New rules to control mutual fund liquidity risks in China are set to hit the country’s money market funds (MMFs) hardest by making it tougher to attract outsourced bank money with bespoke products.

Issued by the China Securities Regulatory Commission (CSRC) and due to come into force on October 1, the regulatory overhaul comes after the 2015 stock market crash and last year's bond market rout triggered heavy redemptions, Rachel Wang, director of Chinese fund manager research at Morningstar, an investment research firm, told AsianInvestor.

A liquidity crunch in the fourth quarter last year, for example, sparked huge redemptions from mainland Chinese MMFs. The country's biggest exchange-traded MMF—Fortune SG Tianyi MMF—saw Rmb5.6 billion (US$ 840 billion) of outflows on December 20 alone.

MMFs are a key focus of the new rules because the assets they hold are the most liquid compared with other types of mutual funds. A single chapter in the document is dedicated solely to MMFs, which account for 51% of China's Rmb10 trillion mutual fund assets.
 
Chinese MMF assets under management were spread across 321 funds as of June-end 2017 and stood at Rmb5.1 trillion—almost nine times what it was at the end of 2012, when there were 62 MMFs, data provided by Morningstar shows. And that's despite an AUM drop last year. Tianhong Asset Management's retail-focused Yu'e Bao alone makes up Rmb1.4 trillion in assets, over one quarter the entire MMF market in China.

But the CSRC's new rules are likely to have a dampening effect on MMF growth, Huang Li, associate director for funds & asset managers rating group at Fitch Ratings, told AsianInvestor.

Tailor-made funds

In part, that's because the rules discourage the formation of funds tailor-made for large institutional investors to ensure MMF ownership isn't too concentrated, Huang said.

Concentration risk and liquidity risk are related because if a dominant MMF investor needs to redeem its investment for whatever reason, then the chances are high that there will be insufficient liquid assets in the MMF to meet these obligations, especially during weak market conditions. That would potentially hurt the interests of other investors in the fund too, she said.

According to the new rules, the more concentrated the number of investors there are in an MMF, the higher the liquidity requirement for investments it holds (see box).

Highlights of new MMF rules

For newly set-up MMFs, when any single investor owns more than 50% of the assets in the fund, the cost of investment cannot be amortised. Otherwise, more than 80% of the fund’s assets should invest in cash, treasury bonds, central bank bills, policy financial bonds, or other financial tools that will mature in the coming five trading days.

For existing MMFs, when the top-10 investors together own more than 50% of the fund, the weighted average maturity and duration of the assets in the investment portfolio will be limited to 60 days and 120 days, respectively. In addition, the fund's investments into the above-mentioned short-term financial products must be higher than 30%.

And existing MMFs cannot have more than 10% of their assets actively invested in illiquid assets, down from the current 30%.

Source: CSRC, with additional information from Fitch Ratings

A switch to more mark-to-market accounting also means asset values will fluctuate according to market conditions, meaning investors will show a loss when the market is not doing well, Morningstar’s Wang said.

In response funds could choose to invest in only super-safe, very short-term financial tools with very low yields. Either way, where an investor dominates a MMF, it is likely to become less attractive for investors, she said.

Entrusted investments

Directly related to the issue of bespoke MMFs and investor concentration are the so-called entrusted investments—funds that financial institutions in China farm out to external asset managers.

These were the main growth engine for MMFs following the A-share market meltdown in the second half of 2015, as funds exited equities and sought safer assets, Fitch's Huang said.

Chinese commercial banks, especially, outsourced the management of internal assets to circumvent stringent rules on their own investments and to secure higher yields, prompting fund houses to create tailor-made funds that best-served their needs, according to a July report by Fitch Ratings.

Banks may now choose to place their entrusted investments in different MMFs but it is still likely that the new rules will dampen fund flows into MMFs, Fitch's Huang said.

“They only [had] to handle one asset manager before, but now they [will] have to handle different asset managers, [so] different types of costs will go up,” she said. 

In any case, entrusted investments generally are something the Chinese authorities have been trying to discourage, to lessen systemic risks. This helps to explain why MMF assets dropped to Rmb4.33 trillion at the end of 2016 from Rmb4.62 trillion a year earlier, Fitch believes. 

In an April report, Deutsche Bank estimated investments entrusted by Chinese banks at between Rmb5 trillion and Rmb6 trillion. But faced with more stringent rules, some banks have started to withdraw entrusted investments, it said.