Two weeks ago, when commenting on the PBOC's latest required reserve ratio cut, we pointed out that one of the more prominent risks facing the Chinese stock market, and potentially explaining why the Shanghai Composite simply can't catch a bid during the recent rout, is the risk of a wave of margin calls resulting in forced selling of stocks pledged as collateral for loans.

The pledging of shares as loan collateral - a practice that has gotten increasingly more popular over the years - has been especially prevalent among smaller companies as we observed in February and initially, last June. Unlike in the U.S., where institutional shareholders are a big market presence, private Chinese firms are often controlled by a major shareholders, who often own more than half of company. These big stakes are the most convenient tool for such big shareholders to raise their own funds.

Here, the risk for other shareholders is that when major investors take out such share-backed loans is that stocks can plunge sharply when the borrowers run into trouble, and are forced to liquidate stocks to repay the loan. Hong Kong-listed China Huishan Dairy fell 85% in one day in March 2017: It is unclear what triggered the selloff in the first place, but the fact that Huishan’s chairman had pledged almost all of his majority shareholding in the company to creditors was likely a key factor.

Small caps aside, the marketwide numbers are staggering: about $1 trillion worth of stocks listed in China's two main markets, Shanghai or Shenzhen, are being pledged as collateral for loans, according to data from the China Securities Depository and ChinaClear. More ominously, this trends has exploded in the past three years, and according to Bank of America, some 23% of all market positions were leveraged in some way by the end of last year in China, double from the start of 2015.

As a result of the recent market rout which sent the Shanghai Composite into bear market territory, in June UBS warned that it sees a growing risk in China's stock pledges; the bank calculated that the market cap of pledged stocks that have fallen below levels triggering liquidation amounts to 440 billion yuan with some 500 billion yuan below warning line, which translates to ~1% and 1.1% of China’s entire market value of $6.8 trillion. A separate analysis by TF Securities, as of Jun 19th, stock prices of 619 companies were close to levels where margin calls will be triggered. Since then, that number has increased.

Now, a new analysis by Morgan Stanley looks at the threat rolling margin calls pose to China's brokers, who are the intermediaries most exposed to stock pledged financing and over-pledging.

According to the bank's own analysis, shares pledged account for ~10% of total A-share market cap, with 123...