The extreme volatility in the Mainland's A-share market has drawn international attention over the past few weeks, and raised some specific questions about how the A-share market functions and broader questions over the pace of internationalisation on the Mainland. Now that the market appears to have stabilised and everybody has had time to catch their breath, people have begun trying to make sense of what happened and why. The most commonly asked questions include:
1. How did the rapid bull-run come about? What fuelled it?
2. Why did the bull-run end so quickly and why was the decline so steep?
3. Should the government have intervened? Should it have intervened earlier? Maybe later? Did it intervene enough or too much? How has the intervention impacted China, the capital markets, and international sentiment? What would have happened had the government not intervened?
4. How did various stakeholders contribute to the boom and bust? What else contributed? Short sellers? Weak regulation? Leverage? OTC financing? The internet? Domestic speculators?
5. In what ways has the Chinese market structure itself played a role in this crisis?
There is a lot to digest here. Identifying the root causes and getting the right answers could take months, if not years, of effort and study, particularly as more precise and extensive data becomes available over time. In this blog, I want to focus on China's market structure and leave the other questions to be addressed later once the dust is more settled. With Stock Connect providing more opportunities for funds to flow across the border, a greater understanding of the A-share market is an important starting point to better make sense of what happened.
Many people are already aware that the Chinese stock market is, in essence, a retail investor-dominated market. Most of the direct participants are retail, so the market is uniquely organised to help meet their specific needs while many policy decisions are made with a strong orientation toward their interests. But understanding how China's market structure developed around retail investors and assessing whether it's been effective at protecting them is helpful, particularly to market operators such as HKEx, which has worked hard to develop mutual market access with the Mainland.
What are the key features of the Mainland market?
In a nutshell, the Chinese stock market is the world’s only completely "see through" market where almost all of its approximately 200 million investors directly participate in the exchange markets through their own unique account number, without much involvement from the intermediary layers of brokers, dealers or institutional fund managers. More specifically, the Chinese stock market has the following key features:
Individual accounts of retail investors are all directly opened with the Shanghai and Shenzhen exchanges, China Clear and the custodian banks. In contrast, international and Hong Kong investors typically maintain their accounts with their brokers, who in turn are participants of the exchanges. Typically, only participants are able to trade directly through the exchanges in international markets.
Investor assets such as cash, securities, margin, reserve fund contributions, or lent and borrowed stocks are all centrally maintained, controlled and managed by the central market structure operators, such the two exchanges, clearing houses, state margin protection, and stock lending and borrowing corporations. In contrast, international investors' assets are typically maintained and managed by their broker/dealers while stock lending, borrowing and financing are also handled by brokers. Brokers then put up margins and contributions to the central counterparty on a net basis.
Trading, clearing and settlement of all securities, though channelled through brokers, are matched and cleared directly and centrally at the exchange and clearing houses on a gross basis. In contrast, international investors typically trade and clear through their brokers, who can internalise matching and only net clear with the central counterparty.
These unique market structures, with central control over all investor assets and market access, allows the Chinese regulators to essentially regulate through software and hardware so that prohibited conduct and practices will not be able to be executed directly through system.
Beyond market structures, the Chinese stock markets also embrace many regulatory prerogatives with a strong bias toward retail investors, such as constant tight control over primary market fundraising by corporates, strict electronic auction control of IPO subscriptions, daily 10 per cent price movement and eligibility hurdles for retail investors to trade in the futures markets.
Why does China's market work this way?
The international markets have developed and evolved for well over a century, with the broker/dealers initially acting as the primary intermediary or mini exchange for their own investing customers and the stock issuance corporates. The broker/dealers then formed exchanges in which only they were members, and therefore qualified to deal and trade on behalf of the investing public. Large institutional investors emerged over the more recent decades and became the primary intermediaries to deal with the broker/dealers and the exchanges.
China started its stock market development essentially along a similar path, although the concept of issuers, brokers, exchanges, securities regulators and investors (largely individuals) were all "born" about the same time at the beginning of the 1990s. The market was initially structured with a bias toward financing state-owned enterprises; but, given the large number of retail investors, regulatory orientation has decisively begun to shift to how to comprehensively protect retail investors.
