A golden opportunity for foreign custodians in China

Foreign custodians may be able to tap opportunities in China

Citigroup made headlines in September with the announcement that its China unit has been awarded a local fund custody licence. This will allow Citi China to provide custody-related services to both mutual funds and private funds domiciled in the country, subject to passing onsite inspection by the China Securities Regulatory Commission (CSRC) later this year.

Citi is the first US bank, and the second foreign player after the UK’s Standard Chartered Bank, to be granted the much coveted licence. Standard Chartered Bank China got the licence two years ago.

The timing of Citi’s licence approval is very significant, coming as it did amid the rapidly worsening relationship between China and the US. According to Chinese media, it shows that Beijing is fulfilling its commitment under the phase one trade deal with the US signed in January.

It’s also noteworthy that Citi China met the minimum 20 billion RMB (US$2.95 billion) asset requirement for the licence based on the size of its parent bank’s assets overseas, by virtue of an amendment CSRC made on July 7. Prior to this, applicants were required to be operating as a locally incorporated bank with assets of at least 20 billion RMB. This ruled out many of the world’s largest custodian banks such as JPMorgan Chase and BNP Paribas, whose local units didn’t meet the asset requirement, or BNY Mellon and State Street, which operate as a foreign branch.

Foreign custodians are rushing to grab the long-awaited opportunity. Applications by HSBC and Deutsche Bank are reportedly pending CSRC approval. According to market sources, several other custodian banks are either working on their applications, or are in active discussions with their head offices to get the greenlight to file applications.

Mutual funds and private funds

Data on China’s mutual funds and private funds underscore the growth potential of the market. China’s first open-ended mutual fund, the Huaan Innovation Fund, was introduced in September 2001 and was fully subscribed at the maximum limit of 3 billion RMB within hours on the day of launch.

That set the stage for exponential market growth over the last nearly two decades. As of end-June 2020, open-ended mutual fund assets had grown to 15.58 trillion RMB, or almost $2.3 trillion, roughly half of it in money market funds. Although that’s still far behind the $22 trillion US mutual fund market, there’s a lot of room to grow given the 63.12 trillion RMB of total household savings in China, and 177.5 trillion RMB of deposits in the banking system.

On the other hand, China’s private fund market drew little attention outside the country until 2016, when regulations were introduced to allow foreign asset managers to set up onshore wholly-owned units to manage private funds.

The term ‘private funds’ is rather confusing as it refers to fundraising channels rather than the specific asset types that these funds are invested in. As long as they are distributed through non-public channels to institutional investors or high-net-worth individuals, funds investing in private equity or venture capital, as well as bonds, stocks and futures in the secondary market, can be registered as private funds.

Private funds have undergone spectacular growth since 2004, when they started working with trust companies to launch so-called sunshine trust investment funds. As of end-August 2020, total private fund assets stood at 31.5 trillion RMB, double the mutual fund market.

And yet, most foreign players’ ability to unlock all that domestic wealth has been unimpressive over the past 20 years. Which begs the question, how would it be different this time?

Effective April 1, 2020, global fund managers have been allowed to own 100% of their fund management companies, enabling them create and distribute mutual funds to retail investors in China. J.P. Morgan Asset Management has already announced it will pay $1 billion to buy out its joint venture partner Shanghai International Trust’s 49% stake in China International Fund Management.

BlackRock, the world’s largest asset manager, has received approval to run its own mutual fund business in China instead of through its partnership with Bank of China Investment Management. And Vanguard is moving its regional headquarters from Hong Kong to Shanghai, announcing that its “future focus in Asia is on mainland China”.

Early movers

For some foreign custodians, their efforts as early movers in accompanying clients into China are paying off in handsome returns as cross-border business develops.

When Beijing introduced the Qualified Foreign Institutional Investor (QFII) programme in November 2002, HSBC, Citibank and Standard Chartered Bank were the first foreign banks, together with six local lenders, that were granted onshore QFII custody licenses. The programme had a slow start due to very tight quota controls during the initial stages. But overseas investments started to accelerate over the last decade as China opened up its markets.

