Since the beginning of this year, with the continuous decline of the A-share market, a large number of financial products, dubbed "Snowball" products, suddenly appeared on the market and experienced a wave of forced liquidations. This not only caused substantial losses for many high-net-worth individuals, wiping out their capital but also became a significant force further driving the market downturn.
Many people may have never heard of this mysterious Snowball product before. There hasn't been much media coverage about it either. However, it's a beloved investment tool among many wealthy individuals. In previous years, the profits from these products were quite substantial. In China alone, the annual issuance exceeded hundreds of billions of yuan. Globally, similar products, known as structured products, reached an annual issuance scale of trillions of US dollars.
Today, let's discuss this peculiar product from a professional perspective, examining its intricate structure, potentially high risks and returns, and why it's favored by affluent investors. We'll explore why Snowball products experienced concentrated liquidations this year and how they contributed to the market decline.
Look, I'm wearing red today! It's a new year, and I want to bring everyone good luck. I've had some dealings with the products we're discussing today, and it might get a little brain-taxing. But I encourage you to bear with me and listen patiently because it involves many technical details related to mathematics and other professional fields.
While preparing for this, I've tried my best to avoid overly complex concepts and focus on the fundamental aspects, particularly those related to human nature and game theory. However, I want to give you a heads-up: I can't completely avoid some technical aspects. Skipping them entirely wouldn't be very rigorous.
So, I've come up with a clever idea. Whenever I start discussing more technical content, a light will appear on the screen, serving as a reminder. When you see this light, you'll know it's likely something technical, and it's okay if you don't understand or choose to skip ahead.
Alright, let's begin!
What is a Snowball Product?
First and foremost, let's clarify one thing: the Snowball product we're talking about has absolutely nothing to do with the Snowball media platform. I've had many friends wonder, "Has Snowball become so powerful that it's creating complex products capable of influencing the market?" No, it's just a coincidence in names.
Getting back to the point, the Snowball product is a type of structured product. Structured products aren't exactly new. They emerged in the United States back in the 1980s. What are they essentially? In essence, they're basically bonds bundled with a DIY financial package.
Bonds are easy to understand. They're like depositing money in a bank. You receive interest periodically, and upon maturity, you get your principal back along with the accrued interest. A structured product takes this concept a step further. On top of the bond component, it's also linked to indicators like stocks, stock indices, foreign exchange rates, interest rates, and so on.
What does this mean? A regular bond pays interest as usual, but a structured product might say, "If this stock index rises to a certain level, your return will be [specific amount]." Or, "If the stock drops to a certain level, your return will be [another amount]." You get the idea.
Why would anyone create such a complex product, and why would anyone buy it? Well, we know that for most ordinary investors, their investment options are limited. In the secondary market, it's mainly stocks and bonds. Some investors might think, "Investing in stocks is too risky. I could lose everything. But investing in bonds with a measly 3% or 4% annual interest rate isn't very appealing either. Is there a middle ground? I want a higher interest rate than bonds but without taking on the significant risks associated with the stock market."
This is where financial institutions come in. Within investment banks and brokerage firms, there's a group of people called "structurers." They might be a bunch of math or physics PhDs who say, "No problem, sir, we can meet your needs. Just tell us what kind of product you want, and we'll leverage our expertise to package it for you and give you a quote."
For instance, let's say you want exposure to stock market returns. They might offer you a product where you buy it without any interest, but after three years, you'll receive the same percentage gain as the S&P 500, capped at 30%. Suppose you invest $1 million in this product. If the S&P 500 rises by 20% after three years, you'll get $1.2 million. But what if the S&P 500 drops? No worries, you won't lose money. You'll still get your $1 million back, although you won't receive any interest during those three years. This is a simplified example of a structured product linked to the S&P 500.
The payoff diagram for this product would show that you make money when the stock market goes up and break even when it goes down. Those with some finance knowledge might exclaim, "Isn't this just a combination of call options?" Exactly, you've hit the nail on the head! That's why I said earlier that structured products are essentially bonds combined with a DIY financial package. In this case, the package consists of two call options.
