In June 2015, the Chinese stock market, the second-largest in the world, hit an all-time high. Any market peak can mean that a correction is due, but few expected the crash that evaporated 40% of the market’s value in one month. The speed and intensity of the event led to comparisons with the 1929 crash of the U.S. stock market.
What turns corrections into damaging panics? In both 1929 and 2015, excessive leverage was believed to have contributed. In rising markets, leverage allows investors to boost returns dramatically. However, if markets fall, particularly if they fall sharply, highly leveraged investors may be forced to sell, causing prices to drop further and leading to a downward spiral. A critical mass of such excessively leveraged investors creates a fire sale.
While the principle has been understood for a long time, the 2015 Chinese market crash created an opportunity to ground the idea in empirical research. Yale’s Kelly Shue, with Jiangze Bian of the University of International Business and Economics, Zhiguo He of the University of Chicago Booth School of Business, and Hao Zhou of Tsinghua University, combed through account-level data from hundreds of thousands of investors to understand the various factors that created the crash.
“[W]e were interested in studying the Chinese market because it’s an example of what happens when fintech and innovation get ahead of government regulation,” Shue says. Margin trading—where leverage is part of the trading strategy—is highly regulated in China. However, fintech platforms created a shadow sector where average retail investors were able to trade with leverage as much as 20 to 1. “Because the Chinese government believed that the shadow sector was partly responsible for the crash, it seized the data from some shadow lending platforms and allowed us to analyze it.”
Shue talked with Yale Insights about the research, the long-standing potential of leverage-induced fire sales to cause market crashes, and the impact of new investing technology.
Q: What is a leverage-induced fire sale?
A leverage-induced fire sale requires two pre-conditions. First, a number of investors or financial institutions have to borrow a lot relative to the amount of equity or cash that they put in, and second, there has to be a maximum leverage limit.
Then a negative shock, even a small one such as a government announcement that it plans to tighten regulations in the future, can trigger the highly leveraged investors to sell assets so that they don’t hit their leverage limits.
These sales then depress asset prices. The depression in asset prices feeds back because it makes already leveraged investors even more levered. They need to continue selling assets but as they sell more, prices keep falling, so they have to keep selling. This can lead to a devastating downward spiral—a leverage-induced fire sale.
Q: Can anything be done to stop the spiral?
One thing that governments can do is regulate leverage in the first place in order to reduce the risk of this type of fire sale occurring.
Once a fire sale starts, the key is restoring confidence. A fire sale is defined as a drop in prices below their fundamental value. Once liquidity returns to the market, the price should go back up to reflect the asset’s fundamental value.
What governments often do to stem the spiral is engage in buy orders to support prices. It doesn’t need to be the government; deep-pocketed investors who believe that the drop in prices is a fire sale rather than a drop in fundamental value should come in and buy assets at depressed prices.
Once there is a restoration of confidence, injecting liquidity into the market will cause prices to go back up.
Q: What role have leverage-induced fire sales played in past market crashes?
Downward leverage spirals are believed to be one of the main triggers of the 1929 U.S. stock market crash. At that point, margin trading was unregulated, and many margin investors sold suddenly, leading to very large single-day point drops in asset prices. Leverage-induced fire sales were also a contributing factor to the 2007-2008 financial crisis in the U.S.
In our research, we studied the Chinese stock market crash in the summer of 2015. It was actually quite similar to 1929. Both were fueled by unregulated margin trading that was not directly observed or monitored by governments. In both cases, margin traders were highly levered. They were driven a lot by small retail traders as well as small institutions and investors. Both led to a correction of fundamentals, but the crash took place within a number of days.
A notable difference is that the 2015 crash was fueled by fintech and software platforms which were obviously not around in 1929.
Q: What made you interested in the Chinese stock market and its 2015 crash?
First, the Chinese stock market is huge. I don’t think investors appreciate that enough. At the height of the market in 2015, the Chinese market was actually half the size of the U.S. stock market, and even today, it’s approximately one-third of the size of the U.S. market.
Second, the Chinese stock market is really interesting because it’s dominated by retail investors—it’s approximately 85% retail. By studying the Chinese market, we can learn what kinds of risk are associated with that.
