Unraveling Network Risk — The Case of Hong Kong’s “Enigma Network”
The Hong Kong Stock Exchange (HKex) and its sister Growth Enterprise Market (GEM) came under the spotlight In June 2017 after a number of small cap stocks plunged sharply, wiping off around US$6.1bn in market value. The hardest hit shares saw more than 90% stripped of their price, while 13 others fell by nearly 50%. Most of the affected companies were part of a group named by activist investor David Webb in his May 2017 report entitled “The Enigma Network: 50 stocks not to own”.
The report highlighted a web of 50 Hong Kong-listed companies with complex cross-ownership structures. Within the network, companies hold stakes in one another ranging from less than 1% to more than 50%, spanning multiple sectors, including real estate, finance and consumer products. Some of the companies were known bubbles, highlighted Webb, on which the Securities and Futures Commission of Hong Kong (SFC) had previously issued concentration warnings. In his report, Webb urged investors not to purchase shares in the companies due to their opaque structures and balance sheet disclosures.
One glance at the enigma network using Datarama’s mapping tool highlights the interconnectedness of the 50 companies in question, and the intricacy of the mapping is stunning. At the centre of the network lie China Jicheng Holdings Ltd and GreaterChina Professional Services Ltd, whose shares sank by more than 90% amid the crash.
Even though the exact trigger for the rout remains a mystery, many analysts pointed to links between the companies affected and Lerado Financial Group Co Ltd as the potential cause. According to South China Morning Post, Hong Kong’s Securities and Futures Commission ordered Lerado to suspend trading in June 2017 after it was suspected to have released “materially false, incomplete or misleading information” in an October 2015 circular regarding an open offer. After Lerado was put under investigation, it disclosed in a statement that it had sold 1.48bn shares in China Jicheng, contributing to the crash in that company’s shares. Lerado was also known to have previously had an underwriting role in a GreaterChina share placement in 2015, and was revealed to be indirectly connected to GreaterChina through China Environmental Energy Investment Ltd.
Some of the companies on Webb’s list saw their shares rebound in early July 2017. Nevertheless, this sudden plunge affecting Hong Kong’s small-cap companies highlights the need for greater emphasis on network risk.
Network risk arises as a result of an increase in counterparty credit risk, particularly in an environment of market stress. In the case of the enigma network, the decliners generally held low volumes and concentrated shareholdings; with connections that are highly entangled, this exacerbates the impact of a single adverse event on the whole network, resulting in a contagious effect. In addition, as increased risk causes the web of companies and their surrounding parties to seek additional protection and liquidity, there is a danger that network risk upscales to become a systemic risk affecting the entire market.
In-depth due diligence checks and an understanding of the network ecosystem surrounding companies or individuals of interest are vital for businesses to mitigate their network risk. The Datarama relationship mapping tool makes use of big data visualisation technology to provide insights into the interconnections between companies and individuals — up to a few degrees of separation — simplifying the complexity into valuable information. Our risk rating mechanism also takes into account network risk, helping firms to better manage and select their preferred risk profiles.
With the world economy increasingly integrated and business relationships becoming more intertwined, assessing network risk and discovering hedging strategies to mitigate it has become an inextricable part of doing business.
The Datarama platform facilitates big data visualisation. Our platform enables users to identify potential risk exposure at a glance, allowing for better risk management. Find out more at www.datarama.com.
Written by Datarama analyst Siting.