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Lawrence Komo, managing director and regional head for Asia-Pacific securities finance at Citi and chairman of the Pan Asia Securities Lending Association, has just been briefed by CSRC officials about their intentions. He says the programme will come with several important limitations before being gradually relaxed.
China only announced its intention to allow short selling and stock margin trading last week, a marked contrast to the panicky bans on shorting imposed by regulators in London, Washington, Canberra and elsewhere.
This has been the only source of good news for custody bankers whose revenues have depended on lending investors' securities; last year saw $3.5 trillion worth of securities on loan, providing liquidity, cover for failed trades, tools for financing and the fodder for short selling, but that business is now headed for uncharted waters as Western governments impose short-selling bans.
The CSRC's programme will initially be limited to qualified retail investors, with 11 domestic broker/dealers identified to begin operations, based on things like a strong capital base and an ability to understand the risk involved. These brokers are now preparing the required systems, operations and team-building to lend or borrow securities. The initial pool of eligible stocks will be limited to the most liquid blue-chips.
In theory this can support a new generation of long/short equity hedge funds in China. There is already roughly $12 billion of assets being managed by China-focused hedge funds around the world, and the Shanghai and Shenzhen markets see average daily trading volumes of $17 billion. Stock lending and borrowing can not only support new hedge funds, but also increase revenues for participating broker/dealers and eventually help local custodians acting as agent lenders. Ultimately it should also benefit large institutional investors who can earn fees for lending their assets.
But Komo says a number of challenges must be met before stock lending and margin trading are a success in China. The regulators want a Japan-style centralised counterparty and clearing organisation, and plan to establish a new corporation to handle this work.
For now only local broker/dealers can participate, but experience in markets such as Korea and Taiwan shows that it is offshore investors that will really drive liquidity. For now the CSRC is unlikely to allow these to participate, Komo says.
Tax issues in China have yet to be addressed, and this will be critical, says Komo. For example, are lending fees taxable? Will loans incur stamp duty? Will there be capital gains tax on loaned assets? What about on interest paid on cash collateral? "Clarity is critical for an efficient and robust securities borrowing and lending environment," Komo says.
Contracts need to evolve. There is no standardised contract in China for lending a security. And the legal system is untested. For example, can it support the right of automatic set-off, so that if a broker/dealer becomes insolvent, the assets are immediately returned to the original lender? In the United States, contracts did ensure this took place when Lehman Brothers collapsed. But in China nothing may be known for sure until there is a local default event.
The first 11 broker/dealers are now working on their risk-management systems; will these be sufficiently robust? Can their trading systems handle a high volume of small trades with varying fee schedules? Can these be properly integrated into broker/dealers' broader risk and position-management systems? Again, Komo says foreign participants could inject experience as well as liquidity into the market, but that the CSRC is reluctant to allow this to happen too quickly. So the readiness of broker/dealer systems is going to be tested by their own experience.
Brokers will need access to new sources of funding for the system to grow. Initially they are limited to lending from their own proprietary long-only books. This will keep China's sec-lending and margin financing to a very modest size û which no doubt the regulators want, for now. But the authorities must develop ways for brokers to access additional funding, from money market funds or securities finance corporations. And a huge education programme must commence in order for domestic institutional investors û currently prohibited from lending assets û to join in. "Without institutional supply, there won't be any trading," Komo notes.
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