Last year, China’s stock market took a tumble, which sent shock waves through the global securities markets. Now, money market funds are booming in China and could present the next systemic risk. While Chinese regulators have taken steps to reduce that risk, the question is whether they have gone far enough.
Assets of Chinese money market funds have doubled in the last year – from approximately $350 billion at the end of 2014 to over $700 billion at the end of 2015. These funds are primarily sold online to individual investors by Internet giants like Alibaba and Baidu.
Money market funds have become so popular in China because they offer higher interest rates than retail bank deposits. But these funds achieve higher rates by investing in a much riskier array of debt securities than U.S. money market funds – and the average Chinese investor may not be aware of the level of risk involved. If there were significant defaults in the debt securities held by
Chinese money market funds, investors would likely run for the exits, just as they did last summer in the Chinese stock market.
To prevent these potential problems, the Chinese Securities Regulatory Commission has adopted rules, which became effective in February of this year. These rules are designed to decrease the riskiness and increase the liquidity of Chinese money market funds, although the rules are still looser than the regulations for U.S. money market funds.
Since Chinese money market funds are not backed by the government, they can approach bank-like levels of risk only by holding high-quality debt securities with very short maturities. Such maturities reduce the fund’s exposure to defaults and other adverse events that can happen between the purchase date and the payment date.
The new regulations move in this direction by shortening the holding period until payment of a Chinese money market fund (the weighted average maturity of its debt securities) from 180 to 120 days. But this time limit is still twice as high as the time limit in the U.S., where the weighted average maturity is 60 days for a money market fund.
U.S. money market funds are also not allowed to use any leverage — borrowing monies and investing these monies in additional securities. Leverage is dangerous because it exposes the fund to significant risks — it would have to pay back the borrowed monies even if those additional securities defaulted.
Again, the Chinese regulations move in the right direction, though not as far as the safer U.S. standard. They reduce the maximum leverage of a Chinese money market fund from 40 to 20 percent of its assets.
Money market funds must generally stand ready to meet all shareholder redemptions on a daily basis. Given the volatile Chinese securities markets, it is critical that Chinese money market funds hold a significant portion of their assets in readily traded instruments to meet redemption requests.
Under the new regulations, a Chinese money market fund must hold a minimum of 5 percent of its assets in specified instruments with very high liquidity — cash, government bonds, bonds of government policy banks, and central bank bills. Moreover, the fund must hold a minimum of 10 percent of its assets in the above specified instruments or others due within 5 trading days.
Liquidity is especially important for wholesale bank deposits – a large holding for most Chinese money market funds. Under the new regulations, a money market fund may not hold more than 30 percent of its assets in fixed-term bank deposits, unless there is an agreement on early withdrawal. The new regulations also permit a money market fund for the first time to invest in negotiable certificates of deposits, which are traded in a secondary market.
Nevertheless, the new liquidity requirements are not as strict as those for U.S. money market funds: 10 percent of their assets must have overnight liquidity and 25 percent must have weekly maturities.
To cope with turbulent markets, the new regulations give Chinese money market funds, like their American counterparts, more tools to meet heavy redemptions. When the liquidity of a Chinese money market fund is thin, it must impose a 1 percent redemption fee on anyone redeeming more than 1 percent of the fund. And if someone tries to redeem more than 10 percent of any Chinese money market fund, it may delay the transaction or postpone payment of the proceeds.
More broadly, the regulations mandate an array of disclosures designed to educate investors about the risks of Chinese money market funds. For instance, a fund must display prominently in all sales literature that it is not a bank and offers no guaranteed returns. All sales literature must be approved by the fund manager or authorized sales institution. And any fund sold online must develop effective methods of communicating to investors its basic features, services offered, and financial risks.
Yet, the new regulations make one potentially significant change in the credit rating of fund investments, which may not be readily apparent to retail investors. Specifically, the regulations lower the minimum rating for fund investments in non-financial bonds from AAA to AA+. These are ratings from Chinese rating agencies, which some experts already view as using less rigorous standards than international rating agencies.
On the other hand, under the new regulations, fund managers are not supposed to automatically accept the bond ratings of external agencies. Instead, managers of money market funds are instructed to compare these external ratings to their own internal risk ratings before purchasing corporate bonds.
In short, the recent regulations have generally reduced the risks associated with Chinese money market funds, although they do not yet meet international best practice standards. Over the next few years, we will see whether the new restrictions will be adequately enforced by the Chinese securities regulators, and even if so, if they are enough to make this booming investment safe for individual Chinese investors.
Editor’s note: This piece originally appeared in Real Clear Markets.