As of end-May 2020, 292 foreign fund management firms, pensions, endowments and sovereign funds were approved to invest a combined $116.26 billion in Chinese stocks and bonds through the programme. Market sources estimate that HSBC and Citibank together have captured about 50% of these investments, even though the number of approved local and foreign QFII custodians has expanded to 19.

On September 10, China announced that it was scrapping the QFII quota system to allow unfettered investment inflows.

When the groundbreaking Shanghai-Hong Kong Connect scheme began operations in November 2014, HSBC, Citibank, BNP Paribas and Standard Chartered Bank were the first foreign providers to offer solutions for northbound investments. This was followed by the introduction of Shenzhen Connect in December 2016, and Bond Connect in July 2017.

Today, these three schemes have become the key channels for foreign investments going into China through Hong Kong, with combined average daily trading value of over 60 billion RMB in August 2020. All the early movers servicing these schemes are enjoying thriving business from increasing transaction flows.

Local competition

Will foreign custodians be able to repeat this kind of success onshore competing with local rivals?

According to CSRC figures, there were 48 approved Chinese custodians for onshore mutual funds as of end-August, comprising 28 commercial banks and 20 securities companies. Over the years, they have developed a reasonable level of expertise and experience as well as the technology platforms, client base, business scale and industry network to operate effectively in the domestic business and regulatory environment. The custody business has been generating significant profits for the banks.

The most formidable competitive advantage that Chinese custodians have is their distribution channels. The Industrial and Commercial Bank of China and other big Chinese banks have, with their large nationwide branch networks, naturally become fund managers’ working partners for retail fund distribution. China Merchant Bank, which is specialised in wealth management, has been rapidly gaining market share among the late entrants.

These Chinese custodians are generally the main product distribution channels because most of the time they provide an implicit guarantee on the amount of money raised for new funds. Even though securities companies also distribute mutual funds, their focus is largely on private funds for which they provide brokerage and custody as bundled services.

Technology

But there is scope for optimism from the growing importance of technology as a distribution channel. Ant Group, through its Alipay or Zhifubao app, Tencent Holdings, through the WeChat app, JD Finance and other digital platforms are selling financial products with low subscription and redemption fees. Their impact on mutual fund sales is becoming much more important, although their market share is still relatively small.

Similarly, private fund managers are now raising funds through independent wealth management platforms owned by securities companies, such as Noah or Ease Credit, and private fund digital platforms such as Howbuy, Simuwang and Jinfuzi, in addition to private banks and futures companies.

These digital sales channels have been working effectively with simple investment products like money market and index funds, and may allow fund managers to consider using foreign custodians for the products. But sophisticated products would require a level of sales and after-sales support that a digital channel might not be able to provide at this time.

Another positive trend is the rise of private sector institutional investors and high-net-worth individuals, two segments that are increasingly looking for multi-asset strategies, offshore exposure, and innovative products for alpha generation to build their investment portfolios. This type of institutional business is generally more profitable than retail, but requires greater customisation, flexibility and agility. Know-your-client compliance and legal document negotiations could sometimes be challenging in meeting foreign custodians’ global requirements.

In spite of these positive developments, business opportunities for foreign custodians is likely to be confined to niche areas in the near term. It will take them time to accumulate a substantial client base to build scale.

It’s always been a challenge for executives of international financial firms to build a business case for investing in China. The business case for a custody licence will not be any easier as it requires a level of capital outlay and infrastructure build upfront, which typically take several years to pay back, even in markets that are more transparent than China. Early movers are generally much better positioned to ride on favourable policies and development trends before changes occur that might negatively impact business growth.

Investing in China requires tremendous faith in the market and the economy. There will be a lot of headwinds along the way. It may be a cliché to say that investing in China requires long-term commitment, but it’s also the hard truth. The time horizon of this commitment is becoming more tested amid the rapidly worsening China-US relationship.

* This article was published in the Asia Asset Management’s October 2020 magazine titled “Gaining footholds.”