What Exactly Is the Controversial Snowball in the Market? - Huxiu#
#Omnivore
Highlights#
💰 Snowball products are a type of investment tool with a time limit, where investors need to bear the risk of knock-in, and the possibility of loss increases the longer the time goes on.
• 🎢 Snowball products are a type of put option, where the rise and fall of the linked index determine whether it is knocked out or knocked in. Market conditions have a significant impact on the product, and investors need to choose their timing carefully.
• 🏦 Brokers launch snowball products to profit from multiple angles, earning returns through hedging and dynamic operations. However, their profit model also carries risks, and they may face losses. ⤴️ ^371b35c5
What Exactly Is the Controversial Snowball in the Market?#
This article explores the reasons behind the controversy surrounding snowball products in the market, as well as the underlying logic and risks. Through interviews with brokerage advisors and industry professionals, it reveals the characteristics and impacts of snowball products, as well as what investors should pay attention to.
• ==💰 Snowball products are a type of investment tool with a time limit, where investors need to bear the risk of knock-in, and the possibility of loss increases the longer the time goes on.==
==• 🎢 Snowball products are a type of put option, where the rise and fall of the linked index determine whether it is knocked out or knocked in. Market conditions have a significant impact on the product, and investors need to choose their timing carefully.==
==• 🏦 Brokers launch snowball products to profit from multiple angles, earning returns through hedging and dynamic operations. However, their profit model also carries risks, and they may face losses.==
Since the beginning of 2024, as the two major indices that snowball products are primarily linked to, the CSI 500 and CSI 1000, continue to decline, the pressure from leveraged products collapsing and snowball knock-ins is affecting more and more investors. The ones getting hurt are not just ordinary novices; even professional brokerage advisors are feeling the impact.
So, why do brokers launch snowball products, and what is the logic behind them? Are snowballs truly the "innovative" products claimed by the industry, or are they a "guessing index game" that market participants question as "helping institutions cover losses"? With these questions in mind, a reporter from the Daily Economic News recently interviewed a brokerage advisor who was also "hurt" by a snowball knock-in, as well as several brokerage and futures analysts, in an attempt to explore the answers to these questions with investors.
- Anxious Brokerage Advisors
Zhang Le has worked at a large brokerage firm for many years as a brokerage advisor, but recently he has been feeling anxious.
"I am also a participant in snowball products and am currently facing the risk of loss; I have also been hurt by this round of knock-ins," Zhang Le said, appearing somewhat frustrated when discussing his snowball investments.
During the conversation, he did not disclose the specific amount he invested in snowball products, but generally speaking, the investment threshold for individual investors is 1 million.
Although some institutions have publicly disclosed some countermeasures in research reports regarding snowball knock-ins, such as hedging through on-exchange options and futures, and rolling over to a new round of snowball products, Zhang Le feels that these countermeasures seem somewhat pale in the face of reality.
Zhang Le bluntly stated, "The problem with snowballs is that they have a time limit, so they are not easy to hold. If the funds or stocks I buy lose value, I can still recover losses through long-term holding. But snowballs have a time limit; once the time is up, I can only recognize the loss."
In fact, fundamentally, a snowball is a type of put option with a barrier price; simply put, it is a game of "guessing the index" within the specified time of the product.
In the process of investing in snowballs, the most important concepts for investors to pay attention to are the knock-out line, knock-in line, and product duration.
In short, the knock-out line and knock-in line can be understood as the upper and lower limits of the target index's operating range; if the target index rises above the upper limit, it is knocked out, and if it falls below the lower limit, it is knocked in. Generally speaking, the knock-out line is 100%-103% of the index point when investors buy the snowball, while the knock-in line is 75%-80% of the index point when investors buy the snowball.
In fact, in recent years, there have been instances in the industry where a large number of snowballs were knocked in, similar to the recent situation, such as a significant market decline from January to April 2022, which fully exposed the risks of snowball knock-ins. However, Zhang Le believes that the risks exposed by this round of snowball knock-ins may be greater than two years ago, "Last time, most people may have only knocked in after holding for six months, having bought in at the end of 2021, with another year and a half until expiration. This time, however, many people may have held for a long time, and as the expiration approaches, if they get knocked in, even if the index can recover in the future, there is not much time left for investors, and the index may not recover within the limited product duration."
