Global banks eye China’s structured products surge

Following a government crackdown on local products, foreign banks look to open joint ventures onshore

  • Chinese regulators have cracked down on the sale of short-dated, high-coupon wealth management products that were popular with local investors.
  • Although the majority of these products did not offer explicit guarantees, investors believed banks would bail them out if they hit trouble.
  • With guarantees in wealth management products now banned, investors have flocked to structured products as an alternative.
  • Foreign banks need a local joint venture to issue cheaper products linked to certificates, but a 49% ownership cap had held many back from the market.
  • New rules allow foreign firms to own a majority stake, prompting firms such as Societe Generale, JP Morgan and Nomura to set up in the country.

For investment banks eyeing a move into China’s glinting wealth management market, the stars seem to have lined up nicely.

A confluence of factors has led to an explosion in structured products, derivatives-linked investments sold by banks, in the first half of this year. China clamped down on traditional wealth management products, a trillion-dollar market hawking products that carried, if little else, an assumed guarantee against loss. Structured products, which can still offer some form of principal protection, seem to have quickly filled the void.

For foreign firms, the news was even better. Last April, the Chinese government raised the amount foreign entities can own in joint ventures to a majority stake, and eventually full ownership – allowing them a new, firmer standing in what has been a largely closed market.

“This year is a pivotal year for the Chinese market,” says CG Lai, head of global markets for China at BNP Paribas in Shanghai. “The Chinese are now re-engineering their wealth management products and this is one of the biggest markets in the world. Everyone is putting out structured products.”

According to data from the People’s Bank of China, the market for structured products shot up to 9.4 trillion renminbi ($1.4 trillion) of notional value at the end of June from 6 trillion ($878 billion) at the start of the year.  

The takeoff in structured products roughly dovetails with the Chinese government’s chastising of shadow banking, a loosely regulated world of off-balance sheet lending that offers among other things, wealth management products. Typically short-dated products with a high coupon, their proceeds go to finance a range of investments. But disclosure of the underlying holdings is patchy, and when disclosed, often reveals a maturity mismatch. 

But it may have been the guarantees on wealth management products that were the source of their popularity – as well as the government’s anger. While banks explicitly guaranteed some products, a Bank for International Settlements study found that nearly 80% of wealth management products had no explicit guarantee as of 2016. A 2015 study by the Reserve Bank of Australia however said investors assumed that, even without an explicit guarantee, the products would be bailed out by the banks. Given many Chinese banks are state-owned, this would leave the government on the hook.

The Chinese are now re-engineering their wealth management products and this is one of the biggest markets in the world. Everyone is putting out structured products
CG Lai, BNP Paribas

But in April, the People’s Bank of China intervened, followed by the China Banking and Insurance Regulatory Commission in July, serving up a new set of regulations that would go into effect by the end of 2020. Among them: a ban on explicit and implicit guarantees embedded in wealth management products, and a cap on investments in such products to 20% of an asset manager’s total net asset value.

“Traditionally, wealth management products have been a risk-free guarantee of a higher return,” says Simon Zhang, a lawyer at Linklaters’ capital markets practice in Hong Kong. “Financial institutions are now required to give full disclosure to the investors, let the investor know what is the ultimate underlying, and give more detailed risk disclosure and ongoing reports to the investor,” he adds. “It is a new era for Chinese investors.”

Despite the rules not coming into force till 2020, the regulatory commission bared its teeth in June, fining three Chinese banks – among them the China Merchants Bank, one of the country’s largest – for improper practices in their wealth management products businesses. According to Chinese media, the offences included illegally guaranteeing products and investing in overly risky underlying securities.

But there’s still a guarantee?

With guarantees on wealth management products off the table, investors began moving en masse into alternative vehicles – in particular, structured products – a move that began as news of the coming crackdown began to circulate at the end of last year.

Beijing-based China Minsheng Bank saw a significant rise in its structured products business in the first half of the year, largely because of a decline in traditional wealth management products.

“Since banks can no longer issue principal-protected products, we firmly believe that structured products will become the defining product of the market,” says Chongfeng Ran, head of structuring at China Minsheng. “This is a direct consequence of the new regulation.”

According to Ran, most of the demand has been for structured deposits – accounts that combine a traditional savings account with an investment on a derivative instrument linked to assets such as currencies, equities, commodities or bonds. Structured deposits are the only type of structured product allowed to offer explicit principal protection guarantees, as they are held on the bank’s balance sheet.

Signs are that the products are becoming more sophisticated, too, which would only help overseas banks looking to use their structuring expertise to break into the market.

We firmly believe that structured products will become the defining product of the market. This is a direct consequence of the new regulation
Chongfeng Ran, China Minsheng

The head of derivatives at another Chinese investment bank, which relies on global banks for much of its structuring needs, says its clients are increasingly demanding a more comprehensive range of products. A popular one is the ‘shark fin,’ where the investor receives a minimum return plus any increase of the underlying up to a knock-out point, at which the upside is fixed. Range accrual products, notes where the accrual of the coupon is linked to an index staying in a predetermined range, and some customised Asian options, where the payoff depends on the average price of the underlying security over a period of time, are also proving popular, he says.

There are other favored options. For example, a sales head at a US private bank in Shanghai says equity-linked notes are becoming a popular way for investors to gain exposure to offshore equities, given the restrictions that currently prevent direct investment in overseas stocks and indexes

“When we offer offshore structured notes, one advantage is that local Chinese cannot freely invest in offshore equities, and structured products provide an opportunity for indirect access to offshore equities,” he says. “They are good entry products for local investors to invest offshore.”

