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China must get a grip on 'leftover treasure'

HONG KONG -- Yu'E Bao is now the hottest online "piggy bank" in China. It also has the disturbing potential to roil the country's financial sector.

     The online money market fund being sold by Internet marketplace giant Alibaba Group and managed by Tianhong Asset Management has offered customers an annualized return of as much as 6.76%, 27 times the rate paid on bank deposits.

     Since its launch last June, Chinese savers have stampeded into the fund, causing it to swell to 500 billion yuan ($81.3 billion) by March. Yu'E Bao fever has lifted money market funds as a whole, with the sector's assets under management more than tripling in just nine months to more than 1 trillion yuan. These investment vehicles now account for a third of the assets under management at Chinese funds.

     The success of Yu'E Bao, which means "leftover treasure" -- is no accident; It stems from the slow pace of interest-rate liberalization in China and the favorable environment there for financial innovation. High interest rates in China's interbank market amid tightening liquidity enabled the fund to offer high returns last year even as bank deposit rates remained capped.

Potential for disaster

The fund has thus helped speed up the pace of interest-rate liberalization, encourage financial innovation and foster the development of Internet finance. That said, Yu'E Bao's growth creates mounting risks that call for greater regulation and supervision to protect consumers and avert systemic volatility.

     Liquidity risks are a serious issue. Yu'E Bao takes an aggressive "T plus 0" approach to settling transactions the same day buy or sell orders are made. Most money market funds are run as "T plus 1," with the settlements coming the next day. Although Yu'E Bao in January set daily and monthly withdrawal limits of 50,000 yuan and 200,000 yuan, respectively, the one-day difference could still be dangerous if there is a run on deposits.

     This concern is amplified by the mismatch between the fund's assets and liabilities. Some 90% of the money it holds is in the form of negotiated bank deposits with terms of between one week and one month, with the rest in longer-term bonds. A surge in withdrawals could quickly drain liquidity from Yu'E Bao. As it stands, the fund now sets aside cash to cover 5% of its estimated fund outflow needs, compared with the 20% required for banks.

     At the moment, there is no official regulator overseeing Internet finance in China. Some aspects of Yu'E Bao's operations come under the supervision of the China Securities Regulatory Commission, while others fall under the ambit of the People's Bank of China. Some activities appear to be unregulated, such as the practice of allowing customers to top up their accounts at convenience stores or drugstores -- essentially a form of deposit-taking.

     This situation creates an opening for possible money laundering, tax evasion or illegal transactions, given the difficulty of tracing the origin of transferred funds and the absence of the kind of due diligence practices required of banks.

     Another result of inadequate supervision is a lack of transparency. Yu'E Bao's website highlights only past yields and shows the procedures for opening accounts. Information on the fund's underlying assets, investment scope, management strategy and associated risks are all absent, which could lead customers to misjudge the risk of investing. Also, Yu'E Bao's customer identity verification systems are looser than those of banks, which has already led to several cases of fraudulent withdrawals.

Time for real oversight     

Enthusiasm for Yu'E Bao has cooled slightly now that competing products from Internet rivals, including Tencent Holdings and Baidu, are entering the market. Also contributing to the fading excitement is that banks are awakening to the new threat from the web, and yields are being pushed lower by the decline in interbank rates. But supervision quickly needs to catch up with innovation, because Yu'E Bao's expansion could present systemic risks to the financial sector.

     China's four main financial regulators should form a joint committee with the Ministry of Industry and Information Technology to ensure comprehensive supervision. Stricter due diligence should be required to minimize the risks of illegal fund flows. Also, capital requirements should be clearly addressed, with more funds required to be set aside to discourage aggressive risk-taking.

     Last but not least, there needs to be a new regulatory framework for protecting consumers that clearly identifies the responsibilities and obligations of online financial services providers, including the full disclosure of product information, fund structures, and the risks and returns involved. This will also require a customer insurance system and a dispute arbitration system.

     The rapid growth of internet finance is forcing China to confront the need to liberalize its interest rates. Banks will be challenged on their efficiency when deposit rates rise and interest spreads narrow. The country urgently needs to move forward on a long-awaited deposit insurance system to lower risks in the financial sector.

Yifan Hu is chief economist, head of research and managing director of Haitong International Research in Hong Kong and the author of "Strategic Priorities: China's Reforms and the Reshaping of the Global Order."

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