December 25th 2014, 14:30 HKT
The last post covered how Chinese retail investors, spurred on by continuous bull market news stories, took advantage of borrowed money to gamble on the stock market. This post delves deeper into this new form of margin lending, which is different to the normal margin trading mainly reported in the foreign press. As yet there’s no detailed explanation of the entire process in English or Chinese media. Thus this investigation is based on translating an informative Chinese Caixin article (HT @niubi), searching trust fund websites, an interview with a local broker, and industry experience.
Background:- After many years of political deliberation, and delays due to the effects of the global financial crisis, China’s margin trading pilot program was first launched in 2010. In 2012, rules were relaxed, including allowing stock brokers to borrow funds that can then be lent to clients to leverage their trades. However there are still many restrictions in place, for example: Broker eligibility, minimum client requirements, leverage ratios (1:2), margin call calculations and stocks eligible for margin trading. All of such margin trades are backed by the official China Securities Finance Corporation, and reported to the China Securities Regulatory Commission (CSRC).
According to Caixin, “this margin trading has already reached 800 billion yuan, doubling in July, and will soon be worth over 1 trillion yuan”. But they remark “after 4 years, margin trading has already become quite common, so brokers now have a new tool to offer their high net worth and institutional clients, which has a market size of 300 billion yuan. And the portion of that used for direct margin lending and trade leverage is worth 10 billion yuan”.
This new margin lending (in Chinese ‘peizi’ 配资) does not face any of the usual margin trading restrictions. ‘Peizi’ is a runaround of the regulations that provides greater leverage of up to 5 times, and the borrowed money used for this trading goes unreported, creating an oversight problem for the CSRC.
So how does it work? The Caixin article provides the clearest explanation:
“Since 2011 some commercial banks and trusts have created ‘umbrella trusts’. Under an umbrella trust account are sub-accounts held by smaller private equity funds which receive funds for trading. China Everbright Bank, China Merchants Bank and China Minsheng Bank have already setup this type of business. The banks have preferential subscription status, which entitles them to a fixed rate of return. The funds have normal subscription status and must guarantee to repay the principal and interest to the preferential subscription holders. In return the funds can leverage 2 to 3 or even 5 times, much higher than in normal margin trading. Furthermore the umbrella trust is not limited in the trades it can trade on margin, effectively creating a regulatory blackhole.
There’s no concrete data on the total size of umbrella trusts but some trust professionals and stockbrokers’ estimates range from 150 to 200 billion yuan. If we include leverage trust products aimed at funds, then this market size could be up to 300 billion yuan. In light of the declining market risk-free rate of return and the shrinking ‘non-standard’ asset market, 15 trillion yuan of bank wealth management products are looking for new investment channels. CSRC already permits banks to open broker accounts and trade bonds, preferential shares and other low risk products, but does not allow banks to invest in shares directly. Therefore banks must invest in shares via trusts, which adds another layer for the regulators to penetrate”.
These umbrella trusts, are sold in the market by banks and trusts as ‘collective investment schemes’ (CIS), where a fixed rate of return is currently advertised at paying around 3.5%. Based on this and other publicised rates, one can estimate the funds operating in the CIS guarantee the banks around 6% for the money borrowed for leverage. (The funds receive a floating rate of return).
Same as standard margin trading practice, its safe to assume in order to cover their risk, the banks will receive a margin from the funds and as these sub-trusts are operated under the CIS, the banks have security over the shares held in the sub-trust accounts. As such the shares can be sold off in case a fund loses money past a certain threshold, and are unable to meet margin calls.
But avoiding margin trading restrictions does not necessarily mean this is a high risk business. The players are all professional institutional investors with risk management controls in place. Furthermore the government might be willing to turn a blind eye in this case, as this scheme attracts more long term funds to a stock market which has consistently underperformed.
The recent change though has been the sudden influx of retail investors using this arrangement to leverage up in the bull market, aided by ambitious trust funds, brokers and shadow banks. Last week a salesman at one of the big brokerage’s Shenzhen branch confirmed how this ‘umbrella trust’ service works, as well as how it has now evolved.
“I’ve already read that Caixin article, but now there’s an additional channel, whereby the funds themselves are then lending on to retail investors, who then trade the market themselves”.
This seems slightly disturbing as might indicate these private equity funds see greater returns from lending to retail investors, than investing directly in the market.
To learn more about how trust funds are now utilising this CIS model, one can look up on their websites. Investors face minimal requirements such as “must be a Chinese national over 18 years old, with one years trading experience, and high risk tolerance levels”. Once investors jump these ‘hurdles’, they can place a small deposit with the fund, and in return receive a leverage up to 5 times. The advertised borrowing rates are around 10%, usually for periods ranging from 1 month to half a year. The more one leverages, the higher the interest rate, up to 14%. So thats a few percentage points profit for the trust fund or shadow bank, for taking the banks money and diverting it to smaller investors.
As websites explain in their Q&A sections, this lending is legal as it falls under private lending law. And as per the previous cases, if a trader exceeds their margin limits (i.e. because the value of their shareholdings has dropped), the shadow bank can make a margin call or sell off the client’s shares. A typical level could be set to when the account value falls to around 115% of the original borrowed amount.
And how is it possible the funds can sell off an investors shares? Because the investor is trading under the funds own trading account in HOMS, an industry wide trading system for professional investors. As the website explains, the customer first signs the loan agreement with the trust fund. Then pays a margin into the trust fund’s designated bank account. Once confirmed, the fund creates a new sub-account in HOMS, then credits the money lent, plus the customer’s original deposit, into that sub-trading account.
Then the account number and password are sent to the retail client, who is free to operate this sub-account themselves, routing orders through to the funds partner stockbroker. (Who incidentally may have sold the trust fund product to the client in the first place). Yet on the stockbrokers records, these trades are all booked under the name of the trust, and presumably this is what the CSRC sees when they inspect them. Hence this form of margin trading is difficult to detect operationally, and to control legally from the regulator’s perspective.
This new form of margin lending is only made possible by HOMS, whose revenues increase as more trade volume passes through its system, the cost of which is paid by the retail investor. The recent bull run has already seen record turnover, boosting stockbrokers and bank shares. But the other silent winner is Hangzhou based Hundsun Technologies which owns HOMS. And in April 2014 a Jack Ma subsidiary paid 3.3 billion yuan to become their largest and controlling shareholder, meaning that without risking any of his own capital in the market, Jack Ma was in place early to benefit from the recent stock market rally.
(Article not to be copied or reproduced without citation or permission)
Included in the popular Sinocism newsletter, January 5th 2015.
Cited by Asia Times, April 20th 2015.