Alex Guo is disconsolate. On this cold Shanghai winter’s evening, the head of institutional investments and sales at Tebon Securities, has little hope for the coming year.
"The whole global economy is very negative, and I hear bad news from all over the world. Even for me, I worry about my own job," he said.
How did it come to this? In 2007, as investors poured into the stock market, China’s brokerages raked in cash: Everbright Securities, a major firm, saw its profits increase more than 400% to US$684 million. This was a far cry from the tough times of mid-2005, when the total debt of China’s brokerages was estimated to be US$20 billion in the red, as the Shanghai Composite Index fell 50% over a four-year period.
The bull market pulled the sector out of the doldrums, but there were few signs that brokerages’ better results were a result of any fundamental changes.
As the economy weakens and the A-share market remains depressed, change may finally be in the air for domestic brokerages. Pressures toward consolidation and opening to increased competition may be the sector’s salvation.
For some, however, the cure may be little better than the ailment: Progress will inevitably see many brokerages fall.
The most obvious problem facing China’s brokerages is an income structure that depends heavily on market performance, said Martin Wang, head securities analyst at China Chengxin International (CCXI), a ratings agency. According to a KPMG report on China’s securities industry, brokerages derived 58% of their operating income from trading commissions in 2007, up from 48% the year before. A further 32% came from investment income, and gains and losses on trading and derivatives positions.
Brokerages have done little to overcome that dependence. In a rising market, profits came easily and, as long as their role has been simply to provide access to the market, few brokerages have seen the need to provide exceptional services.
"For a long time, they’ve had a privileged position … It’s been a seller’s market," said Fraser Howie, author of a book on China’s A-share market and a former employee of China International Capital Corp (CICC). "Providing access was such easy business that anybody could do it."
Time to consolidate
With minimal differentiation in the market, there has been little to recommend one brokerage over another. An opportunity for that to change may lie in reforms already proposed by Beijing. These policies have had the implicit goal of forcing minor players out of the market and encouraging the development of a smaller number of larger firms.
Starting in 2007, large brokers including CICC and CITIC Securities were allowed to set up private-equity arms. A select group of players have also been granted Qualified Domestic Institutional Investor (QDII) licenses, giving them access to foreign securities markets.
In September, Beijing announced that it would approve the introduction of margin trading and short selling under new China Securities Regulatory Commission (CSRC) rules. The reforms would, in theory, benefit brokerages by giving them more products to sell, even in market downturns. The CSRC named 11 securities firms to test the program; other brokerages were not included.
"For now, the government will not give us a license. [This means] investors will go to the bigger securities companies if they want the derivative products," said Guo of Tebon Securities.
The launch was later put on hold. That might be good news for smaller brokerages, but it highlights a larger problem. Given Beijing’s haphazard approach to introducing derivatives, it’s not just firms without licenses that could be hurt.
"Some brokerages have set up departments preparing to do index futures and short selling. These investments will be totally in vain," said Dr Chen Chung-Hsing, head of Xinhua Finance Ratings. "We don’t know exactly whether the government is serious about this one."
A small consolation may be that while the outlook is gloomy, brokerages are not yet in deep trouble. Index numbers are down but transaction volume remains relatively strong, pushing industry revenues up more than 21% in the fourth quarter of 2008 from the previous quarter.
And while the economic climate may cool securities transactions in the short term, longer term prospects remain brighter. Brokerages could use their expertise in mergers and acquisitions to facilitate consolidation in other industries.
But few of these opportunities will encourage brokerages to address their own fundamental problems.
"Their success in China is because of very limited circumstances in which they’ve not necessarily needed to compete," said Fraser Howie. "When you come to an international arena, I think they’re an extremely poor bunch."
Even basic functions like research, Howie says, can be "pretty ropey."
Guo at Tebon Securities acknowledges weaknesses in the industry. Research reports last year that predicted the market would shoot beyond 10,000 points eroded investors’ trust, and the economic downturn is further complicating efforts to win it back, he says.
Raising the stakes
If a lack of competition produced a sector with little differentiation and poor quality, some hope that opening it up to more competition – both domestic and international – could force brokerages to improve their products.
Foreigners are clearly interested: Despite regulations limiting their participation in the sector, foreign firms continue to invest in setting up securities joint ventures in China. Deutsche Bank became the most recent example when it set up a joint venture, Zhong De Securities, with domestic broker Shanxi Securities.
A person close to the deal said it was intended as a long-term investment. "It’s a good fit … As the market becomes larger, more sophisticated, and there are more participants in the market, it will mature and opportunities will become greater."
The venture gives Deutsche Bank a spot along established players, including Credit Suisse, UBS and Goldman Sachs.
Regulators profess to be in favor of these kinds of deals. A source with ties to the CSRC said that foreign expertise, particularly in areas of risk management and the design of new financial products, is both necessary and welcome. Beijing would do well to follow its instincts.
