(Updates share performance in third paragraph under subhead ‘Untested Software.’)
Sept. 30 (Bloomberg) -- China’s securities watchdog is forging ahead with rules that allow brokers to invest in complex financial products and enter risky new businesses even after an unprecedented $3.8 billion trading error roiled markets.
In the past six weeks, the China Securities Regulatory Commission ended an 18-year hiatus on trading of treasury bond futures and said it would let more brokerages borrow stock for short selling. Those measures were disclosed after misplaced bets caused by faulty software at Everbright Securities Co. on Aug. 16 caused the wildest swings in Shanghai shares since 2009.
Policy makers in China, seeking to improve allocation of capital, have since 2008 permitted brokerages including Shanghai-based Everbright to offer clients short selling and margin trading, as well as betting on derivatives with their own funds. While the state-controlled brokerage has now been suspended from most proprietary trading, CSRC Chairman Xiao Gang shows no loss of appetite for risk taking.
“This is definitely the direction to go for brokerages in China, but with great opportunities come great risks,” Zhang Yanbing, Shanghai-based analyst at Zheshang Securities Co., said by telephone. “When things become more complex, it will bring unpredictable risks. There’s a lot about market risks that we need to learn from developed markets.”
Faulty trading software used by Everbright’s proprietary- trading desk, which specializes in high-frequency trading, sent out 26,082 unintended buy orders in just two seconds on Aug. 16, the company said in a statement two days later. The mistake, which the securities regulator characterized as unprecedented in China, led the benchmark Shanghai Composite Index to swing more than 6 percent.
Two weeks later, the CSRC, led by Xiao, 55, said futures contracts on five-year treasury bonds would start trading from Sept. 6. A week later, it gave approval for the Dalian commodity exchange to start trading of iron-ore futures.
That was followed by China Securities Finance Corp.’s decision to expand a program that allows brokerages to borrow stocks from the state agency and lend to clients: The list of firms was broadened and the number of securities that qualify was tripled, it said Sept. 17.
Press officials for the CSRC didn’t reply to questions faxed to their Beijing office seeking comment. Everbright didn’t respond to questions sent to its Shanghai office.
Last month’s trading error has shed a spotlight on potential weaknesses in new businesses such as computer-driven trading, Zhou Xiaowen, an analyst at Huachuang Securities Co., said by telephone from Beijing.
“People weren’t paying much attention to the risks associated with brokerages’ use of quantitative investment strategies,” Zhou said. “Companies that have been aggressive, but lacked robust internal controls, will start to pay more attention to potential problems tied to trading systems.”
High-frequency trading, which allows hedge funds and institutional investors to use computers to execute orders in milliseconds, has led to problems in the U.S. as well.
Knight Capital Group Inc., based in Jersey City, New Jersey, bombarded exchanges with mistaken orders on Aug. 1, 2012. The firm, which has been renamed as KCG after being purchased by Getco LLC, almost went bankrupt following the software malfunction that caused more than $450 million in trading losses.
Computer errors also caused the Nasdaq Stock Market to halt transactions in all of its shares for about three hours on Aug. 22. That came two days after a glitch at a Goldman Sachs Group Inc. computer flooded options markets with orders.
China’s securities watchdog has pledged to scrutinize risk controls among the nation’s brokerages. The regulator said on Aug. 30 that it was setting up special groups to study ways to improve oversight of the securities industry.
Measures to clarify the definitions and standards for abnormal trading -- and determine if requests to erase an erroneous trade are justified -- will be issued, the CSRC said on Sept. 6. The regulator also aims to enhance the management of trading systems and related controls, establish a system for canceling orders and set up a disclosure mechanism, it said.
While internal risk controls need to be strengthened at the brokerages, the market-driven changes are improving regulation within China’s securities industry, according to Luo Yi, a Shenzhen-based analyst at China Merchant Securities Co.
