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Cultivation and Growth of Innovative Business

As China loosens its regulation on securities companies, cases of institutional innovation emerge one after the other. The depth and breadth of securities companies' engagement in innovative business and their innovative capability will accelerate the transformation of the profitability model of securities companies. In 2011, the regulators sped up the promulgation of provisions concerning innovative business of securities companies. The constant development and deepening of innovative business of Chinese securities companies in the future will surely change the profitability model of Chinese securities companies. Table 4.12 highlights major events that took place in 2011.

Profit Growth Points Brought about by Innovative Business

Securities Margin Trading One year after the introduction of the securities margin trading, listed securities traders already started reaping some profit from the business. From the perspective of absolute numerical value, the revenue from securities margin trading was still only a small part of the total

TABLE 4.12 Major Events in the Securities Industry in 2011

Major Events in the Securities Industry in 2011

revenue of the securities industry. In the long run, with a rising proportion of securities trading in the A-share market, and combined with the magnifying effect of the establishment of refinancing companies on the securities margin trading, the securities margin trading business had an appealing growth space.

The establishment of China Securities Finance Corporation Ltd. in October 2011 signified that the refinancing business had entered into a substantial preparatory stage. The establishment of refinancing companies made it so that the conduct of the securities margin trading business could break through the constraint of the securities trader's own capital and securities. For the conduct of the "two-finance" (securities and capital) business, it could magnify the effect of leverage. Although the refinancing business was yet to be introduced by the end of 2011, the introduction of refinancing companies was seen as a vital step toward making routine the securities margin trading business.

As the securities margin trading business develops and matures, the participation of long-term capital, such as insurance companies and funds for social security funds in the securities borrowing practice, will further increase the balance of securities margin trading, according to experience from overseas. Hopefully, this will boost its proportion in the total revenue of the industry to over 10 percent. For most securities traders, that is equivalent to creating yet another investment banking division, while allowing the securities trader to play just the role of the capital intermediary in the securities margin trading business. The stability of revenues and the relatively low risks are indeed very appealing.

Direct Investment The first pilot for direct investment business of securities companies was launched in September 2007. As of July 2011, a total of 34 securities companies had set up their direct investment subsidiaries, totaling CNY 21.6 billion in registered capital. Six of the direct investment subsidiaries had invested in and were managing seven industrial funds.

The significance of the direct investment business lies in its ability to expand investment channels for securities companies, improve capital utilization efficiency, and enable securities companies to participate in market transactions more effectively. However, the development of the direct investment business requires well-standardized operation as a fundamental prerequisite.

In terms of the future development of the direct investment business, the direct investment business realized the integration of industrial capital and financial capital. But the relationship of the two is likely to bring about issues such as interest transmission. This problem is worth paying special attention to. The industrial fund essentially represents the securities trader's own interest. After making investment in an enterprise, it becomes the best choice for the securities trader to have the enterprise listed in the stock market for maximum profit.

After having its interest tied to that of the investment company, the securities trader ought to be the impartial intermediary. The overturned role tends to make it possible to skew the securities trader's criteria, which is expected to be impartial and objective. From the perspective of image-building, there are risks of financial statement whitewash, cover-up of connected transactions, and exaggeration of profitability. From the perspective of listing price, however, the higher the issuing price of the listed company in the first-tier market, the better. This is because the price directly determines the fundraising scale of the listed company, thereby determining the issuance income for the securities trader.

The direct investment business may bring about progress in many respects, such as changing the pan-banking and overly homogenous profitability models, curbing fluctuations in revenues, and expanding the scope of financial services. However, the associated problem of interest transmission is still worth paying attention to.

Stock Index Future Business The stock index future business has great depth and breadth for exploration. Building upon the introduction of the Shanghai-Shenzhen 300 Stock Index Future pilot, the regulators will deepen and widen their exploration. They will launch other types of stock index futures, as well as mini-futures. Futures companies with a securities trader background may benefit from stock index futures in various aspects. They can share the fruit of improved performance of their affiliated futures companies and also acquire commission revenues through the IB business. They can attract new customers while maintaining existing customers and provide hedging and strategic diversity for their own proprietary business and asset-management business. In addition, stock index futures are conducive to innovation in the structure of invested products and industries. They include strategy diversification, product diversification, the exploration and development of arbitrage systems, and across-the-board innovation of other derivatives.

The development of stock index futures can directly bring to a securities company procedure fees from the IB business and revenues form proprietary business. Based on the current volume of stock index futures transactions and the depth of securities companies' involvement, the stock index future business is bringing CNY 1 to 2 billion to the securities industry. As the depth and breadth of stock index futures business increase, it will become an important revenue source and investment instrument for securities companies.