He believes that 2021 saw the most purchases of snowballs; after buying in 2021 and knocking out, they continued to buy in 2022. In 2023, the market has not been good, and there have been no good opportunities for snowballs to knock out, so much of that capital is locked in. He estimates that most of the funds currently locked in snowballs are from 2022.
Zhang Le stated that most of the snowball products he is currently stuck in were also purchased in 2022.
Zhang Le's thoughts have also been confirmed. A wealth management professional from a medium-sized brokerage firm told reporters, "The main issue is that the snowballs issued in 2022 had relatively high coupon rates, which puts a lot of pressure on them. After the products are knocked in, they also have concentrated expirations, and clients quickly end up with losses."
According to the relevant rules of snowballs, since the purchased products have no leverage, there are several possibilities in front of Zhang Le. One possibility is that the CSI 500 index experiences a significant rebound and rises above the knock-out line, allowing him to receive the principal and coupon; another possibility is that it continues to remain in a knock-in state until expiration, resulting in losses equal to the actual decline of the index. If the CSI 500 index recovers the knock-in line but does not knock out, Zhang Le will likely bear the actual loss of the target index.
Despite the market experiencing a V-shaped reversal on the day of the conversation, Zhang Le's mood still seemed pessimistic, "Indeed, the index may rebound above the knock-in line, but that is meaningless because you need it to knock out. The knock-out point for the CSI 500 index would need to be between 5800 and 6400 points, which means a 20% rise from here, equivalent to pulling a carrot out of the ground. The Shanghai Composite Index would also need to rise above 3150 points, which is not easy."
- Snowball Products: A Guessing Game with a Set Time Limit?
Recent snowball pricing information released by a certain platform shows that snowball products mainly consist of several key elements: product structure, knock-out line, knock-in line, product duration, lock-in period, margin, coupon, observation days, etc.
Once a knock-out occurs within the product duration, investors will directly settle the annualized coupon, and the product will automatically end. If a knock-in occurs, it means that investors may face losses, and without leverage, the extent of the loss will be the actual decline of the target index at the time of expiration compared to the initial point.
Assuming investor Xiao Wang buys a snowball product with a margin of 1 million and no leverage: the knock-in line is 80%, the knock-out line is 103%, and the product duration is two years. During the two-year product duration, the snowball will have the following four profit and loss scenarios:
Scenario 1: A knock-out occurs on any knock-out observation day (knock-out observation days are usually observed monthly after the product lock-in period) without a knock-in, and the product ends early. If it knocks out in the sixth month, the investment return = annualized coupon × 6 ÷ 12.
Scenario 2: A knock-in occurs on a knock-in observation day (knock-in observation days are observed daily), but later a knock-out occurs on a knock-out observation day, and the product ends early. If it knocks out in the ninth month, the investment return = annualized coupon × 9 ÷ 12.
Scenario 3: No knock-in or knock-out occurs during the product duration, and the product ends at expiration. Investment profit and loss = annualized coupon × 2.
Scenario 4: A knock-in occurs on a knock-in observation day, and the product does not knock out until expiration, and the target price declines by the expiration date, resulting in a loss of the principal, with the loss ratio = the decline of the target index during the product duration.
From the above four scenarios, the maximum profit for investors is in Scenario 3, while Scenario 4 is the one that has recently garnered significant market attention. In fact, a knock-in does not necessarily mean a loss, especially in the early stages of the product's existence; investors still have ample time to patiently wait for the target index to turn upward. However, if a knock-in occurs close to the product's expiration, there is little room for maneuver left for investors, meaning that the later the knock-in occurs, the greater the likelihood of actual losses for investors.
Based on different product structures, snowball products have developed various types, including early profit snowballs, butterfly snowballs, reduced knock-in snowballs, and flat knock-in snowballs. The differences among these various structured snowballs typically manifest in the coupon rates, while the knock-out and knock-in lines remain relatively fixed. For example, early profit snowballs and butterfly snowballs are characterized by offering significantly higher annualized coupons if investors knock out in the early stages of the product's duration.
Additionally, snowball products can generally be divided into guaranteed snowball structures and non-guaranteed snowball structures. In a guaranteed snowball structure, these products carry leverage, with the maximum loss being the margin ratio and the maximum profit being the fixed coupon income. In a non-guaranteed snowball structure, the margin is 100%, the maximum loss is the maximum decline, and additional margin can be added, with the maximum profit being the fixed coupon income.
A quantitative analyst from a futures company stated that from the broker's perspective, holding a snowball is similar to holding a long position in a put option. In this case, they actually need to hedge using long index futures in the background to achieve delta neutrality.
