China Snowball Derivatives and their Potential Losses

USD13 Billion worth of China Snowball Derivatives are approaching loss levels as the ongoing route of China’s stock market is pressurising these structured products, threatening to raise market volatility. Indeed, over the years snowballs have attracted China’s wealthy and institutional investors, but a rapid decline in the Chinese stock market is now exposing risks to these derivatives hitting loss-triggering levels. But what exactly are “Snowball” derivatives?

A Snowball product is a structured hybrid derivative which pays a bond-like coupon and consists of additional options on basic financial assets, which include underlying assets such as stocks or stock indexes. The word snowball derives from the fact that coupons can be rolled over and coupon pay-outs rely on the underlying asset trading within a certain range. 

Currently, experts are advising that circa USD4.2 Billion (Yuan30 Billion) of snowballs that are tied to the CSI 1000 Index* are approaching levels that trigger losses at maturity, whilst another circa USD8.4 Billion (Yuan 60 Billion) are between 5 and 10% away from their knock-in** thresholds. This week on Wednesday 15th January, the CSI 1000 index closed at its lowest level since April 2022. 

*The CSI 1000 Stock Index – This index is composed of 1,000 small and liquid stocks of all A-shares, excluding the CSI 800 constituents (follows the 800 largest stocks by free-float market cap and represents large and mid-cap A-share stocks). It reflects the stock price performance of a group of small-cap companies in the Chinese A-share market. 

**Knock Ins – There are two types of knock-in options: down-and-in and up-and-in. The former (currently China’s problem) is triggered if the underlying asset price falls below a certain level and the latter is triggered if the underlying asset price rises to a certain level. 

During the Covid-19 Pandemic, snowballs gained in popularity among the wealthy Chinese and asset managers, with brokers typically offering such grand returns or coupon rates of between 12 and 20%. 

Between February and April 2023, many of the outstanding snowball derivatives were issued, and since then the CSI 1000 has fallen by circa 22%, and for those who bought a one year contract with an 80% knock in last February, if there is no rebound in the market, next month they may be holding some serious losses. 

Despite government efforts to kick-start the stock markets by halving stamp duty on stock trades (August 2023), or their own exchanges launching new blue chip benchmarks where sectors such as chip manufacturing or renewables are granted greater weightings, sadly for snowball holders such small measures have failed to work with many investors now looking elsewhere. Unless the government engages in the type of quantitative easing as seen in the past in Europe, the United Kingdom and the United States, there is little else the government can do to stop the pessimism that is sweeping through the stock markets, signalling losses for many snowball holders.