Internet Finance: Barbarians in the House

Yifan Hu (PIIE)



Yuebao is now the hottest online “piggy bank” in China. It is essentially an online money market fund at Alibaba managed by Tianhong Asset Management Corporation that offers daily settlement of interest returns up to 6.76% annualized rates, 27 times higher than that at the transaction account in banks. The fund’s rising yield since last July further heated the popularity of Yuebao and drew billions of RMB from millions of investors. Yuebao reached RMB 100 bn last November, six months after its launch, and shot to RMB 400 bn this February. The fever for Yuebao has also fueled money market funds as a whole, sending its assets under management (AUM) to over RMB 1 tn from RMB 303.8 bn in nine months, accounting for one third of the total AUM of China’s fund sector.

The success of Yuebao is not accidental but a mixed result of special timing in the process of interest rate liberalization and favorable environment for financial innovations. On one hand, interest rates in the interbank market have been fueled by tightening liquidity conditions since last October, leading to a surge in the interbank Shibor rates especially before the Chinese new year. For example, 1-week Shibor rates soared to 8.84% last December, and 5.36% in February. Yields of Yuebao, 90% of which come from Negotiated Deposits (ND), have therefore surged. On the other hand, deposit rates remain regulated in China despite the recent liberalization of loan rates, therefore banks can only offer limited upside to depositors. Yuebao has leveraged the concept of money market funds providing rates linked to Shibor and of transaction accounts offering daily settlement. High yield with perfect liquidity has made Yuebao an unbeatable product, draining RMB 400 bn from banks in a click.

Rapid expansion of Yuebao has de facto speeded up the pace of interest rate liberalization, pushed banks to face challenges of rate hikes, encouraged financial innovations and fostered development of internet finance. On the other hand, however, increasing risks and concerns have gradually observed in this new field and called urgently for proper regulation and supervision to avoid large system fluctuations and protect consumer interests.

Serious liquidity risks further amplified by fund structure

Liquidity risks are a serious issue for Yuebao’s case, mainly originating from its aggressive T+0 terms in transactions, significant maturity mismatch between assets and liabilities, and loose risk management. Specifically,

  • Yuebao offers aggressive T+0 terms in transactions while money market funds run under T+1 basis, which imlies Yuebao is responsible for paying one day in advance for daily settlement. The 1-day time difference could raise serious troubles for Yuebao in the case of bank run despite its efforts in January to set RMB 50 k and 200 k as daily and monthly cap respectively for funds withdraws.
  • Significant mismatch of maturity in liabilities and assets is another core. About 90% of Yuebao’s assets are allocated on ND with maturity of 7 day, 2 weeks and 1 month; and the rest are put on bonds with longer term and higher yields. Daily settlement at T+0 terms suggests that a large flow of withdraws that exceeds provisions could quickly drain liquidity of Yuebao and cause defaults immediately.
  • Aggressive risk-taking strategy makes Yuebao to use their own model to estimate cash needs and keep 5% of estimated funds outflows as extra provisions comparing with 20% reserve requirements for banks.

Furthermore, as a typical internet financial product, liquidity risks associated with Yuebao could be amplified and spread quickly online, and therefore intensified in adverse situation via fat tail effects. For example, the incident of Yuebao’s yield ticking to zero on February 12, which was later proved to be a technical issue, caused panic among depositors and led to quick fund outflows, reflecting fragility of internet finance.

Absent any clear framework of regulations and supervisions

There is no official regulatory body on internet finance thus far despite its rapid expansion. Currently, Yuebao’s settlement account of the money market fund is supervised by CSRC, while its provision account is supervised by PBOC. Money transfer between these two accounts is lack of any clear supervision. In addition, accounts at Yuebao can be topped up via various channels at convenient stores, which are essentially deposit-taking activities but not regulated by the PBOC.

Absence of any clear regulatory framework on internet finance leads to insufficient compliance requirements on this newly growing sector, while in comparison, strict compliance with due diligence is emphasized by the banking sector and other non-banking financial sectors for the purpose of reducing money laundering and crime. Various top up methods of Zhifubao, the parent account of Yuebao, enables anonymous transfer of funds via convenience stores, cell phones, drug stores, post offices, etc., which is ideal for money laundering, tax evasion and illegal transactions. Cross transfers among Zhifubao, Yuebao and other accounts will make it extremely difficult to trace the origin of funds. Furthermore, the de facto deposit-taking activities are also out of any regulations by the PBOC or CBRC.

