The government-controlled Securities Association of China has instructed brokerdealers from 21 of the major brokerage firms to set up a nearly US$20bil fund (120 billion renminbi) that will be used to support stock prices by buying shares in China’s largest and most stable companies.

Separately on Saturday, 25 Chinese mutual funds claimed they would also put more money into shares. Although fund managers did not reveal the exact amount, they noted that they would be investing their own funds.

Saturday’s halt to IPOs could freeze large amounts of cash and dry up liquidity in the market, thus contributing to its stabilization, as large IPOs have been named one of the main factors triggering the current decline.

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The government has already taken a number of measures over the past week, including cutting interest rates, relaxing margin-lending rules, and adding bank liquidity, so far without any success in reassuring investors.

The Asset Management Association of China pledged to halt additional stock investments for at least a year, and later to accelerate the issuance of share funds after the freeze.

The IPO freeze will last until the Shanghai composite index reaches 4,500 points, Reuters reports. On Friday, the index fell by 5.8%, ending at 3,684 points.

Saturday’s halt to IPOs could freeze large amounts of cash and dry up liquidity in the market, thus contributing to its stabilization, as large IPOs have been named one of the main factors triggering the current decline.

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We have stated many times in these pages that China’s stock market is driven mainly by liquidity and much less by corporate operating performance. Therefore, in order to better understand what is driving prices at the moment we wanted to provide this brief background and our view on the stock market correction.

The China Securities Regulatory Commission (“CSRC”) is in ultimate charge of regulating the issuance, listing, trading, registration, depository and clearance of securities, and ensures that the operation of the stock market is in compliance with laws and regulations.

As way of background, China A-share IPO subscriptions need to be 100% pre-funded by cash (no margin loan) and allocations are done on a pro-rata basis via a lottery system (i.e. brokers have no discretion). Once you apply, your funds are put in escrow. Collectively, a large pool of money is out of the monetary system for short periods of time.

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The 1-day average performance of an IPO in this latest uptrend has been over 40% and it is not uncommon for an issue to be 1000 times over-subscribed. Even if you have to lock up funds for a short period of time, and only receive a portion of your order, that setup is akin to a lottery ticket if you are allocated any shares at all.

To put the degree of the math in place consider this: In the week starting June 14, the CSRC approved 24 IPOs to raise ~$6.5 billion. In turn, this effectively, even if only temporarily, locked up ~$1.1 trillion during the escrow period. The main IPO culprit was Guotai Junan Securities Co which listed on Friday. The capital raise for this brokerage equated to $4.9 billion and was the largest in China since 2010. The final numbers are not available but it is fair to say that hundreds of billions of dollars was locked up in escrow as part of their lottery system.

In an effort to clear a large backlog of IPOs created during an over-year long freeze in 2013, the CSRC doubled the pace of IPO approvals to ~20 per month in January, then doubled it again to more than 40 per month since April. This is the main problem that is impacting liquidity, not margin trading, in our opinion.

The pace of secondary issuance is even greater. In the first half of 2015, proceed from capital raises totaled over $70 billion, double the amount raised in all of 2014. (Source: Reuters, Business Insider)

Attached is the Bloomberg China IPO Index (BCIPO), a capitalization-weighted index which measures the performance of Chinese stocks during their first publicly traded year.

As you can see, following a ~32% correction off the highs, the head of the dragon has now been cut off. Not surprisingly, all 10 of this month’s worst-performing stocks in the broader Shanghai Stock Exchange Composite Index (SHCOMP) are IPOs from the class of 2015.

We highlight this because as much as sentiment has turned negative, even at the local level, the risk is that the correction triggers one of two outcomes: a suspension of IPOs or an acceleration of a restructuring of the lottery system. Both of which would be constructive and portend to higher equity market prices going forward.

Now before dismissing this rationale as overly optimistic, we would note that the CSRC has suspended IPOs eight times in the history of the yuan-denominated A-share market, five of which were imposed since 2000 (Source: Xinhua News Agency, Bloomberg). The last moratorium was enforced in late 2012 and not lifted until December 2013.

For the avoidance of doubt, while we are mindful that the local equity markets on Monday rejected the large monetary stimulus provided over the weekend, we are not in the camp that believes the “bubble has burst”. We simply believe it is a function of liquidity and timing of IPO’s. For example, the CSRC approved another 28 IPOs on Friday to hit the market in the next two weeks and the liquidity required to be placed in escrow and absorb the issuance is larger than the monetary stimulus provided over the weekend.

