Attempts by Swiss investment bank UBS to take a 20% stake, and de facto management control, in troubled domestic brokerage Beijing Securities have shown that winning a slice of China's securities pie is not without its problems.
UBS is not saying much about the deal, which would see them become the first foreign company to receive a license to act as a broker in China's domestic markets. A spokesman for the company confirmed last month that the China Securities Regulatory Commission (CSRC) has granted "preparatory approval", but industry insiders say UBS still has many regulatory hurdles to overcome before the deal can be considered in the bag.
That it has even got this far is extraordinary, with the planned buyout riding roughshod over regulatory hurdles that have effectively shut the door on foreign activity in the domestic brokerage industry.
It also looks like UBS may well have caught the last cab of the rank.
An analyst with close ties to the regulator confirmed that the door has now been closed to foreigners until such time as the CSRC completes restructuring domestic brokerages, and until a systematic blueprint for foreign entry has been decided, which would likely take one or two years.
"The CSRC has not drawn up a strategy for opening up yet," he said. "They are concerned about national financial security."
UBS may also have been lucky to scrape through in the face of reluctance from the securities regulator. Pressure from the People's Bank of China (PBOC) is thought to have swayed the decision in UBS's favor.
As the institution that will be forced to bail out failed brokerages, the PBOC is understandably eager to see foreign capital and management expertise flow into the sector. Central bank governor Zhou Xiaochuan also has a reputation as a pro-deregulation liberal.
"The banking regulator has seen foreign entry as minority stakes as a part and parcel of the reform of the banking sector whereas the CSRC has taken a more conservative line to foreign entry," said Standard Chartered economist Stephen Green.
The securities regulator is helmed by the conservative Shang Fulin, and appears to be wary of upsetting the regional governments that own domestic securities firms. At the forefront of its concerns is a repeat of London's Big Bang, which devastated domestic brokerages when the London Stock Exchange dropped its restrictions on allowing foreign participation in 1986.
But the reforms were not all bad, setting the stage for the modernization of trading and establishing London as the center of European investment banking. The financial sector's share of UK GDP went from 13.6% in 1985 to 17.2% in 1990.
While the CSRC is trying to introduce similar reforms, it is desperate to avoid what the Japanese have termed the "Wimbledon Phenomenon", derived from the fact that although Britain provides the world's foremost tennis tournament at Wimbledon, the winners tend to be foreigners.
Although foreign banks have been allowed limited entry into domestic investment banking since July 2002 through 33% joint venture stakes, UBS stands to become the first foreign bank to get its hands directly on a secondary trading license, notwithstanding two notable exceptions.
Of the six foreign entrants – seven if you include Bank of China International – only Morgan Stanley has received a license to broker A-sharesm, through its joint venture China International Capital Corporation. That was only granted because the bank got in early, striking a one-off deal with Beijing to take 35% of the company when it was established in 1995.
But even here the situation is far from satisfactory, with Morgan Stanley having no sway over the brokerage's operations.
Rumors abound that the bank is looking to shed its stake and look for other opportunities. It has been linked to efforts to buy up to 50% of beleaguered AJ Securities, and there were reports of failed efforts to buy into Shanxi Securities late last year.
"We are actively looking for local partners to work with and further expanding our domestic platforms in China," chairman and CEO John Mack said, but declined to comment further. However, it is widely known that a minority stake means little to the foreign players.
Goldman Sachs has been more successful in its attempts to enter the market. Through a controversial arrangement with veteran Chinese banker Fang Fenglei – who was former deputy chief executive at arch-rival Morgan Stanley's Chinese joint venture – the bank has found a way around the regulatory hurdles to gain access to secondary A-share trading.
Goldman Sachs, which declined to comment, operates its investment banking business through Goldman Sachs Gao Hua Securities, a joint venture with Beijing Gao Hua Securities (BGHS), owned by Fang.
It also has effective control of BGHS, through which it operates its domestic brokerage business.
Fang holds the ownership of the company in trust for Goldman Sachs – which provided him with US$190 million in start-up capital – until such time as Chinese law allows the investment bank to take official control. In the meantime, BGHS is run on the Goldman Sachs model, using Goldman equities research staff who have been transferred to the domestic brokerage's Shanghai and Beijing offices.
Credit Suisse, Citigroup, HSBC and Merrill Lynch have also knocked on the doors of domestic houses.
Merrill Lynch had been waiting since early 2005 for approval to take a one-third stake in Hua'an Securities, JP Morgan was said to be pursuing Liaoning Securities, while Credit Suisse's negotiations with Xiangcai Securities, China's seventh-largest broker, seemed to achieve little.
"The process for foreign investors is delayed but ultimately the government will open it up," said Ivan Chung, managing director of Xinhua Far East China Ratings.
"If the government can open up the banking industry to foreign investors I don't think they are unwilling to open up the brokerage industry, which is strategically less sensitive than the banks."
In preparation, Beijing has shut or arranged the takeover of small or mid-sized securities houses, cutting the number to 109 from about 127 in 2004. It recently announced plans to reduce it to around 50, with each brokerage requiring a license.
In order to qualify, securities firms must return any money they have embezzled from clients' deposits, they must not have heavy debts and their net capital must meet certain standards. The firms will also have to submit monthly reports on their net capital and risk controls.
The CSRC and the China Securities Association (SAC) have already qualified 32 brokerages, meaning around 90 firms are left competing for the last 18 slots. Brokerages without qualifications are likely to be banned from trading after 2006.
According to Bruce Richardson, managing director of research at Xinhua Finance, 50 brokerages is still too many, but organic consolidation should come into play.
