China’s financial technology sector has seen explosive growth in the past few years, sparking concerns about overcooked valuations, even as tighter regulations loom. But there remain worthwhile opportunities if investors follow certain rules, say industry advisers.

Venture capital investments in China fintech have shot up at a compound annual growth rate of 300% over the past three years, according to a report published last week by consultancy Oliver Wyman. China fintech received $6.4 billion in VC investment last year, overtaking the US as the leader in terms of inflows globally, and representing 47% of global fintech investments in 2016, said the report, Fintech in China.

Peer-to-peer lending in China has expanded even more rapidly: the outstanding loan balance for such platforms surged to Rmb856 billion ($127 billion) in 2017 from Rmb31 billion three years ago, according to the report. Moreover, P2P groups such as Creditease and Lufax are committing major resources to building wealth management platforms.

Of course, while there are big fintech success stories – Alibaba affiliate Ant Financial was valued as high as $60 billion the second quarter of 2016 – there are a far larger number of failures.

Some investors are showing concern. Chinese fintech companies will line up to raise money in the US stock market this year, but investors’ questions around earnings may put pressure on their valuations, argued Crawford Jamieson, vice-chairman of global capital markets at Morgan Stanley, speaking at the ‘Finance Disrupted’ conference in Hong Kong in June.

"Regulatory arbitrage"

One thing investors should be wary of is over-valuing “regulatory arbitrage”, said the Oliver Wyman report. It was referring to the fact that fintech companies are able to conduct some business, such as lending and selling certain wealth management products, that domestic banks cannot.

By labelling themselves fintech firms, companies in China have been able to circumvent rules imposed on traditional financial institutions, such as capital provisioning and reserve requirements, noted the report, while in fact they are providing loans and investment products through digital channels. 

This is unlikely to be the case for much longer, say experts. Ultimately, “fintechs” may become no different from just “fins” in their offerings, as regulators tighten rules after a number of high-profile closures and default cases. 

For example, Ezubao, a peer-to-peer lending platform, was shut down in early 2016 after being uncovered as a ponzi scheme. Meanwhile, a $45 million corporate bond sold on Zhaocaibao – a platform run by the payment affiliate of e-commerce giant Alibaba – defaulted in late 2016 after the letters of guarantee for the bonds were found to have been falsified.

However, regulatory moves in China in the past year or so, ranging from capping individuals’ borrowing limits to suspending speculative investment products provided by fintechs, mean the window of arbitrage is closing, said the Oliver Wyman report.

This tightening regulation is a worry for fintech firms and their investors, said Cliff Sheng, partner and head of China financial services at Oliver Wyman after the release of the report Fintech in China. Investors should go back to the fundamentals of fintech businesses, to understand their business models and the risk behind them, he told AsianInvestor.

Besides regulation, competition is the biggest challenge that Chinese fintech startups face and more consolidation is likely, said Zennon Kapron, founder of Kapronasia, a Shanghai-based fintech research firm. 

Companies will exit the market or be acquired by peers, he added, though there are unlikely to be many traditional banks buying fintech start-ups, because of concerns over these firms’ operational and risk management setups.

For instance, at least 60% of the 5,890 P2P platforms launched in China are estimated to have ceased operations according to the Oliver Wyman report.

Fintech success factors

The quality of the business model is key for fintech startup success, said Kapron. “[Fintech startups] need to have solid technology to make them viable, so that’s really the key for these smaller players going forward.” Proper risk management and compliance are also important, he said.

Moreover, the Oliver Wyman report set out four key rules that investors in fintech should follow. One is to avoid over-valuing regulatory arbitrage, as mentioned above.

The consultancy also argued that investors should explore the broader landscape. “The integration of fintech into the regulatory framework has, to a certain degree, levelled the playing field for traditional financial institutions such as banks and securities firms.”

Recent strategic partnerships with fintech players by China’s Minsheng Bank and the introduction of online lending products by ICBC are indicators that that fintech investors should start looking beyond fintech start-ups, added the report.

Thirdly, investors should assess the potential downside. Despite not bearing credit risks in legal terms, fintech platforms could face reputational losses, regulatory actions and even liquidations due to potentially problematic products, noted Oliver Wyman. It cited the case of Ezubao as an example of the issues that could arise.

Lastly, the consultancy advised looking beyond the providers of innovative solutions and products themselves at the infrastructure that enables them.