"So, what is delta neutrality? Simply put, it can be understood as the broker's backend aiming to ensure that the value of the snowball product does not fluctuate, regardless of whether the index rises or falls, meaning delta equals zero. The specific operation method for brokers is to buy long index futures during a market decline and sell long index futures during a market rise," the quantitative analyst further explained.
"So, we see that during a market decline, for example, as it approaches the knock-in line, delta will experience significant fluctuations. The broker's backend operations will involve initially buying a large amount of long index futures and then quickly selling them off in a short period. Such rapid operations have raised concerns in the market about their potential impact on the basis of index futures." In fact, recently, the basis for CSI 500 and CSI 1000 index futures has seen a significant expansion, which many believe is related to the large number of snowball knock-ins.
In recent years, snowballs have been products that many brokerage wealth management departments are eager to recommend to clients. It is understood that some advisory professionals use terms like "quasi-fixed income" and "the longer you hold, the lower the risk" when recommending snowball products, and the characteristic of snowballs earning so-called coupon income has led some investors to believe that the nature of this product is almost identical to fixed income products that earn interest.
It is worth noting whether snowballs are truly "quasi-fixed income" products. At first glance, snowballs do exhibit some characteristics of quasi-fixed income products, such as typically having a product duration of 2-3 years, and the double-digit annualized coupon rates appear very attractive against the backdrop of overall declining interest rates.
However, from the underlying trading mechanism, the coupon of snowballs comes from the volatility trading of index futures, which is inherently not fixed. From this perspective, snowball products differ fundamentally from fixed income products.
Moreover, snowballs are also margin products, and in the financial context, margin is often associated with leverage. In practice, snowball products do tend to have a leverage inclination. During this adjustment phase, the risks of leveraged snowballs have been fully exposed, and the principal of related investors may "go to zero." For instance, it has recently been reported that "Calm Tang," who previously purchased leveraged snowballs, saw his principal go to zero during this downturn. Two years ago, "Tang" purchased snowball products with a margin rate of 25%, which means 4x leverage. However, some leveraged snowballs had previously provided investors with annualized returns of up to 40%, which also fully reflects the characteristic of snowball products where risk is commensurate with return.
The aforementioned quantitative analyst stated that compared to fully margined snowballs, the existence of leveraged snowball products is also reasonable, "Investors can pay the full margin when buying snowballs, but in reality, this capital utilization rate is relatively low, and it does not provide you with greater returns."
In short, the ones that collapse are leveraged snowballs; non-leveraged snowballs do not face collapse situations.
Additionally, it is understood that once a snowball experiences a knock-in, the broker's actual countermeasures are quite limited.
"If investors knock in during the holding period of the snowball and subsequently incur losses, from the broker's perspective, they will not take any special actions, maintaining delta neutrality. If the index subsequently rises, the broker will still reduce their position; if the index continues to fall and breaches the knock-in line, the broker will typically be fully invested and will not take any other actions," the aforementioned quantitative analyst stated.
It is worth mentioning that regarding the recent risks exposed by snowballs, some investors have asked, "If I see that my held snowball is about to knock in soon, but the duration has not yet expired, can I sell the snowball early?"
In Zhang Le's view, such operations are very difficult, "Because many people may have bought the snowball product at the same time. If 100 people buy this product, you can do this, but the premise is that you need to consult with those 100 people. Suppose you think it should stop if it is about to knock in, but later find out that it did not knock in; would there be a risk of customer complaints? So, this is very difficult to achieve."
It is also worth noting that snowball products carry liquidity risks due to the inability to actively redeem clauses. Public funds or private equity funds generally have corresponding redemption clauses, but if a snowball does not experience a knock-out event during its duration, it generally cannot be redeemed early. Once a knock-in occurs, investors need to wait for the market to recover and trigger a knock-out to redeem early; otherwise, they can only wait until the product expires.
- The Controversial Snowball: Pseudo-Innovation? Helping Institutions Cover Losses?
In fact, during the interviews, the internal perception of snowballs among brokers was mixed; some views suggest that snowballs are "finding a group of retail investors to cover for institutions," while others believe that these innovations are unnecessary.
