China’s structured funds saga has continued to deteriorate over the last two days amid the onshore market meltdown, sparking fears of more defaults.

As the funds have suffered from the A-share crash, China’s securities regulator has suspended the registration and approval of such products.

The plunge in stock prices continued yesterday, with the Shanghai and Shenzhen indexes both recording sharp falls. In response, last night the People's Bank of China cut its benchmark interest rate by 0.25%, while the reserve requirement ratio has been reduced by 0.5%.

Over the past two days, the volatile and potentially dangerous nature of structured funds has become clear.

A structured fund is usually an index fund which splits into two units, where unit A invests in low-risk securities and provides a low-yield return, while unit B borrows and leverages unit-A capital to capture a higher return. Both units list on an exchange for trading, and they usually carry two times leverage.

In the event of a sharp A-share decline, a mechanism is triggered which moves around capital between the two units in order to rebalance them – this results in huge losses for unit-B holders.

At least ten structured funds triggered that mechanism to maintain the leverage ratio between their A and B units on Monday (August 24), after the CSI300 index fell by 8.75%, according to fund companies’ announcements.

An additional 15 structured funds triggered the mechanism yesterday after the CSI300 index fell by a further 7.1%, while another 20 structured funds will trigger such a mechanism if their benchmarks drop an additional 10%, according to Jisilu, an internet social platform and financial data provider.  

Structured funds are unique to China, and became one of the biggest-selling products during the fund IPO boom in the first half of this year. In total, fund companies launched 168 structured funds in the first half.

The products’ leveraged nature can make them highly profitable when the market is surging, but their net asset value can drop quickly when markets fall. In many structured funds, when unit B’s net asset value drops about 75%, the rebalancing mechanism is triggered to maintain the leverage ratio between the A and B units, and to protect the capital of a fund's unit A. If a structured fund triggers such a mechanism, the fund’s total asset value can contract about 60%.

The China Securities and Regulatory Commission (CSRC) confirmed last Friday that it had suspended the approval of such products. 

Zhang Xiaojun, a CSRC spokesperson, said: “such structured funds’ mechanism is complicated and average investors find it difficult to understand. There are some new situations and new problems, thus [the regulator] has suspended such products’ registration and is studying relevant policies.”

A total of 207 structured funds are seeking approval to list as of August 19, according to a filing released by the CSRC.

The Shenzhen Stock Exchange warned about nine funds’ risks on July 27 after the CSI300 index plummeted 8.6%. A total of 22 structured funds have triggered the mechanism over the last month, and lost on average 82% of their asset value, Chinese media reported.

Market observers have said that tighter listing rules and more investor education is urgently needed for these structured funds.