Just as China prepares for the development of a new generation of international exchange-traded funds (ETFs), there has been an incident that no government official or fund executive would have wanted to occur. And it has been a sobering reminder that China's ETF platform is yet to fully mature.
The incident involved Bank of Communications Schroder -- the UK investment manager's five-year-old joint venture in China -- and occurred on the morning of December 30, shortly after markets began trading. When calculating the portfolio holdings for the JV's Shanghai Composite 180 Corporate Governance (SHCOMP) ETF, the firm's trading staff grossly overstated the number of shares held in insurer Ping An, mistyping the position as 10,100 units instead of 900.
Apparently the typo was missed by the JV's compliance and risk management units and the numbers were allowed to go live on the Shanghai Stock Exchange (SSE).
China's ETF market functions without appointed market-makers to keep the prices of its ETFs in line. Instead, some 200 brokers and institutional investors are authorised to engage in the daily arbitrage of discrepancies between securities market prices of listed ETFs and net asset values in the ETFs' underlying portfolios.
On December 30, these arbitrageurs helped push BoCom Schroder's SHCOMP 180 ETF, listed on September 28, to its all-time highest turnover of 142,000 in the space of just 40 minutes after market opening. Trading for the ETF was suspended by the Shanghai bourse by 10.24am.
The mistake pushed the opening price for Ping An to Rmb1.75 from an actual secondary market price of Rmb 0.901. When the emergency suspension went into effect, the price listed on the SSE had already reached Rmb1.784.
The potential billion-yuan losses could have been crippling for the JV, but the firm could be in luck this time.
Xie Wei, deputy chief executive at BoCom Schroder, told press there is a clause in the ETF's prospectus and contracts that would cover the firm for the losses. He says a consensus has been reached with the parties involved, including the SSE and the China Securities Depository & Clearing Corporation, as well as the company's "investors".
In a declaration otherwise unthinkable in mature markets, Xie says, investors who had redeemed from the ETF before the trading suspension will need to repay to the company some Rmb89 million ($13.04 million) in "improper profits".
No mention has been made of what will happen to BoCom Schroder's heads of risk management and compliance, nor of the two fund managers behind the ETF -- Qu Lewei, previously a risk manager and assistant fund manager responsible for China Asset Management SHCOMP 50 ETF, and He Xiaobin, previously a financial engineer in the quantitative team at Changsheng Fund Management.
Agricultural Bank of China, the custodian of the fund's assets, has not made any statement on the matter.
There are many more fund management houses in China that, like BoCom Schroder, want to have their own ETF range, even though many have no experience or technical expertise beyond active fund management. The majority of firms in the industry have been in business for just a few years.
It may be that the BoCom Schroder incident will lead more to rethink their plans, particularly those who wish to apply their ETF vision to international products.
The Chinese ETF system, with all its hidden flaws under the arbitrage regime, has so far got by without appointed market-makers. Given the flaws of the arbitrage authorisation mechanism, those who want to venture beyond the physical borders or even the time zone of China will need to tread carefully with international securities.