- Investigation First Focused on Shorting Method for Foreigners
- "Looks from the outside like an unfair and arbitrary search"
The fall from grace for China’s biggest brokerage and investment bank, Citic Securities Co., has been fast and steep. The firm -- sometimes referred to as the Goldman Sachs of China -- began the year on its way to eclipsing UBS Group AG in the ranks of the top four securities firms in the world.
Now it’s embroiled in a police investigation and a probe by the stock-market regulator. Its chairman is being replaced and its top leadership reorganized. At least nine Citic executives have been investigated for alleged insider trading or haven’t shown up to work and can’t be reached.
The origins of its turmoil lie in its role as the highest flier in China’s developing finance field, caught up in the fallout from a stock market crash starting in June that erased $5 trillion in value. Encouraged by multiple pronouncements from policy makers that they wanted Chinese firms to develop the finance tools used in the rest of the world, Citic became a leader. Short selling, stock-index futures, cross-border return swaps -- all were on the table, all permitted with qualified nods by China’s regulators, until the rules changed and suddenly they weren’t.
"The sands of regulation in China are always shifting, and the rules are never quite as solid as you would expect in a more advanced economy," said Arthur Kroeber, Beijing-based managing director of Gavekal Dragonomics, an economic research firm. "They come up with a product at a time when the markets are fairly quiet, and the regulators say fine. Then when there’s a problem, the reflex of the authorities is volatility is bad and this psychology of ‘If markets go down, then someone must be at fault.’"
The initial police probe of Citic Securities focused on whether the firm was giving foreigners a way to short stocks on the so-called A-shares market in China at the same time that it was engaged in government-sponsored plans to prop up the market, according to a person familiar with the events of the past few months who asked not to be identified because of the sensitivity of the investigation.
A presentation to foreign investors seen by Bloomberg News, and people in the finance industry pitched on the products, indicate that Citic Securities was marketing such structures to hedge funds as late as June, after the market began its slide. In July, the Ministry of Public Security said it was investigating “malicious” short selling blamed for the stock rout. Chinese officials embarked on a series of rule changes aimed at halting the market’s decline, including restricting short selling, in which investors borrow securities and then sell them as a bet that their value will fall.
Citic Securities’ privileged position as a unit of China’s first state-owned investment group with an international footprint allowed it to experiment in ways few other brokerages could attempt, testing the limits of China’s push to open to foreign investors in its bid to win a larger overseas clientele. Citic had been on an extraordinary run since November 2014. That month Citic Securities predicted its annual revenue could climb to 120 billion yuan ($18.6 billion) by 2020, a six-fold increase. The next month, it surpassed Credit Suisse Group AG in market size, putting it at No. 4 among global securities firms. In mid-June, Citic Securities raised $3.5 billion selling shares in Hong Kong, attracting sovereign wealth funds from Kuwait, Singapore and Malaysia, just as the Shanghai Composite Index began its retreat from a seven-year peak.
By early July, with the Shanghai gauge off 29 percent, the government ordered Citic and other Chinese brokerages to pour billions of yuan into orchestrated buying -- as much as 900 billion yuan in June and July, Goldman Sachs Group Inc. estimated. Yet the Shanghai index continued its slide, bottoming out on Aug. 26 after a 43 percent fall from its June high.
The police began to focus on cross-border products that Citic offered, called total return swaps, according to people familiar with the investigation. Only after the probe began did police widen their focus, the people said. At least seven Citic executives are being investigated for alleged insider trading, including President Cheng Boming, China’s official Xinhua News Agency has reported. Citic has been unable to reach two other top company officials, according a company exchange filing on Dec. 6.
A Citic Securities’ spokeswoman said that, beyond the filings made to the Hong Kong Stock Exchange, the firm had no additional comment except that it "has and will continue to fully cooperate with the regulators in the relevant investigation and strictly fulfill its disclosure obligations in accordance with the relevant requirements."
The crackdown has also swept up fund managers and regulators, including Zexi Investment’s Xu Xiang and Yao Gang, a vice chairman at China Securities Regulatory Commission who supervised initial public offerings until earlier this year. None of those targeted has been reachable for comment. Late last month Citic disclosed that the CSRC is investigating it over alleged breaches of rules regarding short selling and margin contracts.
The CSRC and China’s Ministry of Public Security didn’t respond to questions via fax seeking comment.
"The Chinese market has been plagued by corruption and insider trading since its early days, and the securities companies have repeatedly been implicated in improper behavior," said Barry Naughton, a professor of Chinese economy at the University of California in San Diego. "So a well-targeted and fair anti-corruption probe there would be welcomed by many people. But this process looks from the outside like an unfair and arbitrary search for someone to blame for the summer market meltdown, and it is making everybody in the industry extremely nervous."
