A host of measures have not stopped the giant selloff that has so far seen $3 trillion wiped off the value of stock since June 12 and their latest regulation is again another example of how little they understand the stock market.
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When the sovereign fund, Zhengjin, tried to boost the confidence of investors by splashing 120 billion yuan (US$19.3 billion) in the market, it was only buying state-owned large cap companies, which are also components of the index. It means the prices have been distorted even further and the real situation in the market is much worse than reflected in the Shanghai Composite Index. Mid-small caps have been sold off continuously. Among them, many companies, hoping to survive the storm of selling, applied for trading suspensions and about 1,200 companies have been suspended.
Problems for the stock market in China have been brewing even when stock-market fever was high because a lot of leverage was created accelerating the whole market to a very high point.
Chinese regulators were naive with leverage, particularly, the so-called "out-of-pitch" leverage, where the borrowing is unregulated and unreported, provided by unregulated financial companies and facilitated by brokerage companies.
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The out-of-pitch leveraging appeared suddenly and they are easily accessible to retail investors with no trading experience. If you go to a search engine in China, you can easily find lots of ads for these kinds of financial companies. It has been said that they are willing to provide 1-to-5 leverage, so a naive retail investor's buying power would suddenly be levered five times higher. Meanwhile, the "in-pitch" leverage, which is reported to the regulators, has been used more than ever before. While this borrowing created huge buying power which drove the market sky high, it would also lead to a free-fall when the tide went out as we are witnessing.
The risk of leverage to the Chinese stock market is still largely unknown, even after this epic fall of the index in such a short period of time, because even today the effect of de-leveraging is still going on: A majority of small stocks that are not likely to be saved by the government are still being sold off. It has been estimated the total size of leveraged finance was 3.3 trillion to 3.7 trillion yuan, therefore, Zhengjin's 120-billion-yuan buying power will not be effective.
Essentially, in the Chinese market, with a lot of trading frictions — that is costs like commissions, fees, interest rates and taxes — even the very sophisticated investors are not able to manage the risk under high leverage.
So when the free fall began, trading frictions and leverage made the investors believe they had to sell their holdings as early as possible to still make a profit, and they had to refrain from buying new stock as they feared they would only be able to sell in the next day. Thus a run on the market began.
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Was it triggered by some purposeful short-selling by some large "hostile international" investors as the government suggests? I doubt this very much, since to sell something when the prices are high is legal and a market would need both selling and buying to achieve an efficient pricing and allocation of resources.
The only thing the government has done right in this whole mess is to clean up the unregulated leverage market. The government is still trying to dictate what should happen in the stock market, which cannot be successful.
I can't see the market turmoil stopping immediately, though I would be reluctant to call the free fall as the "bursting of a bubble" as it was not irrationally high to begin with. It should be called a failure of political intervention. The market is very distorted, after the crash and the government's improper reaction to it, so it is not a good place for investment — at least for now.
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Commentary by Lei Mao, assistant professor of finance at the Warwick Business School.