The financial markets write their own headlines, and most are a result of explosive moves.

Exhibit A is the TerraUSD debacle that unfolded recently in the crypto market.

In April, the stablecoin was sailing along minding its own business and mostly sticking to its 1-to-1 peg with the U.S. dollar. Then, suddenly, the peg unraveled, and TerraUSD spiraled down to a fraction of its previous value. It was like “Humpty Dumpty” suddenly broke into a billion pieces. 

Exhibit B is the current price of crude oil, which spiked dramatically in 2022 after the Tsar (e.g. president) of Russia decided to invade Ukraine. With oil currently trading near the highs of the year, it’s yet another financial headline that has written itself. 

It appears that another important narrative may be simmering on the back burner, preparing to boil over in the same manner as the aforementioned examples. That is the “Chinese delisting” story. 

Chinese companies have been trading on U.S. exchanges for many years. But what wasn’t known—at least until recently—was that many Chinese companies have been exploiting a loophole in the system that allows them to sidestep the stringent auditing standards typically required of overseas listings.

But that shell game came to an end when Congress passed the Holding Foreign Companies Accountable Act (HFCAA) in 2020. Under this new law, foreign companies listed on American exchanges will henceforth be delisted if they fail to turn over audit results for three consecutive years.

The Public Company Accounting Oversight Board (PCAOB) in the United States followed up on that new law by adopting a mechanism for enforcing it: Designating the violating companies officially “non-compliant,” and subject to punitive delisting. The PCAOB basically serves as an auditor of auditors.

In short, that means foreign companies that fail to turn over audit results for the next couple of years will likely be delisted—with limited exceptions. Chinese companies are especially vulnerable to this law because the Chinese government often serves as a major roadblock when it comes to the release of sensitive information to foreign agencies. 

Accordingly, a slew of Chinese delistings could materialize in 2024, if not sooner. Presently, there are an estimated 250 Chinese companies listed on U.S. exchanges, which together represent more than $1 trillion in combined market capitalization. 

The decision to delist—or not to delist—is gathering so much gravity in the markets that this entire narrative seems to be transforming into a potentially massive binary event.

In the trading world, critical developments that trigger gigantic moves in an individual underlying, or a group of underlyings, are frequently referred to as binary events. Such developments can easily be interpreted as absolute positives, or absolute negatives, due to jagged moves on a historical price chart. 

Longtime investors and traders in the biotechnology sector are all-too-familiar with binary events because decisions rendered by the Food and Drug Administration (FDA) can sometimes make or break a company. 

That’s exactly what played out in shares of Ardelyx (ARDX) last July, when the stock cratered by more than 75% after the FDA found a series of deficiencies in Ardelyx’s drug application for an experimental kidney disease treatment known as Tenapanor.

In the case of the Chinese delistings story, it’s likely that any definitive conclusion to this ongoing drama will set the entire group ablaze—the only question is whether it will be an afterburner, or a cataclysmic inferno. 

Where Things Stand Right Now

At this time, negotiators from both China and the U.S. are working hard to avoid the disaster scenario, which would be a mass, involuntary delisting of over 200 Chinese companies from U.S. exchanges.

However, the language of the new law, and the enforcement mechanism enacted by the Public Company Accounting Oversight Board, leave little wiggle room for concessions. From the American perspective, this issue is mostly black and white—Chinese companies listed on U.S. exchanges will either allow the PCAOB to audit their financials, or they won’t.

The Chinese, for their part, appear to be working the grey area. 

In April, the China Securities Regulatory Commission (CSRC) proposed amending secrecy guidelines on the handling of audit papers for overseas-listed companies. These proposed revisions were aimed at reducing the amount of sensitive information recorded in the papers, and would remove language that stipulates foreign regulatory inspections must be led by Chinese authorities. 

Superficially, that proposal appears to be a step in the right direction. But at the end of the day, granting a U.S. agency unfettered access to sensitive information in some of China’s largest companies may simply be a bridge too far. 

Recent actions taken by some Chinese companies—especially those with a significant business presence on U.S. soil—suggest they aren’t counting on a grand bargain between the two countries anytime soon. 

In order to help their cases, some Chinese companies listed in the U.S. have recently hired American accounting companies as their principal auditor. This is significant because while a company can engage multiple auditors, the principal auditor does the bulk of the work, assumes responsibility for the work of other auditors, and officially signs off on the client’s financial statements.

Whether such a move will satisfy U.S. regulators is yet to be seen.

It’s far more likely that the ultimate result of the Chinese delisting story will be dictated by the ability of the regulators to strike a bargain, and the political will of both governments to see it executed in good faith. 

Recent movement in Chinese stocks suggests that a lot is riding on this story. 

Back on March 16, shares in Chinese stocks listed on American exchanges spiked dramatically after it was reported that negotiators from the U.S. and China were progressing toward a plan of cooperation for avoiding a mass delisting event. On that day, Chinese companies such as Alibaba (BABA), Baidu (BIDU) JD.com (JD) and Pinduoduo (PDD) all surged more than 30% in a single trading session.

Chinese stocks (both domestic and overseas) have been stuck in a bear market since valuations peaked last February. For example, the tech-heavy KraneShares CSI China Internet ETF (KWEB) is down roughly 70% since February 1, 2021.

On March 15, 2022—when the two sides reported positive progress on delisting negotiations—KWEB jumped by nearly 40%. That’s a big move for an ETF, and it helps illustrate the type of pressure (and potential) that’s built into this story. 

For reference, the Chinese ride-sharing company DiDi Global (DIDI) announced it would voluntarily delist from the New York Stock Exchange back in December of 2021. DIDI shares have dropped by about 90% since last summer, and are currently trading for $2/share.

While DIDI’s situation is slightly unique—considering the company chose to delist, and wasn’t involuntarily delisted—the performance in its shares may foreshadow the fate of other Chinese stocks if a deal isn’t ultimately struck between the U.S. and China.

One also has to consider the broader trade war between the two countries, and the overall tenor of current relations. It’s possible the U.S. is using the delisting story to gain leverage in another area of the bilateral relationship. 

Regardless, it’s almost certain that whenever the final decision arrives, it will catalyze a huge move (up or down) in the shares of Chinese stocks listed on U.S. exchanges.

Investors and traders with existing positions in such companies, or considering new positions, may therefore want to plan accordingly.

To learn more about stock delistings, review this installment of Options Trading Concepts Live on the tastytrade financial network. For more context on binary events, check out this episode of Options Jive. 

To follow everything moving the markets this summer, tune into TASTYTRADE LIVE.

Sage Anderson is a pseudonym. He’s an experienced trader of equity derivatives and has managed volatility-based portfolios as a former prop trading firm employee. He’s not an employee of Luckbox, tastytrade or any affiliated companies. Readers can direct questions about this blog or other trading-related subjects, to support@luckboxmagazine.com.