Why China Is Ready to Let Wall Street Firms Invade Its Markets

Revenues of Chinese and foreign securities firms

As China considers whether to grant foreign investment banks greater access to its securities market, their biggest local competitor is undaunted.

“It’s quite obvious who are the winners,” said Zhang Jian, who oversees Citic Securities Co.’s mergers advisory business, in an April interview. “I’m not concerned at all.”

Zhang’s confidence might help explain why, after years of imposing restrictions on foreign securities firms, China may be getting ready to ease up. Two decades after Morgan Stanley became the first foreign firm to form a joint venture on the mainland, about 98 percent of revenues in China flow to local investment banks, industry data show.

China’s securities regulator figures greater participation by foreign investment banks might help mitigate the boom-bust cycles of its stock market by bringing in more institutional money, according to people familiar with the matter. To that end, Chinese officials are weighing letting them buy majority stakes in local joint ventures and expand into areas such as stock broking and wealth management, the people said in March.

Such a move could align the interests of China’s government and foreign banks who have lobbied for years for greater access: The banks would get an opportunity to carve out a larger market share in the world’s second-biggest economy, while China gets support for its push to make securities markets more efficient without jeopardizing the dominance of local firms.

“This is an opportunity for China to learn and partake more of international best practices in financial markets and as such hopefully make Chinese markets less subject to excess volatility and retail frothiness,” said Eugene Tan, head of investment banking for Asia at Oppenheimer Investments Asia Ltd.

Underwriting Dominance

Since the current system governing Sino-foreign securities joint ventures was set up in 2007, overseas firms have been limited to owning minority stakes, and have been largely excluded from lucrative businesses such as secondary-market trading in Chinese debt and equities, as well as from managing money for wealthy clients.

Even should China decide to ease curbs, Goldman Sachs Group Inc., Morgan Stanley and other foreign banks face an uphill battle: Institutional investors, their bread-and-butter clients, account for less than a fifth of the $7.3 trillion equities market. And in stock and bond underwriting, two areas foreign-backed JVs are allowed to compete in, local firms dominate.

Amid a bull market that has seen Shanghai’s stock benchmark more than double in the past year, China is now home to six of the world’s 10 largest securities firms by market value. The biggest foreign-backed JV, UBS Securities Co., had revenue of 750 million yuan ($121 million) in 2013, compared with 8.8 billion yuan for Citic Securities’ comparable operations, according to Securities Association of China data.

“It’s not going to be the case that the foreign banks would just swoop in and take away market share from the local firms,” said Zheng Chunming, a Shanghai-based analyst at Capital Securities Corp. “China is sending a message to the outside world that it has become more open. The opening up will be a gradual process.”

Investment Treaty

One question is what China will want in return for opening the industry more. President Xi Jinping agreed in November with U.S. President Barack Obama to jump-start negotiations on a bilateral investment treaty and he may use those talks to extract concessions, which could delay an easing.

“We remain hopeful that the negative list will eventually be a narrow list of strategic industries,” said James Zimmerman, chairman of the American Chamber of Commerce in Beijing, referring to the sectors China will keep protecting.

“That said, I am sure that once BIT negotiations re-commence, there will be much horse-trading going on as to the industry sectors that will remain closed and those that will be open.”

Stock Connect

A quarter-century after China created a stock market, it remains driven by retail investors, whose tendency to rush in when stocks are gaining and abandon equities during slumps has increased volatility. Mechanisms for fundraising lag far behind those in most developed markets. Lawrence D. Fink, the chairman of money manager BlackRock Inc., said last month that China “needs more robust capital markets” to help moderate swings.

Foreign firms are already showing they can help China develop its markets. UBS has been tapped by the Shanghai Stock Exchange to provide advice on setting up the stock connect program, which allows for increased two-way flows between Shanghai’s and Hong Kong’s equity bourses. The Zurich-based bank has also advised on a registration system for domestic initial public offerings, and on a 2012 program to set up algorithmic trading systems.

Overseas firms’ expertise is also being used to develop more sophisticated ways to manage Chinese block trades, which could increase liquidity and make it easier for companies and their investors to raise money quickly.

‘Small Price’

Goldman Sachs has been working on improving compliance standards in China by developing so-called wall-crossing mechanisms, which prevent participants in block trades from taking advantage of their insider knowledge by restricting their ability to trade shares until the deal is completed, according to a person familiar with the matter.

Goldman Sachs managed the only block trade in China in the past 12 months, Bloomberg-compiled data show. A spokesman for the bank declined to comment.

Foreign investment amounts to just 4 percent of China’s equity market, compared with 24 percent in Taiwan, 15 percent in South Korea and 13 percent in India, according to Steve Yang, a strategist at UBS.

“Losing control of a joint venture is a small price to pay for the Chinese to further globalize their markets,” said Lachlan Colquhoun, chief executive officer of financial research company East & Partners Asia. “It’s an important reform which in the long term will deliver much-needed change to Chinese equity markets.”

Full licenses and management control would encourage many foreign firms to get into China’s secondary markets, as well as help the country develop futures and derivatives instruments, according to Michel Lee, Asia-Pacific head of equity solutions at UBS.

Eased restrictions would give foreign firms more “skin in the game” and increase their commitment to China, meaning “more technology investments, greater talent development and research,” said Colquhoun. “It wont be a big bang, the situation will develop over time. Anyone seeing fully-fledged foreign-owned broking houses making big profits in the short term is deluding themself.”

For more, read this QuickTake: The People's Currency

— With assistance by Cathy Chan, and Aipeng Soo

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