Zhang Chenghui, Research Institute of Finance of DRC

Research Report No.192, 2007

I. Definition and Expression of Capital Market System Risks

A system risk of the capital market is one that has a universally harmful impact on a specific category of commodities of the capital market or on the capital market as a whole. While this risk is difficult to be eliminated with technical tools, it is sufficient to cause a chain reaction to multiple market players, plunge them into operational difficulties and inflict major damage to the interests of the investors.

A non-system risk is mainly caused by the market behaviors of the market players (also called an operational risk). The impact of this risk is generally limited to the individual commodities of the capital market or to the individual market players, and does not affect the operation of the whole market. In general, the investors may avoid or partly avoid this risk with risk management tools.

Existing documentary data have diverse explanations about the types and expressions of capital market risks. This article classifies the expressions of system risks into the following four categories according to the extent of capital market stability.

1. Weak capital market system

Past experience indicates that a capital market without a sound system tends very much to produce a system risk when encountering an external inducing factor with a fairly slow recovery. For example, when a capital market is too small and is open to international capital, the market is highly prone to attacks by external capital. When a capital market lacks tiers, it can cause excess trade concentration and excess speculation. When a capital market lacks risk management and hedging tools, the investors will have a visibly lower risk-bearing ability and the market will be unstable. In the course of opening up its capital market, China will inevitably face a wave of financial innovation. When there is an excess development of financial derivatives, regulation will become more difficult because financial derivatives can be much more complex than the investors can understand. And regulatory defects can also help spread risks and aggravate crises.

2. Excess growth of fictitious capital and sustained swelling of related transactions

In recent years, bubble economy has replaced economic recession to become a nightmare for some countries. The burst of Japan's bubble economy that began in the early 1990s landed the Japanese economy in the doldrums for 14 long years. The burst of the “new economy” bubble in the 1999~2000 period triggered a crash of NASDAQ and other stock markets in the United States. The 1997 financial turmoil was also closely related to the bubble economies in Thailand, Malaysia and Indonesia.

Bubble economy is an extremely typical case of market malfunction, whose occurrence has a lot to do with the nature of fictitious capital. Fictitious capital is different from real economy. Once there is a market imbalance, the demanding and supplying parties generally do not adjust their behaviors according to conventional market rules¹. As the prices of the fictitious capital market are more influenced by expectations, market demand will drastically increase rather than reduce because of rising prices and as long as there is an expectation, prices will continue to go up. This is because the investors only want to make profit through trading and have no interest in the use and profitability of assets. As fictitious capital increasingly deviates from the growth of real capital and industrial sector, society and economy demonstrate false prosperity. But the bubble will burst out in the end and cause great damage to economy and society.

3. Trading system problems arising from improper use of electronic and network technologies

Along with the massive use of computer technology, communications technology, network technology and other new technologies in the financial industry, the trading system of the capital market has become increasingly electronic-dependent. In the traditional mode of trading, a trader can only do several dozen stock transactions a day. But in the mode of online stock trading, he can do several hundred or a thousand stock transactions. While new technologies have boosted trading efficiency, they have also brought forth new risks. First is the operational risk. In the age of electronic currency, an erroneous click can cause a heavy loss. In September 1997, an erroneous data entry on the Hong Kong Futures Market nearly caused a loss of US$800 million. The stock market in Japan also encountered similar problems. On December 8, 2005, the Mizuho Securities Co. made an erroneous operation. But as the trading system was problematic, it repeatedly rejected the withdrawal commands sent by the company. This accident caused a loss of about 30 billion yen to the company and triggered an abnormal price fluctuation on the Tokyo Stock Market, sending the Nikkei index down by 301 points. Second is the risk of computer-related financial crimes. Some criminals use hacking software, virus, Trojan program and other technical means to attack the systems and personal mainframes of the securities management institutions, securities companies and listed companies and to steal the funds of the investors and manipulate stock prices. If these criminal acts are not effectively prevented, they will cause extremely serious damage to the financial trading networks. Third is the operational and management risk of electronic systems. As known to all, the more precision an instrument is, the more fragile it will be. The more a company depends on the electronic technology, the more devastating a system malfunction will be. If the electronic infrastructure is unsound and if the operational management system is imperfect and unreliable, greater potential risks will come from the trading system itself. On November 1, 2005, a malfunction of the trading system of the Tokyo Stock Exchange caused a 90-minute break to the trading. On the afternoon of January 18, 2006, the stock exchange had no alternative but to terminate the trading 20 minutes earlier to prevent a system crash because the heavy selling volume was close to the limit of the trading system. As problems of this nature occur from time to time, people begin to question the security of electronic systems.

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¹When prices go up, the demanders reduce demand and the producers increase supply so as to reach an eventual market balance; when prices go down, the demanders increase demand and the producers reduce supply so as to reach a new market balance.