In this regard, a brokerage industry researcher told reporters that the claim that brokers transfer risks through snowballs is not entirely accurate, "In terms of the profit model, the trading desk and clients coexist symbiotically; the trading desk does not wish for a declining market because their trading capabilities also rely on rising markets. With client funds, they can continuously roll over positions; when the market is good, snowballs continue to knock out, allowing new snowball funds to flow in, creating a positive cycle. However, once the market declines, it indeed leads to knock-ins, and the broker's original obligation to pay coupons disappears, shifting the losses to the clients, transferring the risk. However, this heavily depends on the trading desk's judgment of market conditions and basis, which would lead them to choose not to add positions during a downturn, which is risky."
Moreover, there are differences in how brokers internally position their innovations. Meanwhile, a well-known market figure previously shared a snowball-related message, suggesting that "snowballs are just what others have left behind."
However, the aforementioned wealth management professional from a medium-sized brokerage firm believes that snowball products are an important innovation. Compared to other developed markets, Chinese investors have fewer financial products to choose from. In a volatile market, snowball products are a relatively efficient investment tool. The current issue mainly lies in the irregular sales of snowballs in previous years, with insufficient investor education and risk disclosure, leading to misconceptions about such products in the market.
When snowball products were yielding good returns in 2021, they garnered more attention from investors, including those who mistakenly regarded snowballs as fixed income products.
A wealth management professional from a brokerage in Shanghai stated that snowball products are complex structured derivatives and represent an innovation; the products themselves are neutral and do not need to be characterized. They are not the reason the market has declined; rather, it is more about market concerns over deflation.
- Broker Perspective: Multi-Angle Profitability, but Still Potential for Losses
Zhang Le pointed out during the conversation that "The biggest problem with snowballs is that they package risks; in fact, snowballs have significant tail risks, leading to many investors with mismatched risk tolerance purchasing snowballs."
Since snowballs are derivatives with significant tail risks, requiring a higher risk tolerance from investors, why have brokers been vigorously promoting snowball products in recent years?
In response, the aforementioned brokerage industry researcher explained to reporters, "Snowballs are just one of the derivatives business for brokers. The reason brokers engage in derivatives business is primarily to transform directional proprietary investments into client-funded investments focused on volatility."
The industry researcher further analyzed, "The benefits of this are: 1. Not following market fluctuations, brokers essentially earn from segment arbitrage, increasing profitability stability; 2. The upper limit of business space can be opened up; this business is primarily client-funded, allowing for an expanded balance sheet; 3. The expansion of business scale will not lead to unilateral risk expansion like equity pledges or margin financing due to market declines; this business can expand, and if risk control is effective, it can still make money even during downturns." There are speculations in the industry that some leading brokers have achieved impressive profits through this business model.
"Snowballs, to put it bluntly, are when bold brokers do not move or add positions during a market decline; the obligations before and after a knock-in are completely different. Before a knock-in, they must pay coupons; after a knock-in, the clients bear the losses, making the brokers profitable compared to before the knock-in. Of course, this depends on whether the trading desk dares to operate without following the model and under the pressure of risk control," the individual stated.
So, what is the profit model for brokers regarding snowball products?
The aforementioned wealth management professional from a medium-sized brokerage revealed that brokers' profits from snowball products come from multiple angles, including regular product sales fees and hedging profits.
A wealth management professional from a brokerage in Shenzhen stated that in terms of snowball products, brokers' revenue primarily comes from two aspects: one is the pricing difference of options, and the other is dynamic hedging. First, brokers that are eager to issue snowball products may hold a large amount of stock positions and can hedge risks by buying put options issued by investors; if the market subsequently declines, the losses will be borne by the investors. A core variable affecting option prices is volatility; the greater the volatility, the higher the option price, and the volatility of the CSI 500 index is relatively greater than that of the SSE 50 and CSI 300 indices. Second, brokers can also enhance investment returns through dynamic hedging, achieving low buying and high selling.
Simulation of the hedging trading process for snowball products by brokers
It is understood that snowball products are primarily managed and operated by the derivatives departments of brokers and the risk management subsidiaries of futures companies. A wealth management professional from a brokerage firm stated, "After investors purchase snowballs, the broker's trading desk opens positions based on the derivatives contracts, and during trading, the broker engages in grid trading; as the index declines, the broker builds positions, and if it declines and then rises, as long as the broker's risk-return ratio is greater than the coupon paid to investors, the broker makes a profit. Additionally, the snowball business will bring brokers income from the basis of index futures. The basis refers to the price difference between the futures contract and the spot index; generally speaking, because many people hedge by shorting index futures, this leads to more shorts than longs, resulting in a discount, which can also become a source of income for snowballs."
