FUNCTIONAL ORIENTATION FOR SECURITIES FIRMS

Financial Market Service Providers

As the most important financial intermediaries in capital markets, securities firms emerged to help companies and governments in financing. For securities firms, whose business activities have expanded from the very beginning with acceptance of commercial paper (commercial banking activities) to current underwriting and issuance of government bonds and corporate debentures, finance has always been a fountainhead activity. For these companies, issuance of securities and debentures helps not only overcome financial constraint but also bring about added value. Good performance in capital markets can help boost reputation, which may contribute to long-term growth. As for investors, they can share the profits generated from business growth. In this virtuous circle that involves multiple stakeholders, securities firms play a crucial role in reducing information asymmetry by establishing private information marketplaces. Although in capital markets securities firms bring less money to IPO companies than commercial banks do (indirect finance), this does not diminish the role of capital markets in allocation of resources available in the market.

In today's U.S. market, along with structural change and increasing financial products, investment banks focus less on the revenue from securities issuance and underwriting (another fountainhead activity), although that revenue remains at about 10 percent of their total revenue. And unlike their Chinese counterparts whose underwriting revenue comes mainly from the stock market (specifically from IPOs, additional issuance, allotments, and issuance of convertible bonds and others), large investment banks in foreign markets have more underwriting revenue from debt underwriting than equity underwriting (including IPOs, issuance of convertible bonds, and subsequent issuance). Obviously, the reason is largely that compared with the Chinese market, foreign markets have far more bond products, ranging from corporate debentures to mortgage or asset-backed securities (see Table 2.1).

The Chinese capital market is different from the mature U.S. market. As China's economy keeps growing, Chinese companies keep improving their innovation capabilities. The Chinese capital market keeps promoting and consolidating diversification based on the main board, the small and medium-sized enterprise board (SME market), and the growth enterprise board. More companies with financing needs tend to go public, and even more companies go public in international markets.

For Chinese securities firms, therefore, the securities underwriting business may remain thriving, regardless of IPOs, additional issuance, or allotment. Underwriting is clearly an investment banking activity about which Chinese securities firms are confident. However, in the largest IPO market in the world, Chinese securities brokers still get fewer contracts than major international brokers. Table 2.2 details the Chinese brokers' net income from securities underwriting in 2010.

On the other hand, in the Chinese debt underwriting market, commercial banks can claim a landslide win over securities firms in terms of central

TABLE 2.1 Top 10 Investment Banks Regarding Revenue from Securities Underwriting in 2010 (USD in millions)

Source: Thomson Reuters.

TABLE 2.2 Top 10 Chinese Securities Brokers Regarding Underwriting Contract Amount and Underwriting Costs in 2010 (CNY in millions)

Source: Wind Information Co.

bank bills, treasury bonds, and short-term commercial paper. Securities firms easily dominate corporate debentures traded in stock exchanges. Today, the income that securities brokers earn from underwriting corporate debentures is more than half as much as from underwriting IPOs. A growing bond market with an increasing number of well-regulated corporate debentures is a desirable marketplace for more corporate financing activities. Therefore, securities firms still have promising business prospects in the corporate debt underwriting market.

In addition to financing services, securities brokerage is another business activity long practiced in securities firms. Securities firms acting as brokers normally offer securities and custodial services and collect commissions on sales and purchase transactions of marketable securities (including fixed-income products and derivatives). So far, Chinese securities brokerage has been limited chiefly to trading channel services, including helping customers open securities accounts, providing facilities for transactions, and offering competitive commission rates at each business office. Such a profit model may generate great profits in the early stages of a growing market, but homogeneity in this business model makes it very hard to maintain stable growth and consistent progress with increasing competition and deregulation.

In May 2002, the CSRC National Planning Commission and the State Administration of Taxation (SAT) issued a Notice on Adjustment of Standard Securities Trading Commission Rates. The notice specified the following:

Floating rates up to the maximum will apply to trading commissions on stocks (A and B shares) and securities investment funds. A commission charged against a customer by a securities company (including the securities and exchange regulatory fee, stock exchange fees and other fees and charges collected by the securities company on behalf of the regulatory agency, exchange and others) shall be no more than 3 percent of the transaction amount and no less than the aggregate amount of the securities and exchange regulatory fee, stock exchange fees and other fees and charges.

The call-off of fixed commissions, together with a stock market downturn (which continued until 2005) and an epidemic of misappropriation of clients' security deposits, eventually resulted in industry-wide losses. The situation did not persist after the trading volume ballooned, along with the CSRC's escrow requirement for security deposits, the split-share structure reform, the return of overseas-listed Chinese blue chips to the A-share markets, the relaunch of the SME market, and the creation of the growth enterprise board. Despite all this, securities firms are still fighting a commission

FIGURE 2.3 Activity-Specific Revenue Curves of Top 10 American Securities Firms (as per market value) Source: Morrison and Wilhelm (2006).

war. However, industrial restructuring seems inevitable if no change occurs in this profit model that relies only on commissions.

Globally, the liberalization of brokerage commissions is a general trend. The U.S. securities market replaced fixed commissions with negotiable commissions in May 1975. After that, brokerage-commission liberalization spread to France, Australia, and Japan, and intense competition resulted in the dropping of commission rates (see Figure 2.3).

The United States avoided the massive loss China sustained because American securities firms used their good judgment in such situations and adjusted their strategy and business mix. There are two business models: integrated and discount broker.

Typical examples of the integrated model include Merrill Lynch (now known as Bank of America Merrill Lynch) and Morgan Stanley. For example, Merrill Lynch introduced financial advisors to the market and combined brokerage with financial advisory services and asset management services.

A typical discount broker is Schwab, an online wealth management service provider. With the help of the Internet, Schwab gained rapid growth and popularity. With low transaction costs, it attracted a great number of retail investors.

Such accurate positioning in competitive differentiation and market segmentation helps American securities brokers overcome the influence of dropping commission rates and become stronger. This is a great business lesson from which Chinese securities firms should learn.