“Barriers have been brought down in many other areas that had previously been blocked,” Luo said. “The regulator is very clear about its reform agenda, that it wants to let the market play a bigger role and it also wants to step up enforcement.”
The CSRC began easing regulations for the nation’s securities markets in 2008 amid a wider effort to reduce the state’s control over the economy, even as the watchdog’s then Chairman Shang Fulin warned brokerages to be wary of the “financial innovations” that had caused Wall Street to unravel.
Shang, 61, now chairman of China’s banking regulator, began allowing brokerages including Everbright to enter or revive businesses such as margin trading, which is lending funds to clients for share purchases, and short selling, which allows investors to bet against selected stocks.
Those liberalization efforts were stepped up after Guo Shuqing, 57, was named Shang’s successor at the securities watchdog in October 2011. The reshuffle coincided with a drop in domestic initial public offerings, a slump in trading volumes and the Shanghai Composite Index ending the year down 22 percent.
Under Guo, the CSRC issued about 52 new rules in 2012 -- making it one of the watchdog’s most active years -- as it changed the way IPOs are priced in China and tightened the rules for delisting companies.
Guo also began opening up the securities market to more investors to boost trading. Among the steps he took before leaving office in March was doubling the amount of money foreigners are allowed to invest in stocks, bonds and deposits, as well as lowering the fees charged for trading yuan- denominated shares and expanding an over-the-counter market.
He also took aim at China’s brokerages, which he said were too small and weak, according to a report by the official Xinhua News Agency in December 2011. The firms had little influence over the financial system, limited access to sources of funding, weren’t innovative enough and their quality of research was poor, according to the report.
The brokerages’ traditional strongholds of managing domestic IPOs -- which foreign investment banks are allowed to do only through a joint venture with a local firm -- and generating commissions from stock broking have also been weakened.
Fundraising from IPOs in China dropped 80 percent to $14.4 billion last year from a record $71 billion in 2010, data compiled by Bloomberg show. China hasn’t had a first-time share sale for almost a year as the CSRC is drafting new rules to prevent misconduct and fraud by companies and their advisers.
Underwriting new stock offerings had accounted for about 70 percent of the brokerages’ investment-banking revenue from 2009 through 2011, according to He Zongyan, a Shanghai-based analyst at Shenyin & Wanguo. Last year, it shrank to about 40 percent to 50 percent, He estimated.
Trading volumes in China have also declined, curtailing revenue from stockbroking businesses. The 100-day average for Shanghai Composite Index stocks fell as low as 6.3 billion in December before rebounding to about 11 billion this week, data compiled by Bloomberg show. That’s still down from about 15.4 billion in August 2009.
To help the brokerages develop new lines of business, the CSRC in November 2012 expanded the types of financial products that the firms could invest in through their proprietary trading desks to include some over-the-counter securities, according to statements posted on its website. It also allowed qualified firms to trade financial derivatives for investment gains, instead of limiting their use for hedging.
The measures helped China’s securities firms expand. The nation’s 114 brokerages ended 2012 with $281 billion in total assets after posting a combined net income of $5.37 billion, according to the Securities Association of China. That compared with assets of $939 billion and profit of $7.48 billion at New York-based Goldman Sachs.
China’s stock market, which has a history of just about 20 years, is still developing and maturing, said Zhang of Zheshang Securities.
The CSRC said yesterday it would, among other new measures, support securities firms’ offering of over-the-counter trading of commodities and financial derivatives to domestic clients from operations within Shanghai’s free-trade zone. The Chinese government inaugurated the 11-square-mile experiment in more relaxed financial and investment controls at a ceremony yesterday.
Chinese securities firms have embraced the newer, more lucrative lines of business.
The mainland brokerages, which rely on secondary capital markets and are weak in market-making -- a key source of revenue for global firms such as Goldman Sachs -- are exposed to more risk in their proprietary trading desks than U.S. rivals, according to a March report by the CSRC’s Beijing Institute of Securities and Futures research unit.