"New Third Board" Business The "new third board" is the colloquial name of the private company agency share transfer system. It is yet another board launched in the Chinese capital market, following the main board, the SME, and the GEM. Most companies listed on this board are small and medium tech companies. It's an important component of China's multilayer capital market system framework.

The new third board expansion was the focal point of the OTC market reform, which was launched as a pilot on the original agency share transfer system. The year 2011 witnessed rapid expansion of the third board. In November, the number of chief agency brokers increased to 58 from 44 one year earlier, while the number of listed enterprises increased from 82 to 148.

For securities companies, profits from the new third board business mainly include the following:

- Acquiring investment bank income from listing and private placement

- Acquiring commission income through transaction matchmaking

- Acquiring income as underwriters or sponsors from board-switching enterprises

- Price arbitration between the third board and the GEM and SME boards after board-switching

The first two types of profits are currently regular income sources for chief agency brokers. However, due to the small overall size of the third board market, the revenues are limited and even negligible compared with revenues from the main board and the GEM board.

The plan for the new third board expansion was under discussion in 2011, without a definite launch date. Once launched, all-inclusive expansion was planned with many more listed enterprises, chief agency brokers, and investors. Following the introduction of the securities margin trading business, the new third board is likely to become yet another feel-good factor for the securities industry.

Client Margin Management The China Securities Regulatory Commission approved a pilot project, Cinda XIANJINBAO, in which Cinda Securities is allowed to engage in the business of client margin cash management at a scale of up to CNY 7 billion. This is the first time the regulators allowed a securities company to include client margin into the scope of securities management since 2004, when a comprehensive purge of securities traders was conducted. This pilot is significant because the business will become yet another stable source of income for securities companies.

The fee structure of the Cinda XIANJINBAO set up by Sinda Securities includes the following items: management fee (annual rate 0.7 percent), custodian fee (payable to the custodian, annual rate 0.05 percent), and performance fee (given that the annualized profit rate of the product exceeds 0.7 percent, Cinda Securities may extract 30 percent). The management fee and performance fee are the major profit sources of securities traders. The securities trade can also get the performance fee as long as the operation of this part of capital by the securities trader yields a profit rate higher than the low-hanging 1.45 percent. Once the business is opened up, it can bring a new and stable profit source for securities traders. According to incomplete statistics, as of the end of June 2011, the total amount of customer deposits in the securities industry was about CNY 800 to 1,000 billion. Assuming 50 percent of the deposits in the entire industry can be included into the scope of the cash management business, based on the 3.5 percent interest rate, it will bring at least CNY 5 billion for the industry. This is equivalent to about 3 percent of the industry's total revenue in 2010.

Synergism between Innovative Business and Traditional Business

The conduct of innovative business brings new profit points and incremental revenues for securities companies. It also optimizes traditional business, realizing synergism between innovative and traditional business. For example, the proprietary business may offset some losses in self-operation by hedging with instruments such as stock index futures (see Table 4.13). The brokerage business, investment consultancy business, and research business may jointly ensure an obstruction-free industrial chain. This is also an important

TABLE 4.13 Some Publicly Listed Securities Companies' Return on Investment through Derivative Financial Instruments (CNY in 10 thousands)

Name of Securities Trader

Net Profit of Investment through Derivative Financial Instruments in the First Half of 2011 (changes in fair value included)

Net Profit of Investment through Derivative Financial Instruments in 2010 (changes in fair value included)

CITIC Securities

60847.03

43235.41

Haitong Securities

9001.94

7694.63

GF Securities

29341.07

16397.84

Everbright Securities

-356.23

29.27

Source: The companies' annual reports in 2010 and mid-year reports in 2011.

part of transformation of profitability models experienced by Chinese securities companies.

The following measures are designed to exploit synergies between the innovative business and the traditional business of securities companies:

- Greater resource input: Increase HR input from investment banks. Speed up the construction of light operations. Enhance input into asset management product innovation.

- Transition from seller business to buyer business: The key factor for a securities trader to win the competition in the future is its investment capability. This includes the capability to invest in various types of seller business such as self-operation, asset management, direct investment, PE funds, cash management, securities margin trading, agreement-based share buy-back, and other types of capital operation business.

- Encouragement of innovation: Specialized operation can be realized through innovation in product design, sale, and service. Business innovation is also encouraged. Through customer-oriented business such as fixed income business, equity business, and securities margin trading business, new business fields can be created and explored and new growth points can be cultivated.

- Optimization of traditional business by innovative business: The stock index future business is conducive to sharing customer resources, extension and expansion of operation outlets, and improvement of customer services, even more so to the optimization of the proprietary business and asset management business.

- Building up customer resources and encouragement of customer-oriented business development: Based on customer experience, various business lines should be encouraged to improve their product and service innovation capabilities from the perspective of customer needs, so as to find great space for development.

 
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