How Best To Short China? The Answer Is Not Too Simple

Short China? …. China has so much to learn about free markets. Like attacking an 85 year-old hedge fund legend who was only observing what was actively being discussed behind the scenes regarding economic reality. What China needs to learn is how freedom of speech and intellectual thought is necessary in a free market system. It can be summed up in an ever increasing number of hedge fund managers piling on the short China currency bandwagon. Soros, a marvel on several levels, isn’t alone, and wasn’t anywhere close to the first to express concern regarding China. In fact, this time the young guns appear to be picking up the Soros break the bank mantle and engaging in currency wars. The question is: how should they be executing their investment thesis, through bank brokered methods where the counter-party is the bank market maker? Or should this occur in an exchange system that does not bet against the customer?

Short China
Short China – Chart via S&P Capital IQ

Short China – Young guns appear to be targeting breaking a bank

While China’s official state media recently engaged in a brutal broad daylight mugging of playboy George Soros, it is really Hayman Capital’s Kyle Bass who ia  perhaps the lead gun among well-known China currency shorts, as first reported by ZeroHedge on January 5. Other major hedge funds have been onboard the hedge fund selling, notes the Wall Street Journal’s Juliet Chung and Carolyn Cui. As we noted a few weeks ago shorting the Yuan could possibly be “The Next Big Short”.

The alternative finance web site, generally known for its refreshingly bold look at controversial issues in the world of finance, muses about trade execution logic in preparing for the next Yuan devaluation. This is a call that Lu Jun made relative to the “all-weather” termed Congrong Allweather Fund. In a Bloomberg report the hedge fund manager noted that gap between China’s rising wages and the slowing economy “certainly has a limit. It will shrink,” noting trouble ahead.

Lu isn’t the only one to express concern regarding the market environment, as phony numbers, like many cover-ups, are revealed in the wash. But the question becomes: what is the best method to execute such an investment thesis?

Short China – How should a China derivatives trade be managed?

Zerohedge considers several derivatives trades but, unfortunately like many on Wall Street, assumes that “prime brokers” are the prime method of execution. There are, of course, futures commission merchants that trade in regulated derivatives markets. There are significant differences in exchange methodology. In a regulated derivatives exchange, the exchange itself never bets against the market participant. In many unregulated situations the FX exchange is the other side of a trade, which can get sticky when the exchange has informational access to see where customer stops are placed, as one example of the difficulty. Volume can sometimes be light, and there are other pros and cons to consider.

The report points to the options markets, which are often good for long-term spread trades but not always optimal for quick in-and-out trade execution. If a currency player is in these markets, watching how volatility impacts pricing – and implementing a directional volatility strategy that watches for mean reversion, is sometimes the call of professionals.

And then, of course, there is the vaunted credit default swap market. While trying not to get on a soap box, many of the dangers of trading sometimes dark markets where the seller is also the market maker has negative consequence. This is best explained in the movie The Big Short, but oddly little publicly discussed outside that mainstream release. There was a point in the Academy Award-nominated movie when the underlying mortgage-backed loan product was sinking in price and dramatically so. Under most circumstances, one would expect a derivatives product to fall in value along with the underlying product it tracks if it were traded on an open exchange. While contangio and backwardation, the future price trading either above or below the cash price, can impact relative pricing, this is only the case to various degrees — not anything close to the pricing disparity on display in the movie. During 2008, the cash market was clearly giving the indication it was in a rapid downward decent but the lightly traded and custom marketed derivatives initially didn’t move in price. This illustrated how trading on a dark, unregulated markets sometimes magically leads to the price moving in favor of the market maker with directional exposure.

The point is all fiduciaries have a responsibility to understand that just because a “respected” organization is selling something, and the cooperative ratings agency have anointed a seal of approval, don’t assume this means institutional investors should immediately assume validity. If the past years have taught professional investors anything it should be to question offerings and statements. This is the new era of finance, unfortunately. Look at the continued known examples where risk was not disclosed that go back to 2008, MF Global to various degrees and as recent as the Petrobras 100 year bonds prove – Bill Gates is suing those offering these products. They all provide the same cautionary warning and leads to a recommendation: trading on open, lit exchanges with liquidity is often the best method of trade execution.

 

Original Article: ValueWalk