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Management of Risks Associated with the Brokerage Business of Securities Companies

Major Sources of Risks in the Brokerage Business

Based on their sources, operation risks in the securities brokerage business can be divided into the following three types:

1. From inside the securities company (failing to gain an expected market share or profit due to the company's misjudgment of the environment or low efficiency in management)

2. From outside the securities company (as the result of intensified competition within the securities industry or mixed financial operation)

3. Loss of a favorable living environment for the brokerage business (due to macroeconomic changes)

Competition Risks Outside the Industry Competition risks outside the industry mainly come from other financial institutions represented by banks and insurance companies. From a short-term perspective, the expansion of the securities brokerage business has intensified the competition for clients between securities companies and other financial institutions. From a long-term perspective, the financial industry has shown a trend toward mixed operation, which is accentuated by the fierce competition from the banking industry. The current business layout and competition pattern of China's securities industry will change.

Innovation in securities brokerage business has, to some extent, sped up the trend of mixed operation. Current securities companies are far behind banks and insurance companies in terms of management level and scale. As a result, they are in a disadvantaged position in mixed operation.

For example, in the channel service field and financial product sale field of product innovation, channel innovation will accelerate the pace at which other financial institutions enter into the securities industry. When it comes to product innovation, banks enjoy the advantages of better access to markets, foreign currencies, and other product fields. Therefore, compared to securities companies, they are able to provide brokerage products with a more competitive edge. Banks also have outlet and client resource advantages. In the consigned fund market, the share of banks is far greater than that of securities companies. In channel innovation, with the spread of cooperation products and the expansion of cooperation scope, higher levels of cooperation are, in turn, accelerating the formation of such outside competition.

Horizontal Competition Risks Securities companies were used to stable income and low risks. However, faced with fierce market competition, securities companies have seen the percentage of their traditional business decrease year by year, thus constantly raising risks to securities companies. In the first half of 2011, for example, the decline of brokerage business and the increase of fees and taxes in the securities industry had a 15.1 percent and 13.8 percent negative effect on net profit, respectively. The commission rate of the brokerage business of securities traders dropped as much as 22 percent from 0.1054 percent in mid-2010 to 0.0826 percent in mid-2011. Homogenous competition in the securities industry has not fundamentally improved. Therefore, in order to maintain market share and commission rate for a period in the future, the decline of brokerage business's percentage in the total revenue will become an irreversible trend.

The room for further commission rate reduction is limited. Some securities traders have started trying to get off the hook of the vicious price war by means of diversified competition. Brokerage business is shifting from being channel dominated to being added value services dominated. The increase of costs that comes along with added value services is also forcing securities traders to proactively search for a competition model designed for the growth of profit. However, innovation in the brokerage business is easily replicated, which undermines or even erases the value of innovation. The current protection of financial, product-related patents has not been recognized by all the parties concerned, and the awareness of patent protection has yet to be raised in China. Once a financial product or innovative item of other types is introduced, it tends to be conveniently copied by other securities companies, leading to a rapid decrease of the value of brokerage innovation. On the other hand, the brokerage business of securities companies is subject to many constraints, so the room for innovation is small. As a result, innovative products of securities companies are likely to be very similar to one another. Therefore, securities companies should have a clear positioning in innovation. Those positioning themselves as innovation leaders will bear a high cost and the possibility of being copied by other companies, but they will have certain advantages in terms of brand recognition and market share. Those positioning themselves as close followers pay a lower cost, but will face fiercer competition.

Internal Management Risks Internal management risk in the brokerage business of securities companies refers to the possibility of the brokerage business suffering losses due to mistakes in management and operation processes caused by the uncertainty of some financial factors. They are essentially risks caused by out of control operation and management, and are therefore controllable. The operation division is the brokerage risk concentrated spot. It is a weak link in risk control. The following actions by the operation division can all lead to potential risks:

- Engagement in proprietary business in breach of regulations

- Industrial investment without permission or provision of guarantee for others in their economic activities

- Engagement in foreign exchange or overseas business in breach of foreign exchange administration regulations of the country

- Setting up "little coffers" or appropriating and dividing funds without permission

- Fund merger or split

- Setting up transaction rooms without permission

Internal management risk in the brokerage business of securities companies falls under three main categories: (1) compliance risks, (2) credit risks, and (3) legal and policy risks associated with business expansion. These are detailed next.

Compliance Risks Compliance risks refer to the possibility that incompliance with policies and procedures of an organization or with laws and regulations may lead to low efficiency of work, high operation costs, loss in operation revenues, unnecessary delay, punishment, or fines. This includes the following types of risks:

1. Market developing material breaches

2. Risks in securities margin trading for clients

3. Appropriating clients' security deposits

4. Not using uniform account opening protocol of the company or the protocol being in breach of laws or regulations

5. Incomplete or false account opening or closing information

6. Clients failing to go through the confirmation process on time after commissioning through telephone

7. Failing to get the signature of a person receiving a payment

8. Skipping the authorization procedures or incomplete authorization procedures when a client appoints an agent

Credit Risks Credit risks of the brokerage business of securities companies mainly include the risk of losses from overdraft by clients and the risk of losses from the absence of client confirmation in an agency transaction. With the introduction of the securities margin trading business, credit risks will gradually increase.

Legal and Policy Risks Associated with Business Expansion Legal and policy risks have always been among the major risks facing the operation of Chinese securities companies. Innovation in brokerage business is somewhat constrained in terms of products, pricing, means of business expansion, and channels. Business innovation is, to a great extent, made to circumvent constraints of current laws, regulations, and policies.

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