China's Markets Achieve "Flash Crash" Status

By Markets Fool.com

U.S. stocks are little changed in early afternoon trading on Monday, with theS&P 500and theDow Jones Industrial Average (DJINDICES: $INDU)down 0.24% and 0.51%, respectively, at 12:15 p.m. EDT -- nothing like the excitement witnessed in China's financial markets today.

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Goldman is more confident on China

Goldman Sachs, a sometimes kingmaker in financial markets (and at 1500 Pennsylvania Avenue the U.S. Department of the Treasury), has raised its estimate of the odds that index provider MSCI will decide to add China's A-shares to its global indexes next month to 70% in a note published today, up from 50% last month.

A-shares, which are denominated in yuan, trade on the Shanghai and Shenzhen exchanges -- the top two venues for equity trading in China. By lifting its estimate, Goldman managed to raise investors' spirits as well -- the Shanghai and Shenzhen Stock Exchange Composite Indexes gained 3.3% and 4.1%, respectively, on Tuesday.

At the end of April, nearly $450 billion in assets were invested in exchange-traded funds (ETFs) alone linked to MSCI indexes.

China's markets achieve a new pinnacle of sophistication

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Goldman pointed to China's efforts in addressing two of the five weaknesses in its equity markets that MSCI identified in April. While three areas remain for improvement, the index provider will no doubt be heartened to see that China already exhibits a feature that had previously only been witnessed in the world's largest, most sophisticated equity capital market: the "flash crash."

Indeed, futures on the CSI 300 Index, which trade on the China Financial Futures Exchange in Shanghai, were "limit down" at 10:42 a.m. local time, falling by 10% before retracing virtually the entire loss within the same minute. The magnitude of the decline and the speed of the snap-back is even more impressive than the original flash crash of May 2010 that shook the U.S. stock market. If that isn't a sure sign of progress and sophistication, I don't know what is.

The CSI 300 Index is a stock index constituted of 300 leading stocks trading on the Shanghai or Shenzhen Stock Exchanges. The index represents roughly a quarter (27%) of the aggregate market capitalization of both exchanges' A-shares.

No contagion to China's stock market

Interestingly, the wild action in the futures market had no noticeable effect on the cash market ("cash" refers to the fact that, in the stock market, all trades are cash settled, while in commodity futures markets, for example, the seller can deliver the commodity to settle the trade). Contrary to the graph of the futures price, which contains a huge downward spike, that of the underlying index looks perfectly normal.

That's a fundamental difference with the U.S. flash crash, which regulators believe hinged on a tight link between the futures and the cash markets. Indeed, a comprehensive official investigation traced the origin of the flash crash to a large automated sell order in the "e-mini" S&P 500 futures.

The lack of any knock-on effect on the stock market in China must surely owe to the fact that the stock index futures market, which less than 12 months ago was ranked as the most active such market in the world, has suffered a near-terminal chill. Under the weight of new regulations to discourage "abnormal trading" introduced in the wake of last summer's stock market rout, stock index futures volumes have collapsed by roughly 99%. I'm all for discouraging day trading, but, clearly, China still has a long ways to go to make good on its commitment to liberalize its markets.

The article China's Markets Achieve "Flash Crash" Status originally appeared on Fool.com.

Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.