In the early 2000s, China encountered significant stress with the broker/dealer system as there was a lot of abuse of investor assets, with some intermediaries speculating using investor funds in their custody. China took decisive action against the wrongdoers, but also tried to completely eliminate the chance of further wrongdoing. The fear of a retail investor backlash and a strong sense of accountability for their interests led to reforms that started in 2004 and resulted in the system China uses today. It wasn't originally planned like this, but China changed course partway through.
Is China's system better or worse than the international system?
This is not such an easy question. There are pros and cons to both systems.
First, there's no doubt that China's market structure is more transparent because regulators can see everything that happens on the exchanges. Nothing escapes the regulatory eye. With the single identification number, regulators can see right through the system to quickly identify wrongdoing and take immediate action. On the flip side, this "see through" system only applies to on-exchange activities, and has failed to reach the off-exchange market. Internet lender-fuelled leverage, which some speculate contributed greatly to this round of boom-and-bust in China, is relatively new and perhaps caught the regulators off guard. Several investigations have begun in this area and the jury is still out.
Second, China is the "safest" market in the world today from a customer asset perspective. The system is structured in such a way that investors’ assets are left with a central custodian, making them completely off-limits to broker/dealers who may otherwise use the assets to leverage or monetise them. Again, though, there is a downside: the broker/dealer community is deprived of access to a very important pool of resources they could otherwise use to conduct and grow their businesses. Furthermore, broker/dealers in international markets differentiate themselves by learning about their clients, offering appropriate products and managing risk on behalf of investors, which leads to a differentiated and more sophisticated investor base. China lacks this diversification, which could provide an important counterweight to wild swings in the market when most of the investors are pulling in the same direction.
Finally, I have mentioned before that China's market is the most egalitarian, in the sense of widespread equal accessibility to participate in price discovery. China is one of the only countries in the world where ordinary folks crowd into trading halls to watch market data on the big screen as if they are watching a sporting match. The flipside is retail investors are making investment decisions that do not usually go through institutional investors and brokers, who could provide professional and rational investment analysis.
There are many unintended consequences from this retail-focused regulatory regime and I will list only a few:
• As many regulatory and risk management requirements are already pre-built into the system, there is an inherent absence of an institutionalised, compliance and risk management culture among China’s investing public;
• Restrictions on primary market issuances results in an imbalance in the A-share market between issuance supply and demand. Secondary market valuation is less about anticipated corporate earnings and more about anticipated secondary market liquidity;
• The strict controls over the timing, pace, pricing and auctioning of IPOs deprives the A-share market of its natural ability to properly price IPOs.
What does this mean for Hong Kong and the Stock Connect programme?
There's no doubt that the Mainland regulators will learn from this experience, just as Hong Kong and international regulators have learned from past crisis of their own. The last several weeks have shown how volatile the Mainland market can be, but its pace towards greater global integration will remain unchanged. If anything, the recent volatility underscores the urgent need to improve the market, introduce more institutional participation and further open up the market to foreign investors. In this regard, the Stock Connect scheme is a controlled, safe, yet flexible way for the Mainland to continue its liberalisation. It is now more important for China than ever.
While a natural instinct may be to pull back from the Chinese market for a while, the country’s long-term roadmap towards internationalisation is set. As its market becomes stronger and more robust over time, our unique position will bring benefits to Hong Kong. As bridge builders, it is our job to build new bridges, establishing greater connectivity and creating more investment choices. We helped build the Stock Connect bridge; whether and when to cross the bridge is up to investors.
The differences in how the Mainland and Hong Kong responded to the stock market plunge were in stark contrast, and demonstrated to global and Mainland investors alike that our market in Hong Kong is mature and operates in a fair and orderly manner. Our deeply-rooted compliance culture along with our stringent regulatory regime gives investors confidence. Compared to the US or European markets, we have much more direct retail participation, but we remain an international and largely institutional market with no capital controls. We have been an open market for a very long time and have experienced many different crises over the years which have taught our regulators, intermediaries and investors to remain calm in times of market turbulence. These form the foundation of our success.
We intend to utilise these advantages to provide the Mainland with a secure, trusted environment with which to experiment as it grows and matures, while we pursue transformative growth of our markets in Hong Kong.
China is a huge and yet still young market. It will go through some more growing pains and tough times. But there's no doubt that with patience and time, China's market is on its way to becoming the global centre of gravity in the Asian time zone and will help secure the brightest future for Hong Kong.