on sectors from internet to education platforms.
“The risk premium on Chinese stocks has to go up going forward because some institutions are going to be unwilling to trade this market,” said Arthur Budaghyan, emerging markets chief strategist at BCA Research. “And this is on top of geopolitical concerns that many foreign investors have had about investing in Chinese stocks.”
In recent weeks, Beijing turned its sights on quant funds, which have used their big data models to outperform the market for much of the last three years.
In an early sign of what was to come, Chinese Premier Li Qiang on Jan. 22 asked authorities to take more “forceful” measures to stabilize markets as the CSI 300 index hit a five-year-low. Beijing then made a surprise move two weeks later to oust the head of the securities regulator, replacing him with a veteran bureaucrat known as the “broker butcher” for his past crackdowns.
Concerned that quant funds were exacerbating declines by unloading big blocks of shares or making short bets, Beijing started by banning some funds from placing sell orders while limiting their ability to make short trades. The China Securities Regulatory Commission said it had discovered multiple cases of market manipulation and “malicious short selling.”
“It was so annoying,” said Alex Wong, whose Shanghai-based fund was unable to sell borrowed stocks to execute short trades for about two days as small caps tumbled. “I truly felt like smashing the keyboard and slamming the door.”
These restrictions, along with sudden shifts in the market, combined to throttle the quant funds as China headed into its Lunar New Year break this month.
As a Man Group analyst explained, a popular trade for these funds involves buying small-cap stocks, which are more prone to mispricing and more profitable for computer programs to exploit. To hedge their broad market exposure, the funds would short index futures.
This strategy was upended by a sharp decline in small-cap stocks, prompting quant products with heavy exposure to trim holdings. The massive selloff triggered losses in derivatives known as “snowballs,” causing a “quant quake” panic and forcing brokerages to dump index futures as well.
All that volatility pushed up hedging costs for so-called market-neutral products, some of which were leveraged to the hilt by as much as 300%. That forced them to unwind positions, fueling a cascading spiral in the market.
As funds stampeded to the exits, authorities upped their ante to tame the rout, making it even worse for the quants. Government-led funds, known as the “national team,” stepped in to prop up exchange-traded funds, boosting large stocks but leaving small caps behind. The gyrations made the market unpredictable for computer models trained on reading historical data.
“A series of external interventions and changes made it hard for quant models to make predictions, or even adapt,” Shanghai-based Mingxi Capital, a quant fund that manages more than 1 billion yuan ($139 million), wrote in an article on its Wechat account. “The models switched from doing it right to getting it wrong repeatedly.”
Weak Returns
The funds took a beating as a result. Top quants managing more than 10 billion yuan lagged the CSI 500 Index by an average 12 percentage points in the two weeks ended Feb. 8, according to industry data cited in a Huatai Securities Co. report.
More extreme measures ensued. One high-frequency trading firm’s internet access was temporarily suspended, according to a brokerage employee, while others saw their borrowed shares for short bets recalled, according to people familiar.
The crackdown came to a head on Feb. 20, when China’s two main stock exchanges froze the accounts of a major quant fund for three days. Regulators sought to make an example of Ningbo Lingjun Investment Management Partnership after it dumped a combined 2.57 billion yuan in shares within a minute as trading resumed following the holiday.
For now, the strong-armed measures are working to halt the slide. China’s main equity index has risen nine straight sessions — the longest string of gains in six years – including every day last week following the quant crackdown.
Longer term, the moves call into question whether quants will want to operate in a country with such arbitrary changes. The sector has surged in recent years, managing some 1.58 trillion yuan in combined assets. While the industry is dominated by domestic funds, international firms like Two Sigma Investments and Winton Group Ltd. have been expanding, along with DE Shaw & Co.
“After escaping the fire, don’t go back,” Li Bei, founder of macro hedge fund Shanghai Banxia Investment Management Center wrote on the company’s Wechat account Friday, warning investors not to pile back into China’s small stocks.
The changes pave the way for more consolidation, and it will be increasingly hard for smaller players to survive as state participants exert heavier influence.
“Quants need consistent market operating rules and regulations that hold through all market conditions,” said Dalma Capital’s Dugan. “That is not the case in China at this point.”
In their public comments, some Chinese quant fund managers have signaled their support for the measures, which they say will weed out risky players. They note that the US also limited short-selling during the global financial crisis, as have other countries. Yet the way China implemented the moves — the lack of consistency or transparency by using verbal “window guidance” to funds — will only deter global investors.
“The A-share market is so micro-managed, monitored and controlled by the administrators,” said Zhiwu Chen, a finance professor in Hong Kong and a former member of the international advisory board of the CSRC, referring to the domestic market.
Open Market
China’s securities watchdog said that the measures were targeted at “abnormal trading” and not to restrict stock selling.
“Stock market rises and falls, investors buy and sell, that’s the norm. Regulators do not interfere with normal market transactions,” the CSRC said in a statement Thursday. The regulator’s intention isn’t to “beat quants to death,” local media reported, citing a CSRC official.
Still, the trading panic dealt a blow to the image that regulators worked so arduously to craft over three decades, to convince investors that China was committed to a more professional and open market, in line with international standards.
Instead, the list of maligned industries keeps growing. Tech firms like Ant Group Co. have been reined in, while Wall Street banks face growing limits on data, giving them pause after years of expansion in the world’s second-largest economy.
Over the next decade, China needs “capital from the rest of the world,” said George Boubouras, head of research at K2 Asset Management Ltd. It’s “basically sent a signal that market transparency and the search for it is not allowed as much.”