REGULATORS in China have told securities firms to stop expanding their over-the-counter (OTC) derivatives operations involving individual stocks, limiting a profitable business for the brokerage industry and dealing another setback to hedge funds that deploy long-short strategies.

Regulators last week told multiple major brokerages to cap OTC businesses including total return swaps and options at the current levels, said people with knowledge of the matter.

Similar restrictions were imposed on lending of shares for short selling, as well as some proprietary trading activities, the people said.

Contracts only linked to stock indices or exchange-traded funds were exempted, they added.

The instructions came after the China Securities Regulatory Commission published revised risk-control measures for securities firms to better support the economy, easing capital rules for market making and asset management while raising requirements for riskier businesses like OTC derivatives.

In addition to the guidance on OTC derivatives, brokerages have notified some quantitative hedge funds that they can’t further expand the size of swap agreements that add leverage to the clients’ so-called market-neutral products, the people said.

The caps limit an increasingly popular business known as “Direct Market Access (DMA)” that has helped quants boost returns in a tough market environment this year.

Almost 99% of the market-neutral stock products — those that balance bullish and bearish positions — by hedge funds managing more than 10 billion yuan (US$1.4 billion) each made a profit in the first three quarters, averaging a 5.6% gain, according to Shenzhen PaiPaiWang Investment & Management Co.

The DMA model allows them to typically borrow as much as 300% of their investment from brokerages, fueling returns. (SD-Agencies)