However, this is just the simplest form of a structured product. In reality, most structured products are far more complex. Their payoff diagrams might look like complicated curves, and some products can be even more intricate.
For example, maybe you don't want to be solely linked to the S&P 500. You're a seasoned investor with insights into multiple stocks. Let me give you an example of a popular structured product in the US. This product tracks three stocks simultaneously: Apple, JPMorgan Chase, and Tesla. Over the next three years, the performance of these three stocks is observed every month. As long as the best-performing stock among the three doesn't drop by more than 30%, you'll receive a hefty coupon payment, say, 35%. After three years, if the best-performing stock hasn't fallen by more than 30%, you get your principal back in full. However, if the best performer plunges by more than 30%, your principal will suffer a corresponding loss.
Getting a bit dizzy? Don't worry; you don't need to dwell on the details. I'm simply illustrating that it can get extremely complex, and these products can be tailored to your specific desires. You see, examples like these involve more than just combining a few options; they require those financial wizards to price and assemble the components.
Structured products can have a wide array of bizarre structures. They might consider the path a stock has taken over a period, or they might have a capital protection mechanism, or even early redemption features midway through the term. But no matter how they're DIY-ed, what are investors ultimately after? They want to take on a bit more risk in exchange for potentially higher returns. Generally speaking, the higher the risk, the higher the coupon rate. For instance, in the example of the three stocks we just discussed, it's essentially accepting higher risk in return for that attractive 35% coupon payment.
How are structured products sold?
Typically, overseas banks or investment banks, such as Goldman Sachs, Citigroup, Barclays, etc., or domestic brokerage firms, issue these structured products, often backed by their own credit. These products are then sold to high-net-worth investors through channels like private banks and brokerages.
Why are they only sold to high-net-worth individuals? Firstly, these products generally carry higher risks and are quite specialized, leading to high investment thresholds. In Europe and the US, the minimum investment might be $1 million or even several million dollars. In China, it could range from 1 million to 10 million yuan to participate.
For example, a high-net-worth individual might receive a call from their private banker, saying, "Mr. Wang, this is the latest structured note issued by Goldman Sachs [with specific details and potential returns]." Mr. Wang, enticed by the offer, decides to invest 1 million yuan. The relationship manager then goes to Goldman Sachs and places a 1 million yuan order.
Moreover, for significant clients who want to invest $5 million or more, many investment banks will even offer customized solutions. For instance, if Mr. Wang isn't satisfied with the existing structured product offerings, he might request a minimum coupon rate of 20% and ask for a tailored solution. Goldman Sachs might then issue a unique $10 million structured note exclusively for Mr. Wang.
Since these structured products involve various risks, they are arguably among the most complex financial instruments. As a result, you'll find that those within investment banks who are responsible for issuing these structured products are incredibly busy, constantly on the move. They spend half their time away from their desks, frequently interacting with colleagues in trading and sales departments. To design customized products, they need to be familiar with the performance of underlying assets, client demands, and various other factors.
Global Appeal and Recent Trends
Although structured products originated in the United States, they have always been a niche market there. Do you know the main reason behind this?
The US has strict regulations requiring investors to sign a lengthy risk disclosure document, often exceeding 100 pages, before investing in complex financial products. This document essentially states that the investor fully understands and acknowledges the associated risks. Now, imagine yourself as a non-professional investor being asked to read through such a massive document and confirm your complete understanding. Wouldn't you be intimidated?
This requirement deters many non-professional investors in the US from purchasing these products. Consequently, structured products initially gained popularity in Europe and have recently shifted their focus to Asia as their primary market in the past decade. In recent years, the global issuance of these products has reached trillions of US dollars annually.