Vague supervision also leads to a lack of transparency in disclosure and insufficient investor education. Information published by Yuebao on its website only highlights its past yields and account opening procedures, which are not sufficient for investors to fully understand the fund’s underlying assets and associated risks. Fund size, investment scope, management strategy and risk assessment are all in absence. Insufficient public information regarding the fund may mislead investors with less risk preference and caused unexpected losses in adverse market conditions.

Cyber security concern

The loose identity verification mechanism of Yuebao and Zhifubao accounts has led to several cases of unauthorized transfers from victim’s account to a criminal’s. The password of a Zhifubao account can be reset online by providing an identity card number and a 6 digit verification code that is sent to one’s cellphone via text. A forged identity card is therefore sufficient to gain full access to one’s Zhifubao account and linked Yuebao account as Telecom companies only require an identity card for replacement of a SIM card. While this is a convenient solution for forgotten passwords and enhances user experience, there remains a cyber security concern especially after Yuebao allowed larger amounts of cash flows to Zhifubao; in comparison, bank accounts are protected with much stricter verification mechanisms and more solid IT infrastructures.

How far can Yuebao go? Policy orientations to tackle challenges ahead

How far Yuebao can go is not the key point as it will inevitably cool down when favorable market conditions no longer hold. First, the interbank Shibor rates declined due to liquidity easing after Chinese new year, so did the ND rates and Yuebao yields. For example, 1-week Shibor slid to 2.82% on March 3 from 5.41% on February 1 and ND rates dropped to 4% in March from 9% in early February, and thus the annualized yields of Yuebao fell down to 5.93% on March 3 from 6.76% on January 2. Second, Yuebao comparables offered by either internet companies or banks have emerged quickly to compete for market shares. For example, Tencent, Alibaba’s major competitor, offered Caifutong reaching RMB 50 bn for the first 40 days after its launch; eight banks launched wealth management products linked to money market funds via their controlled asset management companies. As a result, Yuebao’s market share will dilute quickly and become a normal player in the market. And Yuebao will not substitute traditional banks, as it mainly competing in sources of liability while banks remain expertise and experience in managing asset side of balance sheet.

The Yuebao fever, however, provides two lessons for China at its current stage of capital market development. First, supervision needs catch up innovations quickly in a fast moving modern society. Yuebao presents serious exposure to risks especially given its rapid expansion, which might trigger systematic risks in the financial sector. Instead of shutting them down, regulations and supervisions should move quickly to vest risks associated with Yuebao and Yuebao comparables. As discussed above, a joint supervisory committee should be established by the PBOC, CSRC, CBRC, CIRC and MIIT (Ministry of Industry and Information Technology) for comprehensive cross-board supervision. Stricter due diligence should be required to minimize potential risks of illegal deals with Yuebao. Furthermore, capital requirements for payment and provision accounts should be clearly addressed. For example, loss provision requirements for money market funds currently set at 10% of accrued management fee with cap of 1% of AUM should be increased to discourage aggressive “risk-taking” behaviors like Yuebao. In fact, CSRC published a clause in 2011 to require loss provisions to cover 200% of accrued interests, but it has not been well implemented in practice. In this case, the loss provisions required for Yuebao will have to rise to about RMB 2 bn from its current RMB 100 mn, which will facilitate a more healthy development of Yuebao. Besides loss provisions, zero punitive deductions for an earlier ND withdraw should be revised to ensure stability of banking system in liquidity management. Last but not least, regulation framework on consumer protection of internet finance should be established urgently given fast movement in the sector to clearly indentify responsibilities and obligations of product providers, fully disclosure product information, structure, returns and risks, set up insurance system, and build up arbitration agency for disputes.

Second, rapid growth of internet finance has de facto push liberalization of interest rates. It forces regulators to liberalize interest rates backed by strong needs of the market, and challenges banks’ capacity for a more efficient management facing rising deposit rates and narrowing interest spread. The long-awaiting deposit insurance system is urgently needed to lower risks of the financial sector.

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