Chinese securities firms are making IT investment, business and recruitment plans as they prepare to apply to the securities regulator to enter China’s fund custody business. They intend to offer custody services initially to ‘sunshine’ private trust firms, the mainland’s equivalent of hedge funds.

Non-bank financial institutions such as securities firms received a green light to expand into custody under provisional rules issued by the China Securities Regulatory Commission (CSRC) in mid-March. These came on the back of the revised Securities Investment Funds Law, which included much-anticipated amendments approved in December for implementation on June 1.

In addition to Chinese securities firms, locally incorporated foreign banks operating on the mainland can also now apply to provide onshore custody services. The CSRC will start accepting applications on June 1.

Shenzhen-based China Merchant Securities is the most advanced in terms of being able to offer custody services. The firm, which also runs an asset management arm, has been acting as a custodian for sunshine funds for about four months.

China Merchant is looking at offering a basket of services such as securities lending for hedge fund short-selling or helping managers cross-list exchange-traded funds outside Chinese exchanges.

Other securities firms are also exploring potential opportunities or looking at investing in fund accounting systems. Sources at such companies say they will initially target sunshine fund managers. Their services will include the calculation of net asset value and oversight of cashflow into and out of fund investors’ accounts.

The mainland fund custody business has traditionally been dominated by domestic commercial banks such as Industrial & Commercial Bank of China and China Construction Bank. 

In China, custodians often play the role of a trustee with fiduciary duties, whereby they are obligated to report directly to regulators any misconduct by fund managers that would harm end investors’ interests. (In contrast with Western markets, Chinese custodians are directly answerable to regulators.)

In China, while the vast bulk of sunshine fund managers operate on a trust platform and are therefore regulated by the China Banking Regulatory Commission, some have chosen to use a limited partnership format, with the fund manager as the general partner and the investors the LPs.

Fund managers on the mainland that operate as GPs don’t have to appoint custodians, unlike those that operate on trust platforms.

In the absence of such a requirement, China Merchant Securities has had a head start with fund custody business because the CSRC last year approved its application to offer this as a service targeting only GP sunshine funds, says the source. The provisional rules announced in mid-March have opened the door to all sunshine funds.   

As elsewhere, custody is a low-margin business. In China, a fund manager’s decision to use a particular custodian is often driven by whichever bank is its key distributor.

But with the revised funds law taking effect in June 1, sunshine fund managers will come under the supervision of the CSRC and be given more flexibility and independence to launch new funds, or trade securities, without the need to partner a trust company.  

As a result, Chinese securities firms are planning to offer a basket of services including brokerage, fund accounting, compliance monitoring and, most importantly, fund marketing and distribution.  

Banks or securities firms that also distribute products for sunshine fund managers get to share additional floating charges if the fund manager gets a performance-based bonus based on achieving a high water mark in terms of returns.

A feature on custody in China will appear in the June issue of AsianInvestor magazine.