To be fair, in order to restore confidence, ideally we would like to a see a similar situation that occurred at Central Huijin Investment Ltd at the beginning of the month. As a reminder, one of the top three catalysts for the start of the correction, alongside an increase in bank margin requirements and large IPO issuance, was the news that Huijin, the domestic investment arm of China Investment Corp (CIC), sold some of its holdings in Industrial and Commercial Bank of China and China Construction Bank.

Following a sizeable sell-off in A-shares Huijin said the next day in a short statement that President Xie Zhichun has stepped down with the board’s approval. Huijin didn’t explain the personnel change nor name a successor. The Beijing News cited a source as saying…… Xie will go to Shenzhen University to teach, denying that his departure had anything to do with last week’s crash. (MNI)

We have no edge in whether there was any truth to the “teach in Shenzhen” story, or whether that is just a Chinese code word for “he will work in a prison camp until he dies”. For his sake, we hope it is the former – although we suspect it may be the latter.

To continue reading the full commentary from Rareview Macro LLC, please click here

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BrokerDealer.com update is courtesy of extract from coverage from TreasuryToday.com. consequent to Monday snafu at the Shanghai Stock Exchange , when China’s stock trading was so abundant that the Shanghai Stock Exchange’s software was unable to properly display the turnover data – apparently there were too many zeros to factor in.

Turnover on the Shanghai Stock Exchange exceeded 1trn yuan ($161.28bn) for the first time on the 20^th April, but the country’s trading fever hit the news for a different reason – the exchange’s software was not designed to report volumes that high and, as a consequence, the data couldn’t be displayed properly.

A statement released by the Shanghai Stock Exchange confirmed that “this is software configuration issue, not a technical glitch.” It continued to explain that current software package, called SHOW2003, would need to be replaced in order to handle the higher volumes of reporting. Trading and price quotes for individual stocks were not affected, however.

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Resolving the software issue will be of upmost importance given the rapid growth of China’s stock market, which has nearly doubled over the past six months. The Shanghai Stock Exchange is now the world’s biggest in terms of turnover, totalling $1.85trn in March this year – surpassing the New York Stock Exchange which had a turnover of $1.53trn for the same month.

The last time this kind of software story was in the news, it was under very different circumstances: namely when the US national debt clock went past the $10trn mark in 2008. The upgrade to fix that glitch saw two extra digits added to the clock in anticipation of the country’s burgeoning debt.

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A week after China allowed foreign investors to bet against shares on the mainland, no one had taken up the challenge. Industry officials say the rules that govern how the short selling should be done make it nearly impossible to bet against the stocks.

The opening of Chinese shares to short selling came as part of the Shanghai-Hong Kong Stock Connect, which gives foreign investors unprecedented access to China’s main stock market in Shanghai. The connection opened in November and trading volume has been weak in its initial months.

Regulators approved short selling via Stock Connect beginning on Monday, and no shares were sold short during the first week of trading, according to data from the Hong Kong Stock Exchange.

Asked whether Stock Connect currently permits short selling of shares, Andy Maynard, global head of trading and execution services at CLSA said: “In theory, yes it does. In practice, no it doesn’t.”

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According to the Stock Connect rules, shares must be loaned out by exchange participants, which generally means brokers. But they typically don’t have shares to lend, instead those shares generally come from custodians or asset managers. And loans of shares between companies—even if they are affiliates of the same bank or fund manager—are prohibited.

“There’s no way you can get the stock into the exchange participant account for that exchange participant to be able to lend to the Street,” CLSA’s Maynard said.

Hong Kong Exchanges and Clearing chief executive Charles Li said that he didn’t know why no shares were shorted in the first week, but that the exchange was “not concerned”.

He acknowledged that the rules made it difficult to short in China. “Only brokers and broker affiliates can participate. If they’re not able to lend, there’s not a lot of shares to borrow from,” Mr. Li said

For the full story from the WSJ, please click here

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Image courtesy of Yip/Reuters

O’Connor, the UBS-owned hedge fund with AUM of $5.6bil is just one of the financial industry firms ratcheting up their presence in Asia as China’s stock market prepares to open its doors to foreigners. Dealers have been hired by it from UBS’s proprietary trading desk and Singapore offices. In August, it hired John Yu, a former analyst at SAC Capital Advisors. But O’Connor is not alone.