The swaps that the authorities began investigating were legal, tuned to China’s push for financial innovation in the nation’s 12th five-year plan, and even lauded -- until the market started to tank. Citic got the go-ahead to offer cross-border swaps, which can also be used for long positions, on a pilot basis in early 2013, according to the person familiar with the matter. Wang Dongming, Citic Securities’ outgoing chairman, discussed the swaps in an interview with the China Securities Journal in May 2013, calling them an innovation that brokerages could use to serve foreign institutional clients and high net-worth individuals. The city government of Shenzhen named the swaps among the top financial innovations of 2014.
The firm made no secret of this strategy in the foreign investment community, as the pitch presentation from unit Citic Securities International Ltd. shows. The document, dated June 2014, was still being circulated to investors in June this year, according to a lawyer who saw it at the time and asked not to be identified because of the crackdown. The target audience of the pitch was hedge funds "still shut off" from China’s "aggressively growing capital markets," according to a preface in the second slide of the presentation.
Citic Securities "is standing out as the leader in the regard of market access and product innovation," ran the rest of the preface. "Rendering greater market opportunities to foreign financial institutions will be a vital prerequisite for the firm’s global strategy and sustainable development."
Swaps allow investors to gain exposure to assets -- shares, stock indexes, bonds -- without owning them. In this case, Citic Securities owned the asset, trading a fixed payment from the foreign investor for the returns from the asset. In the swap structure outlined in the document, Citic Securities proposed to open a sub-account under its proprietary trading operation in mainland China, but have it controlled by "infrastructure/algorithms" provided by the foreign investors or funds.
A diagram in the presentation showed how profits or losses from the onshore trading would be paid or billed to the foreign company outside of China, via Hong Kong-based Citic Securities International. In exchange, Citic International would receive international collateral as well as a fixed fee from the foreign investor. In theory, no money crossed the border, because Citic Securities and Citic Securities International could transfer funds within their own structure.
Citic was effectively allowing foreign firms to trade in China’s onshore markets by issuing instructions to the managed account. There is no indication in the presentation of limits on how the structure might be used -- the diagram lists "investment" going into "Futures, Equities, Fixed Income, etc."
China limits how, and how much, foreign institutions invest in China’s domestic securities market through the Qualified Foreign Institutional Investor program and others. The biggest foreign firms have their own QFII allocation, a money limit that they can use themselves or chop up and rent to smaller institutions. China expanded the program in 2012, but it remains a highly controlled and cumbersome procedure that’s slow and expensive.
China’s newer stock connect program, which allows those outside China to trade Shanghai-listed stocks through a link with the Hong Kong market, has opened up another limited avenue. A swap, on the other hand, could theoretically be set up in a day, if both sides agreed on the terms of the contract. Though cross-border swaps are common in many markets, few institutions in China besides Citic have the domestic and international operations to make them work.
An investment banker who saw the swaps pitched on multiple occasions said Citic marketed them as giving access to any market, from stocks to index futures to commodity futures. A hedge fund adviser who sat in on a pitch for the swaps said Citic touted the swaps as a shorting tool as well. He said he discussed swaps, including shorting index futures, in a meeting with Citic in June. Both asked not to be identified because of the Chinese regulatory scrutiny. Foreign investors, even QFII holders, had very limited means of short selling in the Chinese market. In August, as part of a rescue package for the market, regulators further limited short selling for domestic investors as well.
Last month, the Securities Association of China ordered the country’s brokerages to suspend issuing new swaps that involve borrowing, saying they had been misused as a way to create leverage for stock trading rather than as a risk management tool. If clients want to use leverage for share purchases, they should use margin finance, where the equity holdings are used as collateral for borrowing, the association said.
After the police probe began, Citic set up its own internal inquiry into what happened, according to the people familiar with the investigation. That investigation found that the firm began betting against stocks at the same time as it was participating in the government-sponsored market rescue, they said. Regarding the swap business, the internal investigators concluded that the volume was too small to be held responsible for the wider market drop, the people said. They also found investors may have taken advantage of the swap product but that it was not Citic’s intention to short Chinese markets, one of the people said.
The future of Citic is uncertain. It could be acquired by a rival in a regulator-driven transaction if its woes deepen beyond existing management "turmoil," according to analysis from Daiwa Securities Group Inc. Chairman Wang, 64, who hasn’t been implicated in the government investigations, is officially retiring due to his age, according to a company statement in November.
"They weren’t cracking down on people when prices were going up, then when they went down and they wanted people to cooperate, out came the club," said Patrick Chovanec, chief strategist at Silvercrest Asset Management Group in New York. "It’s like the government has call options on everybody. They’re like, ‘Go do what you want, and I’m going to pretend it’s not happening, but the moment that I want to, I can just call it.’"
— With assistance by Keith Zhai, Dune Lawrence, and Cathy Chan