"You are throwing the spaghetti on the wall to see what sticks," he said. "Some of them will make it and others won't and then you go through another round."
It is likely to be after the second round that the regulator will begin opening up again to foreign hopefuls, possibly as late as 2008. In the meantime, now that the mainland's securities companies have largely recovered from a disastrous 2004, the regulator has lost some of the urgency to inject foreign capital, and expertise, into the market.
Eventual access could hinge on UBS and Goldman Sachs – they are carrying the flag for others who wish to follow in their footsteps.
As Nicole Yuen, head of China equities at UBS, told CHINA ECONOMIC REVIEW in April, the bank has is taking a long-term view. "We want to participate in the local markets so that we can contribute to their wellbeing. We want to help make the system more conducive to doing business."
The sooner they can convince the CSRC it can't live without foreign money and expertise, the sooner the door will reopen.
To this end, foreign aspirants will no doubt be wishing UBS and Goldman Sachs all the best behind the closed door of China's A-share brokerage business.
Tied to the markets
Running a Chinese brokerage is a rather simple game. With few complex trading instruments to speak of, securities companies merely ride the wave up, and hope they survive the plunge on the other side.
It is no wonder then that China's 130-odd securities companies posted a combined net loss of US$2.6 billion in 2004 as the Shanghai Composite Index nosedived from 2001, hitting a six-year low of 998 points on June 6, 2005.
Proprietary trading, in which brokerages invest their own money, was thought to be the single biggest source of losses.
"The problem with China's industry was that it was very vanilla-flavored," said Standard Chartered economist Stephen Green, driven by trading volume and earnings from proprietary trading.
"Everyone was doing exactly the same thing and there was too many of them and so when the market sank, they all sank with it and of course there were huge malpractices as well."
In the finest tradition of China's financial sector, the People's Bank of China (PBOC) moved rapidly to prop up the industry, much as it had done with the big four state-owned banks when they faced collapse over bad loans.
The China Securities Regulatory Commission (CSRC) also took steps to put some tighter controls on the industry. Regulations were introduced in July 2005 forcing securities houses to separate all accounts they traded on their own behalf from those of their clients.
In addition, the regultor called on brokers to set up risk-control mechanisms, including a stop-loss system, and make reports on every detail of their proprietary trading on a regular basis. About 20 of the most problematic brokers were also closed down or taken over by other domestic financial institutions.
An additional five brokerages have since had their trading rights restricted by the CSRC for dodgy dealing.
Zhejiang-based Tianhe Securities, Cifco Securities in Jiangsu, Capital-Bridge Securities in Shaanxi, Aviation Securities in Beijing and China Lion Securities in Shenzhen were all barred in March of this year from making proprietary trades or undertaking any kind of business expansion as punishment for misusing client funds intended for government bond purchases. However, no big names have been allowed to go bust since China Southern Securities – at the time the country's fifth largest brokerage – went under in early 2004.
It is not clear how much brokerages lost in 2005. However, as the market turned bullish again in 2006, with the benchmark Shanghai Composite Index gaining nearly 50% since the start of the year, brokerages are riding the wave.
The 47 brokerages that have publicized their interim reports racked up almost US$1.07 billion in net profit in the first half of 2006 alone, according to the official China Securities Journal, including revenue of US$425 million from proprietary trades.
Ivan Chung, managing director of Xinhua Far East China Ratings, said the model is not sustainable, with the good fortunes of the market doing little to mask the underlying vulnerabilities.
"It always happens that when the market is good they speculate too much of their capital. If the market goes to the wrong side again, they will lose a lot of money."
The regulator is hoping a program of consolidation and mergers will clean out the worst of the domestic brokerage houses before that happens. But according to Standard Chartered economist Stephen Green, the key is not the number of brokerages, but the range of business models.
"You have got the beginning of consolidation in the sector, but at the same time as the market develops there are going to be a lot more niche opportunities for firms to go into as long as the regulators are willing to let that happen."
For the long-term health of the domestic brokerage industry, those that survive consolidation will need to diversify from stock trading only and develop a wider range of trading instruments and fee-based services – financial advising, M&A advising, IPO underwriting and debt underwriting – if the fortunes of the industry are to be separated from those of the market.
"This is a very risky industry so you need to diversify your income sources and you need also to diversify your risk in order to maintain your position in the market," said Xinhua's Chung. "All these businesses moderate income volatility and also enable them to earn a more stable income in spite of market volatility."
One of the first options for domestic brokerages to diversify their income stream will be margin trading, which lets investors buy and sell with money and stocks borrowed from brokerages.
The CSRC launched the program on a trial basis in August as a way to tap China's US$3.6 trillion of bank deposits and to increase trading. Under the trial, brokerages must have net assets of at least US$150 million in the most recent six months to qualify for a license to offer the services, and have been open for three months.
License to hedge
The government has also given the green light to equity futures, enabling brokerages to hedge risk and make money on a down market. Wealth management programs based on asset-backed securities have been approved and index futures are also on the cards, which would allow brokerages to short the index rather than simply individual stocks.
As part of another major step, the regulator is breaking down the silos between the banking, securities and insurance sectors, ushering in a new era of domestic financial conglomerates. However, China is still a long way from having bulge-bracket banks like those seen offshore, said Steven Zhang, sales trader at Everbright Securities, which operates in all three arms of the financial services sector.
"We are learning from overseas institutions but the whole process will be very slow because we don't have the required experience in the Chinese market."
Zhang estimates it could take up to 10 years to develop companies capable of competing with foreign conglomerates on a level playing field.
With foreign bankers circling like sharks, the onus is on domestic firms to get there a little quicker.