Date Submitted: 06 Apr 2017
WHAT’S THE INVESTMENT ISSUE?
In the summer of 2015, Chinese regulators aggressively tightened fairly lax trading rules in the country’s stock index futures market in the midst of a chaotic crash. The move, an effort to tamp down rampant speculation and manipulation, was widely criticized as an overreach. With margin barriers thrown up higher and position sizes significantly capped for nonhedgers, speculators all but vanished (a desired outcome); however, so too did volume, which decreased nearly 100%—not exactly a best-case scenario. “China has killed the world’s biggest stock index futures market,” Bloomberg wrote in September 2015. Illiquidity in the market for futures tied to the China Security Index 300 “was causing problems,” the Financial Times said. In hindsight, it’s worth asking: Were these regulations, while apparently necessary, nevertheless ill-advised? No, assert the authors, who do not gloss over the fact that liquidity was severely impacted. What they do emphasize is a rather counterintuitive finding: A market in which liquidity has ground to a halt does have an upside.
HOW DO THE AUTHORS TACKLE THIS ISSUE?
Eugene Fama’s efficient market hypothesis (EMH) holds that stock prices immediately and inherently reflect all available information such that there’s no predictive power to be gleaned, i.e., it’s all randomness at play. EMH has been endlessly tested and re-tested since it first emerged in the 1970s at a time when low-cost passive management was coming on the scene as a disruptor to active management. Several testing methods were used to batter/gut-check EMH. Prominent among them was the variance ratio (VR) test, put to use, alongside other tests, by authors Lin and Wang. They set out to measure the efficiency levels of the Chinese stock index futures between July 2015 and September 2015. During this period, a slew of rule changes were implemented, making it harder to trade index futures, a prevalent means of speculating, hedging, arbitraging, and as it turned out, carrying out manipulative schemes, e.g., pump-and-dumps or coordinated bear attacks. The futures market plays a major role in price discovery in the broader spot Chinese stock market. Prior to the change, rules for stock index futures trading were indeed loose and transaction costs were low. Leverage was plentiful and dangerously easy to access. When all of these conditions were curbed via tighter rules, something interesting happened. Yes, volume collapsed. But what happened to the market’s efficiency?
WHAT ARE THE FINDINGS?
The results of VR tests (and Granger causality tests) were puzzling. Although the authors thought they would find that regulatory tightening had a detrimental impact on market efficiency and price discovery, just as it had on volume and liquidity, it did not prove to be the case. To the contrary, the VR testing found that absolute VR levels of Chinese index futures’ five-minute returns went from roughly 2.70 before the rule change to around 1.0 after—a decrease of more than 50%. In other words, markets became more efficient in the post-tightening study period. With volume and liquidity in such a freefall, why would that happen? It is possible, explained the authors, that in low liquidity environments trading mainly occurs among the most knowledgeable institutional investors. Speculators and manipulators fall away. So we’re talking about very light trading—but among very well-informed participants free from the distractive din of the less informed. This hypothesis requires testing. If additional data was available, it would be an interesting topic for further research, according to the authors.
WHAT ARE THE IMPLICATIONS FOR INVESTORS AND INVESTMENT PROFESSIONALS?
“Regulators can be helpful in a bad market state,” the authors said, noting that at the time the rules were imposed the stock futures market had been overrun by unchecked manipulators who were abetted by low barriers to leverage and the ability to upsize. The regulatory goal of squeezing nonhedgers out of the market was met. Authorities drastically reduced excessive manipulation—without unintentionally creating a less efficient market. Co-author Hai Lin explained in an email: “While extreme regulations do not happen often, that doesn’t mean that their potential can be ignored.” Regulations can tighten in stressful environments—or in other words, right when investors might be most inclined to employ hedging strategies. In developing risk management strategies, investors need to view regulatory conditions as a factor that can vary over time. ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
Summarized by Rich Blake. Rich is a veteran financial journalist who has written for numerous media outlets, including Reuters, ABC News and Institutional Investor. The views expressed herein reflect those of the authors and do not represent the official views of CFA Institute or the authors’ employers.