Regulatory Soft Interventions in the Chinese Market: Compliance Effects and Impact on Option Market Efficiency

Published date01 May 2019
AuthorJimmy E. Hilliard,Haoran Zhang
Date01 May 2019
The Financial Review 54 (2019) 265–301
Regulatory Soft Interventions in the
Chinese Market: Compliance Effects and
Impact on Option Market Efficiency
Jimmy E. Hilliard and Haoran Zhang
Auburn University
Securities Laws in China are administered by the China Securities Regulatory Com-
mission (CSRC). The CSRC has great flexibility in administering securities laws since the
committee represents the will of the state. Under the state-controlled financial system, the
CSRC works closely with state-controlled financial firms and suggests, but does not man-
date, actions to be taken in the equity market, especially during periods of extreme market
stress. These suggestions, or soft interventions, have been used to block trades associated
with short sales, significantly reducing short-sales volume. With daily and intraday data, we
investigate the impact of these interventions on put-call parity and implied volatilities. There
is overwhelming evidence of increased deviations from put-call parity and changes in implied
volatility after soft interventions. Our results are robust after allowing for bid-ask spreads,
taxes, transaction costs, and difference-in-differences comparisons with control securities in
the Hong Kong market.
Corresponding author: Department of Finance, Auburn University, 405 W Magnolia Ave, Auburn, AL
36849; Phone: (334) 844–5301; Fax: (334) 844-4960; E-mail:
Weacknowledge the helpful comments of an anonymous referee and participants at the 2017 Southwestern
Finance Association Meeting, the 2017 Eastern Finance Association Meeting, the 2017 meeting of the
Southern Finance Association, and participants in the Harbert College of Business Finance Seminar Series.
Wehave also benefitted from discussions with Minglei Liu, Hong Miao, Sanjay Ramchander,Kangli Sheng,
Yinan Ni, and SteveSwidler. The data generously provided by Wind Info, Inc. was arranged for by Albert
C2019 The Eastern Finance Association 265
266 J. E. Hilliard and H. Zhang/The Financial Review 54 (2019) 265–301
Keywords: Chinese market, soft interventions, options, efficient markets, put-call parity
JEL Classifications: G1, G13, G14
1. Introduction
One of the objectives of the China Securities Regulatory Commission (CSRC;
the regulator) is to promote the development of a fair,transparent, and complete Chi-
nese market. To protect the public interest and especially that of individualinvestors,
the regulator is expected to keep the market stable (China Securities Regulatory
Commission, 2016). Without written laws or mandates, the CSRC makes known the
will of the state and compliance by state-influenced firms is expected. We use the
term “soft intervention” to describe such actions by the CSRC.
We investigate the effectiveness of soft intervention by the CSRC and focus
on the nonintended effects on market efficiency as quantified by deviations from
put-call parity and implied volatilities. We findthe soft intervention in 2015 reduced
short-sale volume significantly. Using Huaxia SSE 50 ETF and its options, we find
overwhelming evidence that put-call parity deviations increase significantly and im-
plied volatilities change as predicted after the soft intervention. Weverify robustness
with a difference-in-differences (DiD) analysis using futures options on a mainland
index (Hang Seng China Enterprise Index [HSCEI]) in the Hong Kong market as a
control. The Hong Kong market is not directly regulated by the CSRC.
The paper is organized as follows: Section 2 summarizes the regulatory features
of the Chinese market and Section 3 is the literature review. Section 4 describes the
securities and the data. Section 5 developsthe effect of the regulator’s soft intervention
on market prices. Section 6 develops identification tests and Section 7 concludes.
2. The state-controlled financial system and soft
The financial system in China is tightly controlled by the central government
and state-owned capital. This especially holds true for equity markets. Tight control
is a result of governmental style (McKinnon, 1991) and the questionable reputation
of speculators in the market. At the end of 2016, nine out of the largest 10 commercial
banks and all of the largest 10 brokers were essentially controlled by state-owned
capital. The two stock exchanges (the Shanghai Stock Exchange [SSE] and Shenzhen
Stock Exchange [SZSE]) are both governmental agencies that directly report to
the CSRC. Under this state-controlled financial system, the regulator and financial
firms interact with each other closely. This system makes another form of regulation
available for the CSRC, the soft intervention.
Soft intervention is a strong form of moral suasion where target firms have no
legal obligation to comply. Soft intervention is similar to the practice of “window
J. E. Hilliard and H. Zhang/The Financial Review 54 (2019) 265–301 267
guidance” found in other countries and especially notable in Japan. However, soft
intervention in China is stronger and more efficientunder the state-controlled financial
system. Another notable difference is that while previous works (Hoshi, Scharfstein
and Singleton, 1993; Rhodes and Yoshino, 1999; Ongena, Popov and Van Horen,
2016) mainly documents moral suasion and window guidance in the banking industry,
the CSRC and Chinese government effectivelysoft-intervene in equity and derivatives
markets. The soft intervention in China is a much stronger tool than moral suasion and
window guidance in other countries because state-controlled firms have a dominant
market position and these firms tend to comply with the will of the state.
2.1. The legal basis of securities market regulation
The Securities Law of the People’sRepublic of China grants authority to CSRC
to regulate financial markets in China. The CSRC has multiple departments that work
in different markets and on different issues. For instance, the Bureau of Futures Reg-
ulation focuses on the futures market and the Bureau of Investor Protection focuses
on investors’ issues. These departments make administrativerules and regulations as
they deem appropriate. Such administrative rules and regulations are formal “hard”
rules and regulations. In addition, the CSRC may “suggest” appropriate behavior.
Compliance with these soft interventions is expected, especially by state-controlled
financial firms.
The CSRC has an Administrative Punishment Committee. This committee iden-
tifies violators and decides how to they should be handled. When the CRSC deter-
mines (perhaps subjectively) that some actions by marketparticipants are detrimental,
it will first intervene by communicating with the potential violator in order to obtain
the desired result. The communication may be in a form of window guidance, a warn-
ing letter, or even an informal call. If this does not work and there is solid evidence
showing that a market participant is violating existing laws, rules, and regulations,
the CSRC has the right to levy administrative punishment on the violator.The admin-
istrative punishment can be a fine or a restraining order forbidding the violator from
trading on the market for a period of time. All of these punishments are announced on
the CSRC Web site. If the suspect in violations does not agree with the punishment,
they can provide further evidence and ask the CSRC to reviewit. However, historical
evidence shows that it is very unlikely that the punishment will be changed. To avoid
hard-to-overturn punishment, financial firms tend to comply with soft interventions.
2.2. The mission of the CSRC
The mission of the CSRC is to improve market efficiency, protect investors, and
develop a fair, transparent, and orderly market. Protecting investors and providing
an efficient market are consistent goals in most cases. In part, the regulator seeks to
protect investors by improving market efficiency. However, in some extreme cases,
there is arguably a short-term conflict between protection and efficiency. The regulator

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