Last month, China said it was considering permitting its residents to invest in foreign securities. If allowed, any of China’s more than 170 million retail traders could, for the first time, directly invest as much as US$50,000 a year in US stocks.
To some stock investors, analysts and researchers, the prospect of even a small fraction of those millions of potential new traders coming to the US is unsettling at a time of extreme Wall Street volatility, with social media-fuelled, app-based retail trading reaching record highs.
After all, the Reddit online forum WallStreetBets earlier this year showed how violently American retail money could drive big swings in shares of GameStop, a struggling video game retailer. With new Chinese traders, a larger force of retail investors could turn the US markets into an even bigger casino.
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“This idea of China allowing its citizens to all of a sudden invest in US equities, it is historical and it is likely to end up being hysterical,” said Richard Smith, chief executive of the Foundation for the Study of Cycles, a markets research firm. “It will drive the markets to even more extreme extremes than what we‘ve seen thus far.”
Beijing has not yet made its final decision, but the consideration is serious. Ye Haisheng, China’s head of capital account management at the State Administration of Foreign Exchange, said last month that easing capital controls would reduce pressure on the capital inflows caused by China’s huge trade surplus, which has led to a swift appreciation of the yuan.
China’s global trade surplus reached US$535 billion in 2020, its second-largest on record.
“Loosening restrictions on foreign exchange outflows offers an answer to the problem of how to relieve renminbi appreciation pressure without resorting to large-scale intervention … [that] would risk reigniting US complaints about currency manipulation,” said Gabriel Wildau, an analyst focused on China at the Teneo consultancy.
We would see more unusual stock behaviour, more speculation, I guess you could say, more gambling kind of trades.
John Rekenthaler, Morningstar investment researcher
It’s unclear when or how much Chinese capital would end up in US markets. Individual investors make up 80 per cent of the market participation in China’s US$10 trillion Shanghai and Shenzhen stock markets. If just 5 per cent of that capital shifted to the US, that would add US$400 billion to US exchanges each year.
For the US$50 trillion US equity markets, led by the New York Stock Exchange and Nasdaq Stock Market, that may not seem meaningful at the beginning. But over time, such amounts could add up.
Behind the capital are 170 million individuals who trade extremely often, helping to build the Chinese markets’ reputation for trading anomalies.
Retail investors are typically individuals using their own money to trade. Chinese retail traders reportedly buy and sell stocks multiple times a month, much more active than such investors in other parts of the world. Thus, as a group they are considered a force of instability that can cause stock prices to swing dramatically.
Chinese state media call such traders “dispersed accounts” to capture the feverish nature of their volatile trading behaviour, which is often driven by emotion. Many investors bet solely on the dramatic first-day pops of initial public offerings, a phenomenon known as “hitting the jackpot of new stocks” as traders concertedly rush to buy the newly offered shares and drive their price up exponentially in the early days.
For example, shares at StarPower, a Zhejiang-based chip maker, soared 13 times its opening price to 164 yuan (US$25.19) a share in the first month of its listing on the Shanghai exchange in 2020, triggering 21 circuit-breaker halts in the trading of its shares. The jump alarmed company executives enough that they issued a statement.
“We would like to warn investors of trading risks as the stock is experiencing significant fluctuation since its debut due to hype caused by retail investors,” StarPower said.
A stock analyst from Alpha Zone, a financial trading company, called the surge ridiculous. “At this point, if you want to make money, you’d better make sure someone out there is willing to buy from you at a higher price,” the analyst wrote on the Toutiao news site.
In the United States, retail traders – if not acting in tandem – are usually too small to disrupt markets. What concerns some analysts is that, as China contemplates the measure, the US is reaching its highest recent levels of retail participation.
Retail investors accounted for roughly 20 per cent of stock-market activity in 2020, up from 10 per cent in 2019, according to Citadel Securities, a brokerage firm that executes slightly less than half of all retail order flows.
US stock markets handle five times the volume than those in China, but retail trading activity is nearly comparable, since individual Chinese traders are much more active.