You might be wondering, "With trillions of dollars in annual issuance, why do so few people seem to know about them?" One crucial reason is their target audience: high-net-worth individuals. The "high-net-worth" criterion alone excludes the vast majority of investors. Moreover, they primarily target individual investors. This means that most professional institutions tend to avoid these products. Therefore, you'll rarely come across research reports or media coverage on them.
This explains why these intricate and fascinating financial instruments operate discreetly, hidden within the vast ocean of finance. As for why professional investors tend to steer clear of these products, we'll delve deeper into that later.
Environment Creates Demand, Demand Shapes Products
While they are collectively known as structured products, after hearing all of this, you might feel like they are incredibly flexible, almost like a "you-want-it-we-got-it" type of product. This high degree of flexibility is precisely why different market environments give rise to the popularity of different structures. We call this "environment creates demand, demand shapes products."
For instance, consider the US stock market. Over the past decade or so, it has experienced a remarkable bull run. Naturally, investors wouldn't be particularly interested in fixed-income products. What became popular were products that sacrificed some or even all of the coupon payments in exchange for capital protection. Investors wanted to participate in the potential gains of the US stock market without risking their principal.
I should clarify that products linked to the US stock market aren't exclusively available to US investors. As mentioned earlier, they haven't been particularly popular in the US itself. Investors from Europe and Asia can also invest in products tied to the US stock market.
Now, let's look at markets like Europe or Asia. In the decade leading up to the pandemic, their stock markets paled in comparison to the US, showing little significant movement. Investors in these markets saw that the upside potential wasn't substantial, and neither was the downside risk. Consequently, they developed a preference for products that offered higher coupon payments by taking on some degree of risk. For instance, they might opt for products that provided a 10% annual interest as long as the market didn't experience a significant crash. These products prioritize enhancing returns.
The Rise of Snowball Products
Among these yield-enhancement products, one stands out as particularly important and popular: the Snowball product. It has gained immense popularity in Asia in recent years. Let's first understand what this Snowball product actually is.
It's not that difficult to grasp, but it does involve several moving parts. If you'd rather not delve into the specifics, feel free to skip ahead.
Let's examine a typical Snowball product. It's similar to a bond, paying a 15% coupon rate with a two-year maturity. However, it's also linked to the CSI 500 Index. This linkage introduces two critical price points: the knock-out price and the knock-in price.
For instance, let's say these prices are set at 103% and 75% of the initial price, respectively. If the CSI 500 starts at 5,000 points, the knock-out price would be 5,150 points, and the knock-in price would be 3,750 points. It feels like solving a math problem, doesn't it?
Why are these two price points so crucial? Because during the two-year term of the product, as the CSI 500 Index fluctuates, crossing either of these points will trigger significant events.
Let's break down the different scenarios:
First, let's consider the higher knock-out price. We'll observe the CSI 500 Index every month. If, in any given month, it surpasses 5,150 points, the product is "knocked out." In this case, the contract terminates immediately, and you receive your principal back along with the accrued interest at the annualized rate of 15%. For example, if it's knocked out after six months, you get your principal plus 7.5% interest. If it's knocked out at the end of two years, you get your principal plus 30%.
This mechanism acts like an automatic termination button. Once the stock price reaches the knock-out level, the contract ends immediately. It's also known as an autocall feature. Autocalls are prevalent in structured products.
Second, let's say that during those two years, the CSI 500 Index consistently trades within the range between the knock-in and knock-out prices, never touching either. Upon maturity, you receive your principal plus the full coupon payment, which is 30%.
The third scenario is where things get tricky. If, at any point during the two-year term, the closing price falls below the lower line, which is 3,750 points in our example, the contract is considered "knocked in." From that point onward, if the index fails to recover and reach the knock-out price within the remaining time, it's not a pretty picture. Essentially, it becomes equivalent to directly holding the CSI 500 Index. If the CSI 500 Index loses 10% after two years, you'll only get back 90% of your principal. If it plummets by 40%, you'll only receive 60% of your principal back.
