The China Securities Regulatory Commission’s (CSRC) investigation into Everbright Securities’ (Everbright) (SHA:601788) massive trading software failure on August 16th produced the harshest penalties yet seen for a Chinese brokerage this past September. When a newly installed computer system placed over 26,000 buy orders worth some USD 3.8 billion on the Shanghai Stock Exchange in under two-seconds, Everbright traders were directed to recover their losses with additional trades before alerting exchange regulators or the market.
Four senior executives now face criminal charges and a lifetime ban from trading for their involvement in an event ruled by the CSRC to be insider trading. The company’s president has also been forced to resign following Everbright’s ban from proprietary trading, along with the forced return of all illegal gains made from the original trades, and a record-setting USD 150 million fine.
In contrast to these events, Everbright’s sister-company, China Everbright Bank (CE Bank) (SHA: 601818), was approved by the CSRC to launch its third IPO attempt in Hong Kong during October, and is currently awaiting clearance from HKEx regulators to move ahead with its listing. Taken together, CE Bank and Everbright’s combined experiences over the past several months are reflective of the contradictory trends that currently exist between China’s domestic regulatory environment and capital markets.
Effect of Market Reform on Governance and Financial Performance
At a time when regulators are attempting to restore investor confidence in mainland equity offerings by using listing bans as a means to improve IPO due-diligence standards, domestic securities firms have been permitted by the CSRC to offer broader ranges of trading services in a bid to expand China’s nascent financial services industry.
For the firms that built large brokerage commission businesses around the flood of new IPOs in 2009, however, the continuing decline in quality and trade volume of China’s A-shares has meant that revenues from regular market trading activities have fallen in parallel. Disclosures in SynTao’s IPO Database from Everbright and its second-largest shareholder, China Everbright Limited (CE Ltd.) (HK: 0165), reveal the most material risks that brokerages encounter in mainland markets, along with the difficulties CE Ltd.’s USD 1.7 billion investment has faced amongst increasingly challenging market conditions.
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Company |
Disclosures |
Disclosure Type |
Content |
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CE Limited (HKG:0165) |
- |
Risk Factors |
Explains that growing reliance on IT systems for financial control, risk management, credit analysis and reporting, accounting, and consumer service, is a growing industry risk. p.27 |
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The banking industry in the PRC and associated regulations are undergoing significant changes, and that there is considerable uncertainty surrounding the regulations which already exist. p.29 |
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Everbright Securities |
33% (USD 1.7 Billion) |
Risk Factors |
“Centralized trading and clearance system at headquarters in order tomaximize the automation and control of the system, reducing risk of errors from manual operations.” p.31 |
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Business Model Risks |
“The company has developed a new non-brokerage business in order to reduce exposure to stock market volatility. Everbright has mitigated its risks to some extent by increasing its margin and proprietary trading business.” p.96 |
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Financial Performance |
Total Revenue 2009–2012: -49%, Profit contribution to CE Ltd. 2009–2012: -69% |
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Underwriting revenue 2011-2012: -77%, down to 5% of total 2012 revenue |
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Brokerage commission revenue 2009–2012 : -33%, down to 33% of total 2012 revenue |
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Proprietary and margin trading revenue 2011–2012 : +217%, up to 20% of total 2012 revenue |
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Net profit Jan-Sep 2013: -44%, “August 16 incident may lead to deficit of 2013 accumulated net profits”p.10 |
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CE Bank |
4.21% (USD 832 Million) |
Financial Performance |
Total profits before tax 2009–2012: +301%, profit contribution to CE Ltd. 2010–2012: +730% |
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CE Bank dividend payouts 2009-2012 : +195% |
In order to maintain market position, Everbright, which was permitted by the CSRC to further expand the higher-risk trading services it conducts throughout 2012, may have overstretched its proprietary trading business amidst a steep decline in income from traditional revenue sources. In contrast, despite stating that it has required an additional mainland public offering in order to re-capitalize for three consecutive years, CE Bank has realized steady profit growth ahead of re-announcing its plans to list in Hong Kong.
Combing Reform Efforts with Market Risks
With the Shanghai Composite Index still in long decline relative to 2010, regulators and investment professionals will have to pay much closer attention to how the financial services industry has balanced tough market conditions with new regulatory measures to avoid a repeat of Everbright’s trading incident.
More mature capital markets overseas have faced significant technical and business-model challenges in recent years dealing with the complications proprietary and margin trading units can create on fast-moving exchanges. While the CSRC has made clear to the over 400 remaining IPO applicants how serious it is about improving prospectus standards, the band-aid solution of allowing much smaller securities businesses to take on increased risk in a bearish market requires greater regulator attention should the listing ban continue. In the meantime, investors should work to cross-check ongoing disclosures alongside regular financial reporting to determine which businesses may eventually see their stated core governance and business risks realized.
Written by Ta*ylor Brown
This article was originally published in China ESG Monitor (October 2013) -- a monthly newsletter highlighting ESG trends and research relevant to sustainable investment in China.
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