Are we making a mountain out of a snowball?

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The latest favourite derivatives contract among journalists is the snowball. It’s a high-risk product that looks low risk, offers supposedly all-weather income unless there’s volatility or a bear market, and often comes with leverage levels that invite a total wipeout. The name is intended to suggest a gradual roll-up of returns but also invites avalanche metaphors, which is a gift for headline writers.

Having previously been associated with some legendarily dumb trades, the snowball structure has been sold more recently to investors in crypto and (more significantly) Chinese equities. As the South China Morning Post reported last week:

A slow start to the year for Chinese stocks has exposed some obscure financial derivative products, which investors blame for exacerbating the slump.

Many of the so-called snowball products tracking the underlying CSI Smallcap 500 Index and the CSI 1000 Index have breached preset levels that trigger forced sales of futures contracts, amplifying the panic and fuelling sell-offs on the stock market.

Equity-market snowballs are effectively put options with upper and lower barriers. Buyers of the OTC contracts pay their brokers only the margin and will receive a bond-like coupon until the maturity date, normally two years hence, so long as the underlying index stays rangebound.

If the index doesn’t stay rangebound, there are several possible outcomes. Trigger event definitions and levels vary from contract to contract, but generally speaking, the daily flow chart might look something like this:

Meaning:

1. If the underlying index rises through an upper barrier, known as the knock-out price, the contract terminates early and investors are given a one-off payment at some pre-agreed level, such as one annualised coupon.

2. If the index falls below the contract’s lower barrier, known as the knock-in threshold, all further coupons are cancelled but the investor’s deposit isn’t touched.

3. If the index has ever been below the knock-in threshold in the life of the contract then at maturity, the investor has to pay the difference between the index buy-in price and the prevailing price.

4. Even if the index recovers in full after a knock-in, the most the investor gets at maturity is their principal.

5. That’s unless the index rallies enough from the knock-in price to hit its knock-out price, in which case the snowball terminates as normal and the investor is compensated per scenario 1.

Whatever happens, snowball issuers ought to be fine. They benefit from high volatility because they’re making money from index arbitrage and similar strategies, so while bear markets make their life more difficult, their positions don’t become loss making automatically.

The issue highlighted by recent coverage is that when setting up the snowball contract, the broker will typically go long futures that can be sold if the index reaches the knock-in level. According to reports, selling of these index futures by brokerages is creating a negative feedback loop. This unwind of longs has been blamed in part for the latest leg of a Chinese market sell-off, with the Shanghai Composite Index down 7.5 per cent year to date.

But index futures sales won’t directly affect share trading, snowballs are structured to discourage investors from booking losses mid contract, and any broker with the right hedges in place shouldn’t be forced into liquidating positions. Does any of it add up? JPMorgan analyst Jemmy Huang isn’t convinced:

First, the forced liquidation [from a knock-in event] would only happen upon maturity, which is spread out over different time horizons, rather than as soon as the knock-out level is triggered. So there should be in theory no material selling pressure on any single day. Second, there is no official data on the scale of aggregate ‘snowball’ products but we estimate outstanding balance should be RMB20-40bn at individual leading issuers, largely in line with news reports (Sina, STCN) that nominal contract balance for snowball products should be RMB200-300bn in aggregate, roughly 10% of outstanding OTC derivatives nominal contract balance as of Sep and immaterial compared to RMB70/62trn of total/tradable A-share market cap.

Chinese regulators tightened restrictions on the sale of snowballs in 2019 and again in 2021, which restricted the market’s growth. JPMorgan estimates that among mainstream brokers, the contracts should account for “no more than mid-teens of overall OTC derivatives businesses”, and that the few private banks to sell the products are acting as distributors. Their risk is mostly reputational.

Neat explanations for market stress are always compelling, particularly when they involve funky sounding derivatives favoured by Chinese HNW mainlanders. In this case, however, the story may have snowballed.