Lastly, there's a final possibility. Imagine the CSI 500 Index breaches the knock-in price, but during the two-year period, it stages a comeback and reaches the knock-out price. In this dramatic turn of events, the contract terminates immediately, and you still receive the 15% annualized return plus your principal.
Out of these four scenarios, only the third one, where the CSI 500 Index drops below the knock-in price and fails to recover, results in a significant loss for you. In the other three cases, although the maturity dates differ, you still receive a 15% annualized return, which is quite decent.
In reality, many Snowball products add additional bells and whistles to the four scenarios mentioned above. However, the key takeaway is that as long as the underlying index doesn't experience a sharp decline, investors are rewarded with an attractive coupon payment. However, if it does crash, investors could face substantial losses.
Those with a background in derivatives might have realized that buying a Snowball product is akin to selling a put option. You're absolutely right! Technically, it can be categorized as an exotic option, but broadly speaking, you're selling a put option, betting that the market won't crash in exchange for higher coupon payments. It's a strategy that offers a high probability of small gains but a small probability of significant losses.
Now, looking at the recent A-share market decline, it becomes evident why many Snowball investors suffered losses. The low-probability event of a market crash materialized.
But there's another question: We understand losses are possible, but why are we hearing about people getting liquidated? The issue lies in the leverage employed by many investors. They might use three or four times leverage to purchase Snowball products, aiming for even higher returns. However, if the market takes a downturn and the CSI 500 Index falls below the knock-in price, the brokerage firm might issue a margin call, demanding additional collateral to cover potential losses. If the investor is unable or unwilling to meet the margin call, it essentially means they lose their entire investment, a situation often referred to as "liquidation" or "blowing up."
Take a look at this WeChat screenshot. It appears to be from a relationship manager informing a client named "Mr. Tang" that the CSI 500 Index has fallen below the knock-in price of his Snowball product, exceeding his 25% margin. As a result, Mr. Tang's initial investment of 2 million yuan, along with any accrued interest, is gone. Mr. Tang's simple reply of "Okay" likely masks his silent despair.
We've now examined the structure of a Snowball product and understand why investors incurred losses. However, this is not the whole story. The interconnectedness of financial markets means that this peculiar product, with its billions of dollars in volume, can have a ripple effect, pushing the market further down.
Be warned: things might get a bit mind-boggling from here on. You might want to put down whatever you're holding and focus.
While investors, especially high-net-worth individuals, losing money is unfortunate, in the short term, their tears won't have a significant impact on the market. Notice that I said "short term."
On the other hand, institutions that issue these products, like investment banks and brokerages, need to constantly hedge their positions based on market fluctuations. Think about it: as an investor, regardless of whether you bought a Snowball, Sugarball, or Cottonball product issued by a brokerage, all your gains and losses are determined by your agreement with that brokerage. This means that the brokerage's position is the exact opposite of yours. If you make money, they lose money, and vice versa.
Some might say, "With investors facing such heavy losses and the stock market plummeting, wouldn't the brokerage be making a killing?" That's not entirely true. Brokerages cannot afford to bear such significant risks by taking the opposite side of their clients' bets. Ideally, they would hedge most of their risk in the market. Remember, they are financial service providers. Their primary source of income is from fees and commissions, not from gambling against their clients.
So, let's put ourselves in the shoes of a brokerage that issued a Snowball product. What risks are they facing? Before the knock-in event occurs, their delta, which represents their exposure to the underlying index's movements, might resemble a relatively flat line with a noticeable spike at the knock-in price.
Okay, the "technical content" light is now on!
The next three hours will be dedicated to dissecting this chart!
Just kidding! Obviously, we can't explain this chart in just a few sentences. Let's focus on grasping the general idea.
Notice the sharp spike resembling a nail. It's pretty prominent and hard to miss, right? That's where the problem lies. What does it signify? It means that when the Snowball product is initially issued, the brokerage needs to purchase some underlying index futures to hedge their position. The risk faced by the brokerage changes constantly with market fluctuations. As the stock price falls, the brokerage needs to buy more futures to maintain their hedge. As the stock price recovers, they need to sell. This is a simplified explanation of their hedging logic.
