On Monday, the Chinese stocks got hammered, sending markets around the world into a tailspin. Two of the countries’ main indices, the Shanghai Composite and the Shenzhen Exchange slid 6.9% and 8.2%, respectively, before trading was finally halted. This is the equivalent of our Dow Jones Industrial Average being down over 1,300 points in a single day. Following the models of North American stock exchanges, when indexes breach a certain floor of losses (in China’s case, down 7% intraday) trading is automatically halted to curtail investor’s panic.

The sell-off was a continuation of last summer’s crash that never really ended. Recall that almost $4 trillion in Chinese stock market capitalization was wiped out in one month before the Chinese government simply banned selling by major shareholders in 72% of Chinese stocks.1 This ban, or “lock up” was scheduled to last for the next six months. Unfortunately, that only postponed the date when markets can normalize. That started yesterday.

The lock-up is set to expire this Friday, January 8th. The markets clearly anticipated this and many foreign investors wanted to sell in front of the lock-up where they expected to see a flood of stock from previously frozen accounts. These types of interventions accomplish little-they typically make investors more skittish because they fear another shutdown in trading. “The market will not improve because there will be heavy selling in the near future,” says Huang Cengdong, analyst at Sinolink Securities in Shanghai.2 To be fair, our New York Stock Exchange also has safety measures in place that halt trading in individual stocks for 15 minutes if they break a predetermined floor. But a fifteen minute time-out is a far cry from a six-month selling ban. Of course, some pointed to other catalysts for the sell-off, including tension in the Middle East and slowing Chinese economic data. Whatever the reason, the frenzied trading reminded us of their volatility.

So what caused the turbulence? The Chinese markets had elements of both of our last two financial bubbles-easy credit and heavy public participation. Just like our housing bubble in the mid-2000s, the Chinese stock markets were fueled by leverage and excessive borrowing. At the height of the Shanghai stock market last summer, money borrowed to buy stocks had reached $1.2 trillion, a tripling from the prior year.3 Putting this into perspective, margin debt as a percentage of tradable stocks reached 9%, the highest level of any market in history, according to the Wall street Journal.4 That credit was soon cut by more than half, leading to a cascade of selling.

The next element of the bubble was public participation. China now boasts 90 million retail investors, many of them new investors caught up in the market frenzy. Recall the pictures of old ladies following their stocks at their local brokerage firm (which had an atmosphere like a sports book at a casino). Many of these investors are new, victims of a herd mentality that captivated Chinese investors from cities to farms. From the SWUFE China Household Finance Survey, over two-thirds of new investor households don’t have a high school diploma while almost 6% are illiterate.5 But these investors don’t need to read words, just numbers. And these numbers soared to new heights. These investors are now getting their first tastes of the volatility of a stock market.

Another belief of investors was that the Chinese Communist Party will back-stop the markets no matter what. The PBOC continues to directly inject money into the markets to help support them. Time will tell what length they will continue to do so. A manipulated market is a market people don’t trust, as Chinese investors are discovering.

But many investors still feel the risks of investing in Chinese markets are worth it. China, a complicated mix of capitalism and communism, has tempted investors with a siren’s song of phenomenal growth, the world’s second largest economy and a middle class that has surpassed the United States.6 Compared to its rich history, China’s stock market (the Shanghai Composite) has only been around since 1990. Last year, President Xi has vowed to implement reforms to engender the confidence of investors. These include a crackdown on cybercrime, an easing of the infamous One Child Only birth policy and an assault on corporate fraud. But there’s also the communist side, where the Party still controls the media to a large degree and certainly the financial data. Economic numbers are dubious and depending on who you ask, Chinese economic growth can be anywhere from 3% to 7%.

Applying fundamental analysis to Chinese stocks is very difficult without transparent information. Accompanying the rise in the Shanghai Composite was a dearth of suspect corporate fundamentals. Accounting standards in China are much different than the United States (and much of the developed world) since they don’t need to comply with International Financial Reporting Standards, IFRS. The problem is not only are the companies financials questionable, but the firms auditors are described as ‘sycophantic’. If those hired to detect accounting issues are themselves incompetent or it becomes very difficult to perform real due diligence.

A research firm aptly named ‘Muddy Waters’ was created to shine a spotlight into the dark financial world of many Chinese companies. Founded by American Carson Block, the firm employs forensic accountants, valuation experts and investigators in an attempt to uncover fraud and financial crimes at publicly traded Chinese companies. Block has been quoted as saying “China is to stock fraud as Silicon Valley is to technology”. Muddy Waters provides this research for short-sellers. One problem is short-sellers in China, who can add value by keeping stock prices in check, are arrested.7 Needless to say, Mr. Block has received death threats, presumably from disgruntled investors who blame him for the sell-offs that often follow one of Muddy Water’s scathing reports (his research is now largely conducted from the U.S.) Sometimes, tips simply come in from whistleblowers since Muddy Waters has a ‘submit an idea’ button right on their website.8

No one can be sure the extent of the current turmoil in Chinese markets but investors should brace for the possibility of more volatility. A transition from a secretive Communist economy to a transparent, global financial system takes time. Stay tuned for the headlines that will write the next chapter of this story.