Two weeks ago, when commenting on the PBOC's latest required reserve ratio cut, we pointed out that one of the more prominent risks facing the Chinese stock market, and potentially explaining why the Shanghai Composite simply can't catch a bid during the recent rout, is the risk of a wave of margin calls resulting in forced selling of stocks pledged as collateral for loans.

The pledging of shares as loan collateral - a practice that has gotten increasingly more popular over the years - has been especially prevalent among smaller companies as we observed in February and initially, last June. Unlike in the U.S., where institutional shareholders are a big market presence, private Chinese firms are often controlled by a major shareholders, who often own more than half of company. These big stakes are the most convenient tool for such big shareholders to raise their own funds.

Here, the risk for other shareholders is that when major investors take out such share-backed loans is that stocks can plunge sharply when the borrowers run into trouble, and are forced to liquidate stocks to repay the loan. Hong Kong-listed China Huishan Dairy fell 85% in one day in March 2017: It is unclear what triggered the selloff in the first place, but the fact that Huishan’s chairman had pledged almost all of his majority shareholding in the company to creditors was likely a key factor.

Small caps aside, the marketwide numbers are staggering: about $1 trillion worth of stocks listed in China's two main markets, Shanghai or Shenzhen, are being pledged as collateral for loans, according to data from the China Securities Depository and ChinaClear. More ominously, this trends has exploded in the past three years, and according to Bank of America, some 23% of all market positions were leveraged in some way by the end of last year in China, double from the start of 2015.

As a result of the recent market rout which sent the Shanghai Composite into bear market territory, in June UBS warned that it sees a growing risk in China's stock pledges; the bank calculated that the market cap of pledged stocks that have fallen below levels triggering liquidation amounts to 440 billion yuan with some 500 billion yuan below warning line, which translates to ~1% and 1.1% of China’s entire market value of $6.8 trillion. A separate analysis by TF Securities, as of Jun 19th, stock prices of 619 companies were close to levels where margin calls will be triggered. Since then, that number has increased.

Now, a new analysis by Morgan Stanley looks at the threat rolling margin calls pose to China's brokers, who are the intermediaries most exposed to stock pledged financing and over-pledging.

According to the bank's own analysis, shares pledged account for ~10% of total A-share market cap, with 123 companies over 50% pledged, amounting to a combined pledged market cap of RMB1.0 trn, or 2% of total A-share market cap.

Furthermore, so far in 2018, there have been ~50 A-shares that have suffered price declines over 60%, with an average pledge ratio of 28%, thus likely falling below margin closeout level. According to the Securities Association of China, stocks below margin closeout level amounted to <1% of total A-share market cap as of June 26.

So what does this mean for brokers?

Morgan Stanley estimates that the total stock pledged financing balance at ~RMB2.7trn, of which RMB1.6trn is by brokers. The good news, is that following the introduction of new asset management rules in China, and ongoing financial cleanup, banks' participation has been notably less, since this falls under non-standard credit assets.

The not so good news is that even with regulatory changes, as of end-2017, brokers' stock pledged repo exposure was equivalent to more than all of the brokers' net capital, or 103%, up from 16% in 2013.

Putting these numbers together, Morgan Stanley calculates that it would take ~11% of brokers' net capital to absorb 50% of their exposure to stock pledged financing below margin closeout level.

But how great will the pain for brokers get if the market continues to slide?

That is the question Chinese regulators tried to answer earlier in the year when the awoke to the threat of China's stock-pledged financing, additionally realizing that compared to margin financing or OTC leverage, stocks used for stock pledged financing are less liquid, as major shareholders' stock holdings could be locked up or subject to shareholding reduction restrictions.

Which brings us to the new rule on stock pledged repo business implemented on March 12, 2018 which enforced stricter standards on concentration and collateral, and the Notice on June 1, 2018 essentially suspended OTC stock pledged financing for brokers.

Meanwhile, to ease concerns about margin calls, regulators set the guarantee coverage ratio as 181% for SHEX and 223% for SZEX, still relatively sufficient, if well below the initial levels of ~300%. And, as Morgan Stanley adds, in an attempt to avoid a feedback loop, regulators advised brokers to avoid margin closeout and provide liquidity support by extending contract periods or negotiating for more collateral.

In short, as prices drop ever lower, Chinese regulators are stretching the rules hoping that the current wave of selling ebbs and prices rebound from levels that would have already triggered forced liquidations. Or, as Morgan Stanley writes, China is doing everything in its power "to maintain stability of capital markets and avoid a vicious circle of default and panic selling, causing markets to spiral down further."

What is perhaps most concerning for Beijing regulators, is that despite all its efforts to prevent self-reinforcing liquidations, the Shanghai Composite has continued to sell off despite all its best efforts, and worse, the trade war with the US which has emerged as a major risk for Chinese companies comes at a time when the Composite is on the verge of taking out a critical support level: the lows hit after the bursting of the 2015 Chinese stock bubble.

Which may also be the line in the sand for China, and should the Composite slide another 100 or so points, taking out the critical support at 2,655, then regulators may finally be forced to tap banks and brokers on the shoulder, and demand companies repay loans. The resulting stock mass liquidation could also be the trigger Trump needs to demand capitulation from Beijing as part of the escalating trade war. The big question is, if indeed this is the endgame, whether China will allow this to happen without retaliation, or if Beijing - having little to lose - will sell a few hundred billion Treasurys to punish US capital markets as its own stock market crashes and burns.