Therefore, if the stock price oscillates within a small range, the brokerage essentially buys low and sells high, profiting from the volatility. However, once the index falls below the knock-in price, the brokerage's delta will suddenly skyrocket. At this point, they are forced to sell a large number of index futures to mitigate their risk.
The key takeaway is that once the stock price breaks through the knock-in level, the brokerage needs to aggressively sell index futures to hedge their exposure. Pretty fascinating, right?
You might be thinking, "Wouldn't that add fuel to the fire and exacerbate the market decline?" You're on the right track, but there's more to it.
Remember we talked about how, when the index is declining but hasn't breached the knock-in price yet, the brokerage doesn't sell but buys index futures instead? This action actually helps reduce market volatility.
Therefore, under normal circumstances, when the market is filled with various Snowball products with different maturities, structures, and knock-in levels, even if the market experiences a decline, some brokerages would be buying while others are selling, offsetting each other's actions.
However, that clearly wasn't the case this time. In China, most Snowball products are linked to the CSI 500 or CSI 1000 indices. At the beginning of 2023, the A-share market experienced a surge, with the CSI 500 Index reaching around 6,500 points.
What does a sharp rise mean for Snowball products? It triggers the knock-out, ending the contract prematurely. Consequently, a large number of investors repurchased Snowball products around the same price level, roughly between 6,000 and 6,500 points. The corresponding 75% knock-in level for this range falls between 4,500 and 4,875 points. Coincidentally, this range aligns with the market levels seen earlier this year.
What does this imply? It means that numerous brokerages were simultaneously forced to sell CSI 500 Index futures, amplifying the market decline.
Looking at the performance of major indices since the beginning of this year, both the CSI 500 and CSI 1000 indices have suffered more significant losses compared to the Shanghai Composite and Shenzhen Component indices. Futures also experienced substantial discounts. A significant driving force behind this phenomenon was the hedging activity of brokerages managing Snowball products.
You see, the name "Snowball" was intended to convey the idea that your returns would snowball over time, growing larger and larger. Ironically, it was the number of investors facing forced liquidations that snowballed this time around.
To be clear, I'm not suggesting that Snowball products were the sole culprit behind the market crash. They don't possess such immense power or influence. It's not fair to place the entire blame on a single product. Their impact, at most, was to exacerbate the decline of the CSI 500 and CSI 1000 indices.
Snowball Products: A History of Boom and Bust
This isn't the first time Snowball products have experienced large-scale knock-ins. They gained popularity in mainland China around 2017. Before that, do you know who loved Snowball products the most? South Koreans!
Why? Because South Korea has been in a low-interest-rate environment for an extended period, and their stock market had been range-bound and uneventful for quite some time. This situation created a strong demand among South Korean investors for products like Snowball, which offered high coupon payments and an element of excitement.
Snowball products typically require being linked to a volatile underlying asset to make their coupon payments enticing. However, the South Korean stock market lacked the desired volatility. As a result, many European investment banks, particularly those from France, packaged the Hang Seng Index (Hong Kong stock market) into Snowball products and sold them to South Korean investors.
The story takes a familiar turn. In 2015, the Hang Seng Index experienced a similar pattern to the recent A-share market, starting with a significant rally. This surge triggered the knock-out feature of many Snowball products. As investors repurchased these products, the market took a sharp turn just months later, plummeting by around 50%. This downturn pushed numerous Snowball products below their knock-in levels, forcing European investment banks to sell aggressively to hedge their positions.
This event resulted in substantial losses not only for investors in the Hong Kong stock market but also for those in South Korea who had purchased these Snowball products. Even the European investment banks involved suffered billions of dollars in losses.
