New derivative products on the Chinese markets are attracting the high-frequency traders, notoriously known in the U.S. and Europe as flash boys.
The new derivative tools are intended to help investors hedge risk, but they also make possible complex and sophisticated trading strategies that can generate quick profits, which injects more risk into the markets.
Hedge funds and brokerages are putting computer servers “onto trading floors to gain precious microseconds dealing in new options and futures contracts, helping China’s CSI300 index become the world’s most traded equity futures contract in May,” said Reuters.
With China’s stock market being highly inefficient, the potential for high returns from these inefficiencies is staggering. The problem, of course, is some of these strategies can cause horrific disruptions on stock markets, and have been blamed for the recent “flash crashes” in the U.S. And that’s where derivatives have existed for decades.
Throw in the fact that the Chinese derivative markets barely existed five years ago and that these traders and strategies are virtually untested in that country’s markets and it looks like a recipe for disaster.
“Currently, there are many hedging tools in the market, but liquidity and stability is still a problem the hedge fund industry needs to address,” Hong Lei, deputy head of China’s Asset Management Association, told an industry forum last month, according to Reuters.
So far this year, China has launched two futures instruments, as well as, ETF options. It also plans to roll out more hedging instruments, including single-stock options, in the near future. Meanwhile, local governments are throwing up “hedge fund towns” in an attempt to lure skilled fund managers
Some Chinese nationals who started their careers on Wall Street are coming home to set up hedge funds that use high-frequency trading. This trading automated strategies to execute thousands of transactions per second, aiming to generate giant profits from small movements in prices.
However, these strategies may run into some roadblocks, because Reuters reports exchanges have mechanisms for fending off transaction floods.
“Watching transactions pour in too fast, you can see the exchanges slowing them down,” an exchange regulator told Reuters on condition of anonymity.