Last Tuesday, for example, about US$537 billion of shares were traded in the US, while roughly US$110 billion changed hands in China, according to Cboe Global Markets and data from Shanghai and Shenzhen stock exchanges.
US retail investors traded about US$107 billion that day, while their Chinese counterparts traded roughly US$88 billion.
More capital is generally good news for publicly traded companies, which gain better access to financing their growth. But market watchers said that adding more retail trading in the mix could, over time, distort US markets.
An infusion of Chinese investors “would certainly increase the current trend of retail investors having more influence on segments of the stock market,” said John Rekenthaler, an investment researcher at Morningstar. “We would see more unusual stock behaviour, more speculation, I guess you could say, more gambling kind of trades.”
It would take time for any effect to show up, he noted.
“It‘s not going to be like your boat just getting swamped by a wave in the first week, it’s going to be like your boat is gradually leaking and water’s filling up,” said Rekenthaler.
“And the real question is, are they buying and selling in unison. It’s a fair concern given what we’ve seen how US investors have behaved recently and the power that they have to disrupt the marketplace.”
The most dramatic recent US example of how technology and social media can steer retail investors to concerted action was the frantic January trading of shares in GameStop.
After hedge fund short-sellers bet heavily on GameStop’s share price falling, retail investors in the online chat group WallStreetBets decided to bid up the stock to foil those plans – a classic “short squeeze” – using the free trading platform Robinhood to make their buys.
By January 28, that trading frenzy pushed GameStop stock up to nearly 30 times its US$17.25 share price at the start of the month, an unsustainable rise.
Some Robinhood investors made money, but many others were left holding the bag in the subsequent crash. By February 4, the share price was down to US$53 as Congress and the Securities and Exchange Commission expressed concerns.
Following the GameStop case, US Treasury Secretary Janet Yellen said that a rise in zero-commission trading on platforms like Robinhood had helped spur retail investors’ involvement in stocks.
The SEC, she added, would look into “whether the trading practices are consistent with investor protection and fair and efficient markets”.
Because of Robinhood’s success – and the technology that makes it profitable – the practice of trades that are executed without regulation or intermediaries is bound to grow. And that shift has begun to alarm institutional investors.
“It is absolutely important for even longer-term managers to be more aware of these daily influences,” said Peter Laurelli, head of research at eVestment, a Nasdaq affiliate. Retail investors, he said, “have shown they can shift prices enough to where longer-term valuations come to fruition immediately and could cause managers to make positioning decisions based on those prices and available liquidity”.
At a hearing last week before the House Financial Services Committee – triggered by the GameStop frenzy – Rachel Robasciotti, founder and chief executive of the Adasina Social Capital investment advisory firm, urged regulators to restrict retail trading.
“When fast-moving, high-risk speculators dominate, we have a classic recipe for market disruptions,” Robasciotti said, noting that retail investors’ new-found market-disrupting power used to be exclusively reserved for deep-pocketed Wall Street firms.
For now, the industry is largely left alone as regulators and lawmakers try to catch up.
Once Chinese traders are permitted to invest in US stocks, Robinhood-style trading tools are already available to execute their US trades. Moomoo, an app-based trading platform backed by the Chinese conglomerate Tencent, and Beijing-based Tiger Brokers both handle global trades in multiple languages, including Mandarin.
These apps boast similar features to those on Robinhood, highlighting the most popular trades to potentially steer investors towards small clusters of stocks to cause outsized swings.
Representatives at Robinhood, Tencent and Moomoo, as well as officials at the SEC, the New York Stock Exchange and Nasdaq did not respond to requests for comment.
“I think the cat is out of the bag. And there‘s not a lot that can be done to stop this technology-based world that we’re all living in,” said Smith of the Foundation for the Study of Cycles.
“I don‘t think we should try to shut the gates,” he added. “The citizens of China being able to invest in US equities directly is ultimately a positive step. But I think it should be done gradually and be closely monitored. Otherwise, we’ll all end up paying for it.”
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