Hedge funds now begin facing more unexpected margin calls as Chinese stocks soar, a Bloomberg analysis shows.
China’s largest stock market rally in over a decade is putting significant strain on the country’s quantitative hedge funds.
As stock prices continued to rise earlier this week, quants that short index futures as part of their market strategies faced additional margin calls, per Bloomberg.
Sources familiar with the situation, who wished to remain anonymous, noted that while the volume of margin requests was generally lower than on Friday—when an exchange glitch complicated cash-raising efforts for funds—some fund managers communicated to regulators their need for more time to meet these margin requests, highlighting the intense pressure they were under.
Some were able to fulfill initial margin calls before deadlines to prevent liquidations, according to the reports.
‘Market-neutral’ strategies, which involve holding long positions in specific stocks while shorting stock index futures, experienced drawdowns of 3% to 5% points last week.
These declines are particularly challenging for quants still recovering from a market downturn in February.
According to Liangkui Asset Management, which manages around 3 billion yuan ($428 million), a combination of factors, including a “rare technical exhaustion of liquidity” in the Shanghai market, contributed to the turmoil last week.
Brokerages began closing the short index futures positions of clients who could not meet margin requirements, which Liangkui Asset described as “the last straw” in a letter to investors shared with Bloomberg.
The fund reported an average drawdown of 1.5 to 2.5 percentage points.
These losses stand in stark contrast to a 13% gain in the benchmark CSI 300 stock index since Friday, marking the largest two-day increase since September 2008.
As the surge in index futures outpaced gains in the underlying stocks on Friday, it created paper losses for some quants’ hedging positions.
When brokerages closed the short positions, it further pushed up index futures, exacerbating the short squeeze as investors anticipated a continued rally.
Managers believe that the significant premium on index futures is likely to decrease, which could help quants recover some of the unrealized losses on their hedging positions.
Typically, China’s stock index futures trade at a discount to the underlying indices, an essential element of the hedging costs in market-neutral strategies.
Meanwhile, their long-only strategies, such as enhanced index products, have understandably benefited from the market rally.
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Illegal short sellers will now face life sentence in prison after the National Assembly approved the amendment.
The National Assembly has approved an amendment to the Capital Markets Act aimed at enhancing penalties for illegal short selling, per Business Korea.
Under this new law, individuals who profit illegally from short selling exceeding 5 billion won (around $3.79 million) could face severe penalties, including prison sentences of up to life imprisonment.
On September 27, financial authorities confirmed that the amendment, designed to overhaul the short selling system, passed the National Assembly on September 26.
The legislation mandates that institutional investors must establish an electronic short selling system, and both institutional and corporate investors are now required to implement internal control standards.
Approximately 101 companies, representing 92% of domestic short selling transactions, must adopt these electronic systems.
These firms will also be obligated to report stock balances and over-the-counter (OTC) transactions to the exchange, increasing their compliance responsibilities under the newly instituted central monitoring system.
Securities firms will need to annually verify the internal controls and electronic systems of institutional and corporate investors, following a checklist, and report the findings to the Financial Supervisory Service (FSS).
Non-compliance could result in fines of up to 100 million won.
To standardize short selling conditions for individual and institutional investors, the repayment period for loan transactions related to short selling will also be constrained.
Violations of this rule will incur fines of up to 100 million won, with loan terms extendable in 90-day increments for a maximum of 12 months.
Additionally, the amendment seeks to deter repeated illegal short selling by increasing administrative penalties.
Fines for unfair trading and illegal short selling will rise from three to five times the illicit profit to four to six times.
Offenders earning over 5 billion won from illegal short selling may now face the same enhanced prison terms as those engaging in unfair trading.
Administrative sanctions will be broadened, allowing regulators to restrict trading of financial investment products for up to five years and limit the appointment or reappointment of executives at listed companies.
This aims to tackle the high recidivism rate among financial criminals by effectively barring them from the market for a specified duration.
To combat the concealment of illegal profits, accounts suspected of being involved in unfair trading or illegal short selling can be frozen for up to six months, with a possible extension of an additional six months.
The amended law will take effect on March 31 of next year, providing time for the implementation of the electronic short selling system, which is expected to be operational by then.
However, restrictions on trading financial products and executive appointments will begin six months after the law is enacted, following public consultations.
Upcoming revisions to the enforcement decree will lower the short selling disclosure threshold from 0.5% to 0.01% of outstanding shares and reduce the collateral ratio for individual short sellers to match that of institutional investors, with completion expected by next month.
A representative from the Financial Services Commission (FSC) noted that limiting the loan repayment period for short selling transactions to 12 months, along with finalizing amendments to the Financial Investment Business Regulations, will lower the collateral ratio for individual short sellers from 120% to 105%, leveling the playing field.
The FSC official added, “With the electronic short selling system set to launch in March, the improvements to the short selling framework will be fully realized.
Our goal is to restore investor confidence and enhance the competitiveness of the South Korean stock market.”
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Also Read: Glitch Now Traps Hedge Funds In A Massive Short Squeeze
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