China's crossroads

September 25, 2015 01:00 PM

Current volatility in the Chinese stock market may have come to many as a shock. The 35% price crash did not come after a period of stagnation, but rather on the back of one year of steep price increases of more than 100%. Former U.S. Federal Reserve Chair Alan Greenspan would have likely called it “irrational exuberance.” 

It is a traumatic event for the Chinese economy, but rest assured that the rest of the world has seen a few of these, lived through and learned from them. China can do the same. After Hong Kong’s 1973 market crash, the Hong Kong government strengthened the market surveillance and unified the four exchanges. After the U.S. stock market crashed in 1987, the Fed provided money to banks to lend to people, which probably stopped the panic and prevented more serious problems. 

People usually emerge from a disaster with either a post traumatic disorder requiring a long healing process, or experience a re-birth; gaining insight, strength and wisdom. There is no need for China to panic. Economic cycles are part of the market-based economy. 

For an experienced observer, stock prices were too hot and just needed to cool off. The nominal GDP of China did not grow 100% or even 50%. The overpriced stock market needed a correction to get closer to fair valuation. Not unlike with tectonic plates, the upward pressure had built up steadily during a year before it snapped back in a few days causing tremor waves. 
The stock market did not have a valve to let the steam off gradually.

Chinese financial markets are very young and perhaps lagging behind the country’s economic success. For financial markets to be efficient and able to reflect fair valuation continuously without major hiccups, they must be as complete as possible. They need to have four things: 1) exchanges providing low cost transparent financial transactions; 2) a complete set of financial instruments; 3) diversified market participants, including sophisticated market makers providing fair pricing; and 4) effective regulation that enables seamless commerce with low cost and risk.
transparent low-cost transactions

China has already quite a few functional exchanges. They are well capitalized and have resources backed by the government. The role of an exchange is not only to provide a platform for buyers to meet sellers, but also a platform for a fair price discovery process. Overvaluing is not any better or any worse than undervaluing. Exchanges are central places where transparent commerce happens, ideally continuously at low cost and low risk. Exchanges around the world innovate and roll out contracts that are mutually beneficial for participants. Chinese exchanges need to do the same.

Complete set of financial tools

China lacks whole classes of financial instruments that would allow a transparent fair price discovery process. 

For example, what can you do when you see an overpriced stock? Currently, there is no effective way for the rational investors to express their point of view except waiting for its price to collapse. But if you could sell it, or hedge it with an exchange-traded option, you could perhaps prevent extreme overpricing and the inevitable crash. You would help others to save money buying the stock cheaper. Just like Ying and Yang, the market needs two forces to achieve equilibrium and have true price discovery.

China Financial Futures Exchange (CFFEX) already lists stock market index futures contracts that allow investors to offset some of their long exposure to the market cost-effectively. But taking a long or short position in index futures requires significant capital and encompasses taking significant market risk. Index futures are linear instruments and thus cannot function as insurance. 

When there are options listed on the index futures, investors will be able to buy them as insurance to lower their portfolio volatility. Investors long stocks could buy puts to offset losses when stocks decline. Sellers of the options — typically sophisticated market making firms — need liquid index futures to actively balance their competitive options pricing. 

Besides insurance function, options allow firms to fight miss-valuation by taking directional position at lower cost with lower or limited risk than by taking position in outright futures. This allows more firms and individuals to participate in the important and delicate process of price discovery. Fair pricing removes uncertainty. Lower uncertainty implies lower volatility, which is good for the health of markets and the economy.

Diversified market participants

China not only needs a complete set of financial instruments and good financial data, but also a set of capable sophisticated firms that can price these instruments effectively and competitively and make positive impact on fair valuation. Without having a long history of financial markets it is natural to have a shortage of these kinds of firms with know-how and technology and buying power and interest in indirectly performing a function of fair market valuation by buying undervalued and selling overvalued instruments. For example, sophisticated investors may value a company’s stock as an option on equity of the company, taking into account its debt structure, expected cash flow, expected earnings and its expected variance. 

Effective regulation 

China has resources to make its financial markets more comprehensive, to keep its markets transparent and to breed top quality financial firms with top financial technologies so that they can perform functions of effectively policing markets. 

About the Author

Milan Kratka is the managing partner of ArbHouse, LLC, a fast technology market making and quantitative trading financial firm in Chicago. Previously he built pricing and trading models at TradeLink and worked as a quant at Citadel. Kratka gained his PhD at the University of Chicago.

Carmen Li is President of the Chinese Derivative Association. Previously she was senior analyst at DRW trading. Li has a degree in Finance and Computer Science from the University of Illinois and is currently completing her MBA at Harvard Business School.