"The snowball structure itself is shorting volatility, while the securities company is its counterparty, going long on volatility. Theoretically, the greater the volatility, the more money the securities company makes because the clients' returns are fixed, but high volatility means high risk. If volatility is too high, the snowball will collapse, so the securities company has to protect against knock-ins; if volatility is too high, it will knock in."
In his view, although the risks of snowballs are primarily borne by investors, during a wave of knock-ins, brokers may also incur losses, "Recently, with a large number of snowball knock-ins, for securities companies, if there are no knock-outs within the remaining duration of the snowballs, then the returns from volatility will all belong to the securities company. So from this perspective, the securities company should be profitable. However, from another perspective, a large number of concentrated snowball knock-ins will require the securities company to hedge its risk positions, which can incur significant impact costs. This part of the impact cost can be very large, meaning that brokers may not only not make money but also incur losses due to impact costs, resulting in a situation where both investors and brokers lose."
In fact, there are views in the industry that last year, several brokerage trading desks incurred losses from snowball operations. "When a snowball knocks in, if the trading desk operates according to the model, it is likely to lose money. The so-called risk is transferred to the client only if they do not strictly follow trading discipline and the model, but each brokerage's risk control may not allow for such a large margin of operation," the aforementioned brokerage industry researcher stated.
Overall, if the linked index rises sharply and the snowball knocks out, although the option premium is essentially paid, the leveraged funds from the spot or index futures bought by the broker will earn more returns, with the broker taking the larger share. When the index falls, investors bear the cost, and these risks were all previously outlined in the terms. When the index consolidates with high volatility, investors earn option premiums, while brokers earn their hard-earned fees through dynamic hedging to offset the option premiums paid. When the index consolidates with low volatility, brokers must pay the agreed option fees and cannot dynamically hedge to buy low and sell high, but this situation is very rare.
- The Impact of Snowball Knock-Ins on Market Psychology
The collapse of snowball products has caught many investors off guard, and at the same time, the recent large number of snowball knock-ins has raised concerns in the market.
The aforementioned wealth management professional from a medium-sized brokerage firm stated, "Simply put, investors are selling a knock-in put option to the snowball issuer. The product issuer generally hedges these products accordingly. Currently, the market mainly consists of snowball products linked to broad-based indices, and the derivatives trading desk typically uses index futures for 'buying high and selling low' to hedge snowball products. In most cases, snowball products can smooth market volatility, but after a knock-in, they will sell off part of their futures positions. Therefore, to be precise, snowball products only exert some selling pressure on the futures market after a knock-in; in most cases, they are used to absorb market volatility."
The wealth management professional further pointed out that as long as they are not leveraged snowball products with partial margins, there is no so-called "collapse." For the majority of investors, the basic snowball products are non-leveraged. These products do not end after a knock-in; if the product subsequently knocks out, investors can still receive the coupon. However, if it does not knock out by expiration, clients will bear the decline of the index between the initial point and the expiration date. In recent years, regulatory authorities have been paying attention to the scale of snowballs, ensuring their healthy development. In the sales process, it is essential to fully explain the operational essence of the products to investors to avoid misunderstandings.
Regarding the recent wave of knock-ins and their impact on the market, a quantitative analyst from a brokerage firm previously told reporters that the actual impact of snowball knock-ins is not as significant as the market perceives; an early knock-in allows risks to be fully released, so "no pain, no gain."
After a significant drop on Monday, the market experienced a substantial rebound on Tuesday, Wednesday, and Thursday, and the situation of snowball knock-ins naturally eased to some extent. From the performance of the IC and IM contracts of index futures, the previously expanding discount has shown noticeable convergence on Wednesday and Thursday.
Although market sentiment has slightly eased, the aforementioned wealth management professional still advises investors to remember that timing is crucial when investing in snowball products, as the ideal profit scenario for snowball products is in a volatile market. A unidirectional rising or falling market is not suitable for snowball products. Additionally, some industry insiders believe that purchasing snowball products should not involve "chasing highs"; investors should only buy when the index is at a relatively low level to have a sufficient safety margin.
However, when discussing the future prospects of snowball business, Zhang Le appeared somewhat pessimistic, "Personally, I think this business will decline significantly in the future because clients who previously bought snowballs will definitely be hurt this round, and those who were lucky may also become more cautious. It will be very difficult to attract them to buy snowballs."