Marginal progress

As if to confirm that things were proceeding as normal, October 30 saw the publishing of the Tentative Provisions. They became effective on December 1 and allow securities companies to apply for approval to expand the scope of their business.

But lawyers say that just because Provisions have been published does not mean there will be a sudden surge in margin trading activities. The Tentative Provisions are intended to regulate the scope of the business of securities companies in general, and only briefly mention margin financing and short selling.

Despite this, they are another important piece of the legislative puzzle that has been falling into place over the past few years.

Article 5 states that securities companies can now apply to engage in so-called Novel Business. According to the Regulations for the Oversight of Securities Companies, this kind of business includes margin lending and stock lending.

The Tentative Provisions also give the CSRC 45 working days to approve or deny an application.

“It's important in the sense that it gives a clear timeline,” says Jane Jiang, counsel with Allen & Overy in Beijing. “Theoretically, the first firm could start doing margin trading business early next year.”

Although it has provided a path for the expansion of the securities business in China, the government is making it clear that it will keep very close control of the process and will only approve a few firms at first.

“The CSRC will handpick the first batch of eligible securities firms,” said a November 2008 Xinhua report. An earlier article in the Shenzhen Daily had quoted a CSRC official as naming four firms which the regulator was “likely to pick … as leaders of the programme”.

Citic Securities, Haitong Securities, Guotai Junan Securities and Everbright Securities were specifically mentioned in that report.

“My understanding is that those are the potentially qualified firms to do short selling,” says Jiang. “They are running a pilot scheme – so they have absolute discretion to allow just one or two securities firms to do it in on a small scale.”

Whichever firms get final clearance, it is very likely that they will be chosen from the 11 that successfully finished online testing with the China Securities Depository & Clearing Corporation in October.

Tight scrutiny

The pilot scheme is described in Article 10 of the Tentative Provisions, which also gives the CSRC the power to assess any firms which want to expand their business. Lawyers say that this assessment and approval process is likely to be tough, as regulators will be especially concerned about risk management and control.

“I suspect that at the initial stage, the inspections would be quite stringent particularly in respect of the margin lending business given that it is new to the regulators,” says Fang Jian of Linklaters.

Li Zhi-yong of Chang Tsi & Partners in Beijing takes a different view, pointing out that the CSRC's time limit for approval is relatively short.

“On the other side, criteria for approval are explicitly listed as of Article 8,” he adds.

These are positive developments. Securities companies have always been subject to an approval system for the expansion of their business activities, but the criteria in the Tentative Provisions have been relaxed when compared with the previous rules.

The mention of “experts” in Article 10 also suggests the implementation of an expert evaluation system for Novel Business. This also amounts to a relaxing of approval requirements, says Li.

Once firms have successfully obtained a permit to engage in new business, oversight is likely to remain tough. The Tentative Provisions appear to give the CSRC a broad mandate to continue its monitoring of the firms. Article 18, which is built on the foundation of Article 150 of the PRC Securities Law (中华人民共和国証券法), aims to strengthen supervision and punishment of securities firm. It allows the Commission to “take measures” against a firm if “its risk control indicators fail to comply with provisions”.

Recent events across the world have shown that large-scale risk control and management failures can happen even in the more developed or sophisticated markets. The CSRC is understandably concerned with protecting the integrity of the Chinese securities and financial system, and is proposing a pragmatic approach to risk management: in Article 12, securities companies are told that they must “take effective measures to commence investor education activities” if they begin to engage in margin trading and short sale of securities; the Commission also has power to take corrective action on any errant companies, including the withdrawal of the firm's business permit.

“Hopefully, these measures only need to be preventative in nature. No one wants any risk control failures or to deal with the mess from them,” says Clifford Ng, a Hong Kong partner of K&L Gates.

The time is right

Although China seems to be taking an opposite road to the rest of the world, it is doing it in a unique way, retaining plenty of authority.

“The regulator has absolute control of the number of companies doing it. They can also control the type of stocks that can be traded,” says Jiang of Allen & Overy.

The 2006 Trial Measures stipulate that companies engaging in stock lending can only lend stocks that they themselves own. The Commission has been studying the profiles of the pilot securities companies, says Henry Chan, a tax and business advisory services partner with Ernst & Young in Beijing. The potential scale of stock lending is therefore limited due to the stock position of those securities companies.

“They actually have more cash than stock,” says Chan. “The scale of stock lending might not be very big, because they have more cash to lend than stock.”

Meanwhile, margin lending basically boils down to encouraging people to buy shares, which is not contrary to what the rest of the world is doing.

The government's obvious efforts to modernise its markets should also give people confidence in the regulators, says Ng. Although the current market conditions are bad, that may be helpful in illuminating areas of risk. “[It] certainly reveals risks in a plainer light than in roaring bull markets,” he says.

Specialists agree that margin trading can not rescue the markets or the real economy, but some say that opening up new channels of business can help stabilise the market and provide more liquidity.

“The recommendation of margin trading business at present may bring into full play its function for market salvage,” says Huang Weimin, senior partner of Grandall Legal Group.

No takers so far

The process which has resulted in the (delayed) pilot scheme of December 1 has been long and has stirred up debate. The new Provisions have sparked considerable interest, and should encourage securities companies to expand.

“I think [securities companies] would be willing to apply for profile-raising purposes, and for long-term business scope,” Jiang says.

But no firms have yet applied. A China Daily report dated December 1 quoted brokerage firms as saying they were “still waiting for the specified guidelines from the regulators.”

These guidelines have been described as “more detailed qualification requirements” by one Beijing lawyer. No official explanation has been given for the delay in their publication, and the CSRC did not respond for requests for information. It is likely that the sheer complexity of drafting suitable guidelines in the middle of market turmoil is a significant factor: regulators all over the world are struggling to find rules that work.

“Market participants are on both sides on issues such as the uptick rule in the US,” says Ng. “The addition of shorts and futures adds exponential levels of complexity to the required regulatory framework.”

Nevertheless, the CSRC is not giving up. It has been reported that a final list of firms for the pilot scheme will be published in January 2009. The Shanghai Stock Exchange is also expected to issue its own rules for margin trading.

When the scheme eventually starts, and if all goes well, more areas of business could be opened up to individuals and institutional investors. But it is certain that the regulator will be watching very closely.

“Given the global regulatory direction, I think they will be extremely cautious not to become the laughing stock of other regulators around the world,” says Jiang.