Finally, we were interested in studying the Chinese market because it’s an example of what happens when fintech and innovation get ahead of government regulation. In general, margin trading is highly regulated in China. However, during 2015 many households were able to access the shadow margin trading sector. This was all off the books. In this sector, they could lever up, 7 to 1, 10 to 1, and even 20 to 1. The government was not aware of it and left it unregulated. In that sense, because this financial innovation got ahead of regulation, we see the risks associated with this type of innovation.
Q: What did this shadow market trading actually look like?
I, as an individual investor, can open a brokerage account, but it’s not allowed to have any amount of leverage, according to the government. However, the government can’t stop me from borrowing money, let’s say from a friend or a family member, putting that money in the brokerage account and then investing in the market. That is unofficial shadow margin trading. That has always occurred.
What the fintech and software programs did was, it allowed this type of borrowing to occur on a much larger scale. It allowed me, as an individual investor, to be matched to many large shadow investors. I don’t even have to know them directly, and they can help me borrow off the books.
All the brokerage firm sees is a normal buy order. It does not know that this is a margin trade or that it’s highly levered. Therefore, the brokerage firm has plausible deniability and can tell the Chinese government, “I’m not helping to run a margin trading system. It’s just regular, unlevered brokerage accounts.” When in reality, these are highly leveraged shadow finance trading.
Q: Who’s providing the financing in these situations?
The exact sources of financing are not well known. Some of it could be other stock investors that have put up their own holdings as collateral and borrowed against it and then lend out the proceeds on the shadow market. It could also be peer-to-peer lending platforms. It’s also believed that some of the financial institutions and brokerage firms within China may have also lent out within the shadow sector.
Q: Is shadow borrowing unique to China?
It’s difficult to study the phenomenon very precisely. We do observe shadow lending in various forms growing throughout the world, including in the U.S., and, if left unregulated, this type of lending could mean that household and financial institution leverage keeps rising in a way that is both unregulated and undocumented.
That could lead to higher risks of fire sales in a variety of markets. It could pose potential risks to the worldwide economy or it could be good in that it offers credit to a larger set of households and institutions.
It’s hard to get data on the shadow sector, which is another reason why we turned to China. Because the Chinese government believed that the shadow sector was partly responsible for the crash, it seized the data from some shadow lending platforms and allowed us to analyze it.
Regulated brokerage margin trading is actually about 8 to 10 times larger than the shadow sector. But we believe it was this much smaller shadow trading sector that contributed more to the crash because it was unregulated and much more highly levered.
Q: The crash started the day after Chinese regulators released draft regulations for the shadow system. Was that a coincidence?
We believe that the Chinese government did two things that, while well intentioned, had very negative consequences, at least in the short term. The first is that the Chinese government announced on June 12, 2015, that it planned to limit the growth of the shadow margin trading sector in the future. The announcement immediately triggered a wave of sales, particularly in these highly leveraged shadow finance margin accounts. This led to a very dramatic and quick, almost 40%, market drop on the next trading day.
The second thing that the Chinese government did—again, though well-intentioned it may have had negative short-run consequences—was to impose a 10% limit on stock drops. If an individual stock drops more than 10%, it stops trading in the Chinese market.
That meant investors who were trying to sell a stock that was protected by a price limit might have been forced to sell another stock in their portfolio that was otherwise healthy. That could have created contagion from unhealthy stocks to the healthy stocks that are not protected by the price limit.
Q: Were there underlying economic issues that contributed to the 2015 market crash?
Part of the decline in prices after the 2015 crash was probably a decline in fundamentals. The market hasn’t fully recovered to its peak in 2015, so one view is that the market was fundamentally overvalued. We might have seen a correction absent a fire sale triggered by margin trading accounts. However, we do believe that fire sales led the crash to take on the form of very dramatic, single-day drops that have severe negative consequences for investors.
I think fintech was a critical factor contributing to China’s 2015 crash. Shadow margin trading has always existed on a very small scale, but fintech allows it to happen on a much broader scale.
Q: Are there lessons for investors in this research?
The research does say that investors, if they know that a sudden crash is due to a fire sale, shouldn’t sell because the prices are going to revert.
Also, investors may want to be cautious about how much leverage they take on initially. If they take on too much leverage, even if they realize that it’s a fire sale, they will literally be forced to sell if they get a margin call and the lender seizes control and engages in the sale of assets without the permission of the borrower.