Snowballs or Ice Shards: the derivatives market latest craze

Many people, children and adults alike, love snowball fights. It is the ultimate game understood by everyone, who has ever witnessed snow. People may not know how to play “Uno” or “Monopoly”, but everybody can form a ball and throw it at a friend. Besides its simplicity, the game is also a great deal of fun. The invigorating feeling when you get someone right on the hat, the joy of victory, even if there is no way of winning, and of course the rush of battle. All of this ends though, whenever a deceitful ice shard professing as a snowball hits someone in the face. In that moment the scene of a childish game might turn into a bloody mess and ruin the fun for all those involved. Bad right? Well what if I told you that something similar is happening in the Chinese derivatives market and that in this case instead of a bloody nose someone will get a 40 billion dollar loss? Today we will discuss the current developments in the Chinese derivatives and stock markets caused by the so-called snowballs and see if they might really be Ice-Shards poised to cause a wide wipe-out of wealth. 

But first let us talk a little about what derivatives are. In general, they are a type of financial contract, between two parties, whose value depends on the underlying assets. This asset can be anything: a stock, a market index or even just a benchmark, like the interest rate in a certain country. Most derivatives are over the counter(OCT) i.e. those contracts are being traded without being listed on an exchange, which means that they are less regulated than normal securities. 

The hero of our story, the snowball is a particular type of derivative that became popular in 2020. More than anywhere else it gained traction in China, where most snowballs are tied to the CSI1000 and the CSI500, two large indices consisting of small to middle cap, liquid A-shares stocks. The general idea is that as long as the market is not too volatile or too depressed the investor will receive a daily coupon payment, which over a year add up to about 15% of interest rate. This compounding effect and the daily payout are what gave snowballs their name, relating to the “roll-up” of dividends. There are two crucial numbers for any snowball : the so-called knock-in and knock-out rates, which respectively represent the maximum percentage decrease and increase in the underlying index from the beginning of the contract. If the index is knocked-out your derivative is void and the broker pays out a certain predetermined amount of money. If, however, a knock-in takes place, all of your coupon payments are canceled and if the index is below the initial price you not only lose your deposit but also owe your broker money. This complex structure makes the value of a snowball hard to estimate, but as long as the knock-in and knock-out are relatively widespread, buying them is like betting on the stability of the market. Because of this, many Chinese brokers marketed them as a completely safe way of receiving a high interest rate, some even going as far as comparing them to bank deposits. However, considering the fact that for most snowballs the knock-out rate was only a 3% growth in the underlying index, this “safe bet” reveals to be as safe as letting your wallet navigate a minefield. Nevertheless, the promise of high interest rates was too alluring for many retail investors to resist, they bought snowballs like there was no tomorrow and the market grew to over 45 billion dollars in 2023. And certainly this great rise would have continued, if only not for one unfortunate development. 

Between January 2nd and January 22nd 2024 the CSI1000 and CSI500 have decreased by 14.6% and 11.6% respectively. Which caused a wave of knock-ins to happen. And for a snowball-investor there is no darker nightmare than the knock-in. You see if your contract is knocked-out you lose some portion of the money but it does not wipe you out. With a knock-in however you risk not only losing your deposit (so a 100% loss) but also end up owing money to your broker. But because this rate is set pretty high, usually investors spend more time thinking about the knock-out. Ironic, isn’t it? Well this is not where the party ends. In order to hedge their positions against the risk, brokers take on futures contracts for the same indices as the snowball. So when the snowballs started knocking-in the brokers started selling their futures, depressing the market and causing a maximum daily decrease of 10% for the CSI1000 futures. In turn, this development further decreased the index, which caused another wave of knock-ins. Estimates suggest that around 40% of the contracts have been affected, which converts to a potential loss of wealth of about $20bn. 

The Securities Association of China, a regulatory body with oversight of the derivatives market, stated that the risk of a further meltdown was under control and that only about 7% of the snowballs have reached their knock-in levels. It is unclear however how this number came to be and so investors are highly skeptical. The association also added that this crisis will not lead to a repetition of April 2020, when over a month the CSI 1000 declined by over 20%. Nevertheless, the index continues its decline, as of the moment this article is written the CSI1000 declined by 21.86% compared to the 2nd of January. If this trend continues in the next weeks, even more snowballs will reach their knock-ins causing further pressure on the futures markets and with that on the indices. Combining this with the fact that in 2023 the Chinese stock markets lost over 4.6 billion dollars in net outflows, it is unclear if any of the indices will be able to recover in the foreseeable future, likely causing the investors to take a big loss. 

Overall, the story presents a cautionary tale. It is not the first time, when retail investors were lured into buying a novel and complex financial product by promises of stable, high interest rate. And it is definitely not the first time that this has caused these investors to lose money. For the people unfortunate enough to have invested in the “ice shards”, the only thing to do now is count their losses and hopefully learn a lesson. For others, who will undoubtedly follow a similar path in the future whether it will be with 0DTE or crypto ETF’s or some other new and shiny tool, remember the words of the great british investor Sir John Templeton: “The four most dangerous words in investing are, it’s different this time.”

About this article

Written by:
  • Mikhail Muradov
| Published on: Feb 14, 2024