Bankers, brokerdealer brokerage firms and hedge funds all have been gently expanding their Asian businesses to benefit from a single event: the largest launching into China.

China intends to join the Shanghai stock exchange to its counterpart in Hong Kong over the following month as part of an initiative announced by Premier Li Keqiang this year to open China’s markets to foreign investors that have been largely shut out.

The move will enable foreign investors to trade the shares of firms listed on the Shanghai stock exchange directly for the very first time, and mainland Chinese investors to buy shares.

An open market between the mainland and Hong Kong’s potential rewards are tremendous for investors. Now, the only method for foreign investors to trade stocks that are Chinese is indirectly via a restricted quota plan that allows a trickle of foreign money to the nation.

“This is the single most significant development in China’s aim to internationalize this market,” one senior Western banker in Asia said of the planned reform, speaking on the condition he not be named because he was not authorized to speak freely in the problem.

The application, called Shanghai-Hong Kong Stock Join, will create the second-biggest equity market in the world in regard to the market value of the listed companies that were combined, said Dawn Fitzpatrick, the chief investment officer of O’Connor. The biggest stays the NY Stock Exchange.

“It is additionally likely to develop a more efficient method for the global marketplace to value many Chinese businesses, which aspect alone makes the market more attractive,” she added.

Officials have now been aiming for sometime, although the formal starting date for the plan hasn’t yet been announced. Employees at brokerage firms have been working additional weekend shifts participating in mock trading sessions to examine their readiness for the brand new plan. On one recent weekend, 97 brokerage firms simulated a failure of their copy data systems for the Shanghai-Hong Kong two way trade.

O’Connor, for the part, is among a little group of hedge funds that have participated in the quota program, named the qualified foreign institutional investors plan. They sell and buy shares denominated in both renminbi and Hong Kong dollars.

The wide open connection allows hedge funds like O’Connor to enlarge their business between both exchanges and trade directly. Still, challenges remain, and some significant questions have not been answered.

This program is portion of a more comprehensive reform package announced by President Xi Jinping a year ago. Critics point to other reform initiatives, such as the construction of planned and new free trade zones, that have already been slow to take off.

Last September, regulators in Shanghai agreed to let a small group and British hedge funds raise from Chinese investors within a pilot program. Any of these businesses has complained that progress continues to be slow and weighed down by bureaucratic hurdles.

Linking the Shanghai and Hong Kong exchanges is not a brand new thought. In 2007, Hong Kong officials declared a strategy that was similar allowing Chinese investors to achieve access Hong Kong’s stock market. That plan never took off.

And while foreign and Chinese investors will have the chance to buy hundreds of companies that have been formerly off limits, they will be limited by quotas. The combined two way trading volume will soon be limited at 23.5 billion renminbi ($3.8 billion), about 20 percent of the combined average daily trading volume on both markets. Individual mainland Chinese investors will need at least 500,000 renminbi in their brokerage account to purchase Hong Kong shares, a brink that excludes retail investors.

Foreign buyers will be unable to buy shares and sell them on exactly the same day. It remains uncertain whether they’ll be permitted to take part in short-selling or to purchase shares using margin funding. And, in renminbi, all trades will likely be settled in another hurdle, introducing added risk for foreign investors.

Additionally, there are unresolved dilemmas over taxes. Foreign investors are liable for paying capital gains taxes, but

China has not taxed such investments under the existing quota scheme.
Given these and other uncertainties, businesses which compiles indexes which are monitored by funds with trillions of dollars invested in stocks have so far declined to add mainland Chinese shares in their own indexes.
That could change just as next year, when MSCI is scheduled to review shares that are Chinese.
“Were China’s domestic A-shares to be contained in the MSCI benchmarks, it will be a game-changer, bringing billions of dollars of capital,” analysts at HSBC in Hong Kong wrote this month in a research report.Regardless, some investors are pushing.

Charles Li, the chief executive of Hong Kong Exchanges and Clearing, the stock market operator, has been forthright concerning the limitations of the trading program.”It’s not perfect,” Mr. Li wrote in a post on his official blog last month. “While we’ve managed to find a solution to all the challenges of aligning two very different markets, a few of the differences were so critical that our alternatives will necessarily constrain the market.”

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