Trading strategies such as statistical arbitrage, a technique that relies on mathematical modeling to identify price differences between related securities, helped boost investment income from proprietary trading for China’s 19 publicly traded brokerages by 15 percent in the first half of 2013 to 11.1 billion yuan, according to Wuhan city-based Changjiang Securities Co.
That accounted for almost a third of their combined revenue, which climbed 10 percent to 37.7 billion yuan in the first half, according to Zhang Lei, a Shanghai-based analyst at Tebon Securities Co. Income from stockbroking, now the biggest part of their business, grew 23 percent in the first half as trading volumes rebounded from last year, while underwriting fees slumped 37 percent, Zhang estimated.
“Sitting on excess capital has always been a problem for the brokerage industry due to a lack of investment options,” said He at Shenyin & Wanguo. “By using strategies such as quantitative arbitrage, brokerages are hoping to boost the return rates of their capital.”
The 19 brokerages’ average return on equity, a measure of how well the firms reinvest shareholders’ capital, shrank to 3.48 percent in the first half of this year from 8.76 percent in the first half of 2009, according to Tebon’s Zhang. Increased debt levels and fast-growing operations such as margin financing were critical, helping boost the average ROE by 17 basis points in the first six months, she wrote in a Sept. 9 note.
Everbright, which is part of a group supervised by China’s State Council with businesses ranging from banking and insurance to tourism and property development, was among six brokerages allowed to start margin trading and short selling in 2010.
In 2012, it was permitted to join a trial program that enabled brokerages to borrow funds from China Securities Finance Corp. -- which had been set up in 2011 as a central agency to facilitate margin financing and short selling -- and lend to investors.
In February, Everbright became one of the firms permitted to borrow stocks from the agency and offer them to customers. Short sellers can borrow those shares that they then sell, betting that the stocks can be bought back later at a lower price to profit from the difference.
While these new income sources gave Everbright the chance to bolster earnings following three years of declines, they also allowed the firm to take on more risk.
The value of equities, securities and derivatives held by Everbright’s proprietary trading unit relative to its net capital position was 74 percent at the end of June, the highest among 18 brokerages tracked by Changjiang Securities, and up from 18 percent in December 2010. That compared with 59 percent at Citic Securities Co., the largest Chinese brokerage by market value, and 19.5 percent at second-ranked Haitong Securities Co.
Everbright’s ratio exceeded the 100 percent regulatory limit after the erroneous trade, the company said on Aug. 18.
The snafu “is a watershed in the sense that brokerages’ internal risk controls will face stricter requirements as a result,” said Zhou at Huachuang Securities. “The incident attracted a lot of attention and the regulator will likely introduce new rules to tackle the issue.”
The regulator concluded that Everbright engaged in insider trading when it sold exchange-traded funds and shorted index futures to offset the erroneous trade before telling the market about its mistake. It handed down a record penalty of 523 million yuan, including confiscation of illicit gains, on Aug. 30. It also banned four executives including ex-president Xu Haoming from the securities industry for life and barred the firm from most proprietary trading.
Everbright’s strategic investment department didn’t operate within the firm’s internal risk-control system, and the trading software, which had been in use for less than 15 trading days, was designed and tested by only one programmer, according to the watchdog’s findings.
Shares of the brokerage slumped 22 percent since its mistake through Sept. 30. China’s 19 publicly traded brokerages posted an average stock drop of 0.5 percent in that period, compared with the Shanghai Composite Index’s 5 percent advance.
Hiccups such as Everbright’s trading errors are to be expected in a developing market, said Shenyin & Wanguo’s He.
“The brokerages have been weak on risk management during this two-year period of rapid growth, so it’s not a surprise that we should see such an incident,” He said. “As the brokerages become more of an intermediary of capital, the firms will be required to bolster internal controls.”
--Aipeng Soo, with assistance from Darren Boey in Hong Kong. Editors: Chitra Somayaji, Matthew Brooker