Chinese regulators turn their attention to a fast-growing sector of the market

Quantitative investing has been developing in China for more than a decade, mostly under the radar. But it came under the spotlight recently when a top regulator called attention to the potential risks. 

Speaking at the 60th annual conference of the World Federation of Exchanges held at the Shenzhen Stock Exchange in September, Yi Huiman, chairman of the China Securities Regulatory Commission (CSRC), highlighted the rapidly growing volume of quantitative trades as one of four challenges for Chinese bourses.

“In mature markets, such quantitative and high-frequency trading had led to better liquidity, but also spawned herd behaviours, greater volatility and unfairness,” he said. “How do we brace for the problems brought about by their rapid growth?” 

This immediately sparked discussion about China’s “flash boys” – named after Michael Lewis’s 2014 book about Wall Street’s high-frequency traders – at a sensitive time when Beijing has been taking a number of headline-grabbing actions against technology firms and their use of algorithm in business activities. 

Some Chinese news reports estimated that algo trading now accounts for about 50% of daily total trading volumes of China A-shares. Quant managers and traders were quick to refute the estimates as grossly over-exaggerated; they said the share was only around 20%. Daily total trading volume of A-shares has been hovering at around 1 trillion RMB (US$155 billion) since July.

Chinese brokerage CITIC Securities estimates that onshore quant funds have topped 1 trillion RMB in total assets under management since June. This represents around 5% of the 19 trillion RMB private funds market or 4% of the 23.5 trillion RMB public funds market. In the US, quantitative investments account for around 40% of the managed funds market, so there is still much room for Chinese quants to grow.

But what’s even more striking is that quant funds in China have increased their total assets by nearly ten-fold in four years.

A majority of Chinese quant funds are managed by private fund companies targeted at institutional and high-net-worth clients. Some public fund companies also offer quant funds to retail investors, but their collective assets under management account for less than 15% of the quant sector. 

In the offshore space, there has also been a rapid increase in quantitative trading activities on Chinese equities by global hedge funds through the Hong Kong Exchange’s Stock Connect channel.

The history

The first onshore quantitative fund for China A-shares was launched in 2004 by China Everbright PGIM Asset Management. 

Algo trading for A-shares started around 2007 when sell-side Qualified Financial Institutional Investor investment banks such as UBS began to offer algo trading facilities to their clients and their own proprietary trading desks. Most of these facilities were located in Hong Kong, and connected to their Chinese brokers’ Financial Information eXchange (FIX) gateway via trading networks such as Bloomberg.

This systematic quantitative approach has given quant managers an edge over the erratic investing behaviour of domestic investors.

In 2010, UBS launched onshore algo facilities at its Chinese brokerage joint venture, UBS Securities. This prompted several leading domestic brokers such as CITIC Securities, Guanfa Securities and Guosen Securities to develop their own algo capabilities by installing technology platforms from abroad. They too began to offer algo trading solutions to the local mutual fund industry in 2010. 

The Shanghai Shenzhen CSI 300 Futures Index was launched that same year, providing an important hedging tool for quantitative investing. This paved the way for the quant sector to take off, and attracted a wave of overseas-trained Chinese quant managers back home to set up their own firms. 

However, the growth of algo trading activities using automated programmes to place multiple buy and sell orders in seconds was soon caught in the crosshairs of regulators. 

When the A-shares market crashed in the summer of 2015, the Shanghai and Shenzhen stock exchanges announced in August of that year penalties against 42 trading accounts suspected of using algo trading to distort the market. Of these, 28, including US hedge fund Citadel Securities, were suspended from trading for three months.

At the same time, the China Financial Futures Exchange suspended 164 trading accounts for ‘excessively’ high daily trading frequency. 

All the firms and accounts penalised by the exchanges were investigated for spoofing, a malpractice where traders place large numbers of buy and sell orders and thereafter cancel them, with the aim of moving stock prices. Some of the firms claimed that the high frequency of order cancellations was the result of computer programme flaws that came into play under extreme market volatility.

In October 2015, the CSRC announced new operational and risk management requirements governing quantitative trading in the securities and futures markets. The measures included definition of programme trading, reporting, system verification, controls over trade execution, prohibited trades, and position limits. The move was aimed at addressing perception of unfair treatment of small investors, as well as to reduce market turbulence resulting from speculative, liquidity-fuelled trades placed through automated, high-frequency and other similar trading strategies. 

There has since been a rapid increase in the number of new foreign and domestic quant managers. Around 30 foreign players have now set up shop onshore to jostle for a piece of the market, including prominent names such as Two Sigma, Winton Capital, Man Investment, D.E. Shaw, and Millburn Ridgefield.

The competition has pushed technical capabilities and investment strategies to new levels, generating impressive returns to investors. 

Competing for talent

China’s vast A-shares market is the largest in the world by number of shares traded, and the second largest after the US by trading volume. Although it’s very liquid, it’s still not very efficient. “The market’s many unique attributes present an unparalleled opportunity for quantitative strategies to create alpha,” Lazard Asset Management argued in a research paper published in October last year.

A majority of Chinese quant managers have experience working overseas for international firms. They have successfully adapted technologies and algorithm models from abroad to the local markets. While they may have less robust research and investment systems, they compensate with on-the-ground knowledge that their foreign peers would take time to gain. 

According to CITIC Securities, 20 onshore quant funds have exceeded 10 trillion RMB in total assets under management, including five with more than 50 billion RMB each. By contrast, only six funds had crossed the 10 billion RMB mark at the end of 2019. 

As of this August, the 20 funds together managed 480 billion RMB of assets from both domestic and foreign investors.

The sharp growth has also intensified competition for talent. According to a Bloomberg report in September, graduates in artificial intelligence and computer science are especially in demand; a Chinese quant was said to be competing with Wall Street for talent, offering an annual salary of US$300,000 to lure top college graduates to return to China.

High return, high risk

Quant funds aim at high returns, but this can also mean high risk. Shanghai Minghong Investment Management,  which until recently was China’s largest quant fund, saw a 20% decline in its 70 billion RMB of assets in the first quarter of the year as a result of  redemptions after the fund reported a 27% loss in value.

Algo and high-frequency trading are controversial globally. The US stock market’s flash crash in May 2010 has been blamed on high frequency trading, including accusations of spoofing. Apart from market volatility and potential manipulation, they are perceived as unfair because their huge investments in super-computer and artificial intelligence squeeze out individual investors. Advocates, however, say they improve liquidity and pricing efficiency.

The Hong Kong Monetary Authority (HKMA) recently published a research report regarding algo and high-frequency trading in the Hong Kong stock market. The results were inconclusive; the HKMA said  it would need to gather evidence from participants to further validate the resilience and stability of liquidity of the trading activities and their impact on market volatility during turbulent times. 

However, the HKMA did note that adoption of algo and high-frequency trading technologies can give rise to new sources of risk. It proposed measures to mitigate the risks, such as establishing proper internal controls and governance, implementing volatility control mechanisms, and establishing sandboxes for assessing the impact of changes in market design, policies and regulations.

The CSRC’s concern about the high-octane growth of quantitative trading and investing is understandable. But the sector is hoping that the regulator will strike a  balance between managing market volatility and improving fairness, versus undue interference in the operation of the market.

*This article was published in Asia Asset Management’s November magazine titled “Quants rising”.

**After the publishing of this article, the CSRC announced on November 5 new data reporting requirements on quantitative trading.