The other shoe

Although global banks offer structured products in China at present, they are limited in the ways they can offer them – typically via swaps linked to structured products or through China’s Qualified Domestic Institutional Investor (QDII) scheme, which gives Chinese investors a route to invest in foreign securities, but comes with certain restrictions.

Both deliveries are complex, which not only adds to the transaction cost, but limits who can buy them. For example, swap deals have to be documented under a master agreement, meaning they are typically only offered to more sophisticated investors. While QDII products can be sold to a broader range of clients, banks offering those products must partner with a local custodian bank.

One thing foreign banks cannot offer under the current arrangements are certificates linked to structured products, which would be a simpler, possibly cheaper way of structuring solutions for Chinese clients.

Photo of CG Lai
CG Lai: Pivotal year for the Chinese market

“It’s a question of the clientele,” says Ryan Chan, co-head of business development for cross-structuring in Asia at Societe Generale in Hong Kong.

“If the product is in a certificate format for certain clientele, it’s in a much easier format to be sold to a larger audience, whereas if it’s in a swap or wealth management product format, or in a QDII format, this could limit the counterparties that we could face,” he adds. One solution, of course, would be to issue the products from a Chinese entity. But foreign firms had been at a loss – they were restricted to owning no more than 49% of a Chinese entity.

No longer. In April, the China Securities Regulatory Commission raised the ceiling for foreign ownership of joint venture fund management companies to 51% from 49%, effectively allowing foreigners a controlling stake in any partnership. But there’s more: The commission also said the 51% cap would be removed in three years, allowing global firms to own securities houses in the country outright.

So a number of foreign banks are now considering investing in China. The chief executive of Societe Generale, Frédéric Oudéa, announced in May that it would set up a joint venture in China, with a 51% stake.

Once you own a 51% stake in a firm, you can actually start to apply international standards to the joint venture and basically analyse underlying Chinese assets in this way
Ryan Chan, Societe Generale

Other banks, including JP Morgan and Nomura, announced they had already applied for permission from the regulator to own a 51% stake in a Chinese securities company.

Lawyers say the previous constraints on majority stakes were a deterrent to many global investment banks, which understood they would be at the mercies of their local, majority partners.

“The business culture is quite different,” says Linklaters’ Zhang. “Before, foreign securities companies would find their hands are tied and they may not be able to effectively carry out the business in China that they wanted.” With a majority stake, “they can take a longer view.”

In fact, in 2016 JP Morgan sold its 33% stake in Chinese firm First Capital Securities. Jamie Dimon, JP Morgan’s chief executive, has commented that the bank would like to own 100% of an entity at some point, noting that “joint ventures by their nature have sloppy corporate governance.” That concern is shared by many.

Chinese majority owners “can be a lot more aggressive” in imposing their views on minority partners – even global banks, says Societe Generale’s Chan.

“Once you own a 51% stake in a firm, you can actually start to apply international standards to the joint venture and basically analyse underlying Chinese assets in this way,” he says. “A risk manager from Europe and a risk manager from China may look at risks on the Chinese market very differently.”

Global investment banks like Goldman Sachs, Morgan Stanley, UBS and Credit Suisse currently operate in China through minority-owned ventures. UBS is the only one that, by dint of history, has management control of its joint venture, even though it owns just 25% of the shares; the Swiss firm acquired the stake as part of its bailout of Beijing Securities. Even so, a statement on the Chinese regulatory commission’s website in May showed that UBS is also looking to raise that stake to 51%.

Putting down roots

While the new securities law has renewed interest in joint ventures with securities companies in China and may well foster the creation of a new suite of structured products, some say those who want to explore opportunities in the country need to be prepared for a long-term commitment.

“Everyone thinks it’s a big opportunity when they look at joint ventures,” says one markets head for China at a European investment bank in Hong Kong. “It’s a huge market and they see others who are there and making a lot of money and think they should be there, too.

“The key thing is whether those banks have the resources to deploy into that business,” he continues. “If it’s something they are going to close if it’s not making money after two years, that could be a problem because the Chinese government wants foreign investors to have a long-term relationship with them.”

Another problem for banks is that their joint venture will not be able to borrow at the presumably better credit rating of their global parent. This can make the cost of funding significantly higher, according to China Minsheng’s Ran, who says they have been able to outpace global banks in offering structured products simply because they can offer them cheaper.

Everyone thinks it’s a big opportunity when they look at joint ventures. The key thing is whether those banks have the resource to deploy into that business
Markets head for China at a European investment bank in Hong Kong

A structuring expert from one European bank expanded on the complications. “To use the credit rating of a global bank you need to issue structured products from offshore and then the only way to bring them to the market is via a cross-border swap or a QDII partnership. So you get a better rate of funding, but then you have to pay a significant amount for getting into China,” he says. “You can raise the credit rating of your onshore entity by injecting more capital, but this is not a five-minute decision. Injecting billions of dollars is something you plan over years.”

At the end of the day, buying a securities company outright might not provide the quick entry to the Chinese structured products space that some global banks envision.

“For a lot of the continental European banks or the Japanese… the securities house route appears to be a light-capital, light-asset alternative way of going in and tackling the asset management business,” says the head of global markets at another European bank.

“For them, there may be some value in owning a securities company, depending on what business they are doing. You may find that this is a good solution for a boutique house on a very specific sector of their business in China. But it’s certainly not going to be a game-changer.”

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