Illegal Short Sales Under Scrutiny in Hong Kong's `Enigma' Crash

(Bloomberg) -- Illegal short selling may have contributed to the sudden plunge in dozens of Hong Kong’s small-cap companies this week, according to the city’s stock exchange.

So-called naked short sales, which are banned in Hong Kong, could have played a role in the rout, Hong Kong Exchanges & Clearing Ltd. Chief Executive Officer Charles Li said on Thursday, according to an HKEX spokeswoman’s account of his comments. Li added that the losses may have been fueled by a combination of factors and that HKEX will cooperate with the city’s securities regulator to crack down on market irregularities.

Three days after the $6.1 billion selloff heightened concerns about unexplained swings in the world’s fourth-largest stock market, Hong Kong investors are still waiting for answers. While many pointed to the affected companies’ complex web of cross-shareholdings -- dubbed “The Enigma Network” by activist investor David Webb -- what exactly triggered the rout remains a mystery.

Illegal Short Sales Under Scrutiny in Hong Kong's `Enigma' Crash

Li noted that some of the affected stocks weren’t eligible for regulated short selling and that the decliners generally had low volumes and concentrated shareholdings, according to the HKEX spokeswoman. HKEX will continue to closely monitor trading activities, Li said.

Short selling in Hong Kong is limited to companies with a minimum value of HK$3 billion ($384 million) and an aggregate turnover-to-market capitalization ratio of at least 60 percent. Naked short selling, where an investor takes a short position without borrowing the underlying stock, is not allowed in the city.

Hong Kong’s Securities and Futures Commission has said it can’t comment on whether it’s investigating the rout. But the regulator noted that the biggest decliners tended to have characteristics conducive to extreme volatility and market misconduct: multiple relationships between different companies and listed brokerage firms, high shareholding concentrations, low volume and small public floats.

Among Tuesday’s decliners were China Jicheng Holdings Ltd. and GreaterChina Professional Services Ltd., which both fell more than 90 percent. While traders struggled to nail down a trigger for the moves, many pointed to links between the companies and Lerado Financial Group Co., a brokerage that’s under regulatory investigation. Lerado had previously disclosed an investment in China Jicheng and had an underwriting role on a GreaterChina share placement in 2015.

Lerado said it sold 1.48 billion shares of China Jicheng on Tuesday at an average price of HK$0.0169 per share, according to a statement to the Hong Kong stock exchange. China Jicheng ended the day at HK$0.016, and was trading at HK$0.015 at 10:55 a.m. in Hong Kong.

Both companies were among those flagged by Webb, a former director of the Hong Kong exchange, in a May report titled “The Enigma Network: 50 stocks not to own.”