However, these international investment banks didn't abandon Snowball products despite the significant losses they incurred. In early 2020, when the pandemic first hit, global stock markets experienced a massive sell-off, leading to another wave of pain for Snowball investors worldwide.
You might be wondering if they never learn. Why would they continue to issue these products after experiencing such drawdowns repeatedly? The simple answer is: profits.
While market crashes can inflict short-term losses on these investment banks, most of the time, Snowball products are extremely profitable for them. The structured product issuance desks are among the most lucrative divisions within these institutions. For example, French bank Natixis reportedly generates hundreds of millions of euros annually from issuing Snowball products alone.
Moreover, issuing Snowball products is akin to raising capital for these investment banks and brokerages, similar to issuing bonds. While the volume might not be substantial compared to other funding sources, it's a relatively comfortable way for them to obtain funding. This explains why the volume of structured products, including Snowball products, has been steadily increasing in recent years.
The High Cost of Complexity: Fees and Investor Behavior
Finally, let's have a casual chat about structured products. One point I want to emphasize is that many investors might not realize how expensive these products truly are.
You've witnessed the level of complexity these products can reach. Take Snowball products, for instance. While their structure, with those few scenarios, might not seem overly complicated, from a financial risk perspective, they are incredibly complex. There are numerous risks involved, including correlation risk, volatility risk, volatility skew risk, and so on.
How do brokerages typically hedge these risks? At a basic level, they might hedge their delta exposure. More sophisticated institutions might also hedge their volatility risk, known as vega. However, the remaining plethora of risks might be impossible to hedge effectively, forcing them to bear those risks themselves.
What does bearing those risks translate to? Higher fees for investors. How high are these fees typically? To give you a general idea, data from Asia might not be readily available, but in Europe and the US, complex structured products often come with an annual fee of around 2% to 3%. And that's just the commission.
On top of that, they might also add a hedging cost of a few percentage points. What does this mean? Let's say a brokerage's model determines that a particular structured product should offer a 20% coupon rate. After deducting various fees, commissions, and hedging costs, the actual rate offered to investors might only be 15%. That's how significant these costs can be.
Remember the point I made earlier about why professional investment institutions tend to avoid these products? The primary reason is their high cost. If they have a specific need, being professional investors themselves, they can simply DIY those components using derivatives. Why pay exorbitant fees to purchase from an investment bank?
This isn't to say that investment banks and brokerages are deliberately ripping off their clients. They do assume significant risks in structuring these products. Investors seeking complex products without possessing the knowledge or expertise to assemble them themselves have to bear the associated costs.
Remember: The price of a financial product and its potential profitability are two separate matters. An expensive product can generate profits, while a cheap one can lead to losses. Just because stock trading fees are low doesn't guarantee that stocks will go up.
As for whether structured products are ultimately profitable or not, that's beyond the scope of our discussion today.
So, if structured products are so expensive, why do people still buy them? Because most investors are unaware of the true costs. Fundamentally, there's often a disconnect between the expectations, judgments, and perceptions of ordinary investors and the calculations of those sophisticated models used by financial institutions. The more complex the structure, the wider this gap becomes, leaving ample room for exploitation.
Let me tell you what those financial structurers spend their days pondering: how to design structures that remain appealing and seemingly valuable to investors even after factoring in all those fees and commissions. It's a fascinating behavioral finance problem.
Snowball products, it seems, are particularly adept at exploiting this disconnect. Ordinary investors tend to underestimate the risk of a market crash. Therefore, you'll often see structured products, including Snowball, structured in a way where the investor bears the brunt of the risk in case of a market meltdown. Investors perceive this event as having a low probability, making it seem like a good deal. However, the models tell a different story.
Of course, this isn't to say that investor perceptions are always wrong, and models are always right. Models are not infallible. They rely on historical data and derivative pricing models, which are not guarantees of future outcomes.
Conclusion
These are some of my rambling thoughts on structured products, inspired by the recent Snowball product saga. For those who have made it this far, I applaud your patience! Until next time, take care!