Watchdog eyes more risk taking

Mainland securities regulator seeks to allow brokers to trade complex financial products despite Everbright's fiasco

PUBLISHED : Wednesday, 02 October, 2013, 12:00am
UPDATED : Thursday, 03 October, 2013, 1:48pm

The China Securities Regulatory Commission is forging ahead with rules that allow brokers to invest in complex financial products and enter risky new businesses even after an unprecedented US$3.8 billion trading error roiled markets.

In the past six weeks, the regulator ended an 18-year hiatus on trading of treasury bond futures and said it would let more brokerages borrow stock for short selling.

Those measures were disclosed after misplaced bets caused by faulty software at Everbright Securities in August caused the wildest swings in Shanghai shares since 2009.

Policymakers, seeking to improve allocation of capital, have since 2008 permitted brokerages including Everbright to offer clients short selling and margin trading, as well as betting on derivatives with their own funds.

While the state-controlled brokerage has now been suspended from most proprietary trading, CSRC chairman Xiao Gang shows no loss of appetite for risk taking.

"This is definitely the direction to go for brokerages, but with great opportunities come great risks," said Zhang Yanbing, an analyst at Zheshang Securities in Shanghai. "When things become more complex, it will bring unpredictable risks.

"There's a lot about market risks that we need to learn from developed markets."

Faulty trading software used by Everbright's proprietary trading desk, which specialises in high-frequency trading, sent out 26,082 unintended buy orders in just two seconds on August 16, the company said in a statement two days later.

The mistake, which the securities regulator characterised as unprecedented on the mainland, led the benchmark Shanghai Composite Index to swing more than 6 per cent.

Two weeks later, the CSRC said futures contracts on five-year treasury bonds would start trading from September 6. A week later, it gave approval for the Dalian commodity exchange to start trading of iron ore futures.

That was followed by China Securities Finance's decision to expand a programme that allows brokerages to borrow stocks from the state agency and lend to clients. The list of firms was broadened and the number of securities that qualify was tripled.

August's trading error had thrown a spotlight on potential weaknesses in new businesses such as computer-driven trading, said Zhou Xiaowen, an analyst at Huachuang Securities in Beijing.

"People weren't paying much attention to the risks associated with brokerages' use of quantitative investment strategies," Zhou said. "Companies that have been aggressive, but lacked robust internal controls, will start to pay more attention to potential problems tied to trading systems."

The securities watchdog has pledged to scrutinise risk controls among the brokerages.

Measures to clarify the definitions and standards for abnormal trading - and determine if requests to erase an erroneous trade are justified - would be issued, the CSRC said.

The regulator also aims to enhance the management of trading systems and related controls, establish a system for cancelling orders and set up a disclosure mechanism.

While internal risk controls need to be strengthened at the brokerages, the market-driven changes are improving regulation within the securities industry, according to Luo Yi, an analyst at China Merchant Securities in Shenzhen.

"Barriers have been brought down in many other areas that had previously been blocked," Luo said. "The regulator is very clear about its reform agenda, that it wants to let the market play a bigger role and it also wants to step up enforcement."

To help the brokerages develop new lines of business, the CSRC in November last year expanded the types of financial products that the firms could invest in through their proprietary trading desks to include some over-the-counter securities, according to statements posted on its website.

It also allowed qualified firms to trade financial derivatives for investment gains, instead of limiting their use for hedging.

The Everbright snafu "is a watershed in the sense that brokerages' internal risk controls will face stricter requirements as a result", said Zhou. "The incident attracted a lot of attention and the regulator is likely to introduce new rules to tackle the issue."