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China's shadow banks, increasingly wary of lending into a slowing economy, have turned to the stock market, fueling a surge in unregulated margin lending that has driven the market's dizzying gains over the past year.
Now regulators are cracking down on shadow lending to stock investors, a campaign analysts say is partly to blame for last week's 13 per cent fall in the Shanghai Composite Index — the largest weekly drop since the global financial crisis in 2008.
"The price of funds has increased, the flow has shrunk, and transaction structures are getting more complicated," says a Chongqing-based shadow banker who provides grey-market loans to stock investors.
"We're no longer in a growth period. It's more like, feed the addiction until you die, earn fast money. No one treats this as their main career."
China officially launched margin trading by securities brokerages as a pilot project in 2010. It expanded the program in 2012 with the creation of the China Securities Finance, established by the state-backed stock exchanges specifically to provide funds for brokerages to lend to clients.
Official margin lending totaled Rmb2.2 trillion ($354 billion) as of Wednesday's close, up from Rmb403 billion a year earlier, according to stock exchange figures. Yet this officially sanctioned margin lending, which is tightly regulated and relatively transparent, is only the tip of the iceberg for Chinese leveraged stock investing.
For standardized margin lending by brokerages, only investors with cash and stock worth Rmb500,000 in their securities accounts may participate. Leverage is capped at Rmb2 in loans for every Rmb1 of the investor's own funds, and only certain stocks are eligible for margin trading.
In the murky world of grey-market margin lending, however, few rules apply. Leverage can reach 5:1 or higher, and there are no limits on which shares investors can bet on.
The money for these leveraged bets comes mainly from wealth management products sold by banks and trust companies. WMPs, a form of structured deposit that banks market to customers as a higher-yielding alternative to traditional savings deposits, also spurred China's original shadow banking boom beginning in 2010.
Traditional WMPs are backed by credit assets such as bonds, loans and money-market instruments. Ultimately much of the funds have flowed to property developers and local government infrastructure projects.
But with China's property market suffering a slowdown and the central government focused on curbing the rapid run-up in local-government debt, this form of shadow banking has receded. Meanwhile, monetary loosening has fuelled an equity boom, attracting WMP funds into the market.
"Money has abandoned the real [economy] and entered the fake [financial assets]," Haitong Securities analysts led by Jiang Chao wrote in a recent report.
"The flourishing of financial markets has caused 'ersatz fixed income' products that invest in secondary markets to become the preferred target for wealth management funds."
There is no reliable data on "umbrella trusts" — the most prevalent structure — but Haitong estimates that between Rmb500 billion and Rmb1 trillion in margin lending from trust companies has flowed into the stock market.
With a touch of financial alchemy, trusts transform an equity investment into a structured product that yields a fixed return — that is, unless something goes wrong.
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In the case of umbrella trusts, banks purchase the senior tranche, which guarantees a fixed return. They then slice up this tranche and distribute it to clients as WMPs.
Hedge funds, brokerages and other institutions subscribe to the subordinate tranche, which absorbs the first losses from stock investments but also enjoys all profits once the senior tranche holders have received their fixed return.
Subordinate-tranche investors are effectively borrowing money from senior tranche-holders to make leveraged stock bets. The interest that subordinate tranche-holders pay on the margin loans comprises the fixed returns paid to the senior tranche.
If institutional investors were the only ones making leveraged bets outside the standard margin trading framework, analysts say the risk would still be relatively limited. In reality, other types of investors are also accessing margin finance through umbrella trusts and similar channels.
A universe of so called "fund matching" companies, known in Chinese as peizi, has sprung up over the past year to provide margin funding to virtually anyone who asks. Officially registered as consulting companies, these groups also subscribe to the subordinate tranche of umbrella trusts.
After opening a securities account at a brokerage, fund-matching companies use a software program produced by Shanghai-listed Hundsun Technologies — controlled by Alibaba founder Jack Ma — to divide the account into multiple sub-accounts that enable peizi clients to trade independently. The peizi company, as the official account holder, maintains ultimate control and can liquidate any sub-account if the investor racks up heavy losses.
In mid-April China's securities regulator told brokerages to stop working with umbrella trusts. On June 13, a Saturday, the agency followed up with rules explicitly forbidding them to co-operate with fund-matching companies by offering them direct access to their electronic trading systems. The country's stock markets began their tumble the following Monday.
Market participants say peizi companies are continuing to operate, but that the scale of funds and degree of leverage is significantly reduced.
The Shanghai Composite has recovered 4.7 per cent, as of Wednesday's close, since last week's tumble and many Chinese investors and analysts believe the bull market has further to run.
But with the flow of margin finance now slowing, investors can no longer rely on flush liquidity to drive the market.