Securities firms face inevitable change in business model

Small and medium-sized companies will have to fight to survive

The profit margins of securities brokers on the Chinese mainland will be further eroded as competition intensifies and the market opens up. A focus on product innovation and business diversification is therefore a must for those who want to succeed.

For a long time China's securities sector has tended to market a narrow range of similar products and services. This is especially true for brokerage businesses that provide customers with trade execution platforms only. Heavy reliance on traditional brokerage services as a major income stream has resulted in challenges to sustain growth.

According to KPMG's new survey on China's securities sector, brokerage income as a proportion of gross operating income stood at 52 percent in 2011, compared with 72 percent in 2008. Over the same period, severe competition further affected the brokerage commission rate, which fell from 0.18 percent to 0.08 percent.

The disappointing performance of brokerages due to dwindling trading volumes and commission price wars, together with poor results from proprietary trading amid the weak-performing stock market, largely dragged down the sector's results in 2011, and we saw this trend continue last year as competition remained severe and market performance remained weak.

Gross operating income in 2011 fell 29 percent to 136.3 billion yuan ($21.9 billion; 16.8 billion euros), of which income from traditional brokerage and proprietary trading fell 36 percent and 77 percent respectively. Overall net profit fell 50 percent to 39 billion yuan, even falling short of the levels seen during the 2008 financial crisis (50 billion yuan).

Profit margins are expected to remain under pressure as competition will intensify with more players coming in following recent market reforms. So a shift in the business model is inevitable for China's securities sector if it is to achieve sustainable growth.

As China pushes ahead with reform, it will expedite the development of a multilevel capital market and promote more innovation of financial products in an effort to deepen and broaden its capital market.

With the recent relaxation in rules, the range of customer-driven financial products that securities companies are permitted to sell has been extended to include various financial products endorsed by or filed with the government. These include bank wealth-management products, trust products and private equity investment products.

The new policies allow securities companies to provide integrated financial services, including providing investment advice, wealth management, margin trading and short selling, futures trading and investment banking. Securities firms have a strong franchise and large client base, and it is expected they will leverage their franchise and client base to make the most of the opportunities arising from relaxed rules.

Assets management is one of the business areas with vast potential, but Chinese brokers are yet to explore it. In 2011 asset management contributed only 2 percent of the sector's operating income, compared with 16 percent to 22 percent of their foreign counterparts, KPMG's recent survey showed.

On the other hand, China's capital markets are set to become more market-oriented and internationalized; the pace of opening the market to overseas investors has also accelerated, and is therefore expected to affect Chinese securities firms' performance and development models.

In October the China Securities Regulatory Commission amended rules for the establishment of foreign invested securities companies to raise the ceiling on foreign ownership from 33 percent to 49 percent. It also amended the trial provisions for the establishment of subsidiaries by securities companies to allow subsidiaries of securities companies to extend their business scope after two consecutive years of operation, subject to relevant conditions being met.

These policy changes have markedly shortened the time for some joint-venture securities companies to be granted new business licenses. If additional joint-venture securities companies are allowed to extend their scope of business, further innovation and competition may be introduced into the market.

Now, only 12 out of 109 securities companies in the Chinese mainland are joint ventures. We expect more joint ventures in the pipeline as these changes make the market more appealing to foreign investors as they can now exercise greater influence in joint-venture arrangements. Innovation in products and services can be achieved by introducing overseas experience and expertise, and increasing competition. Meanwhile, China's securities brokers continue to set their sights on expansion and overseas listing opportunities. Nevertheless, only a few Chinese securities companies have entered the overseas markets in recent years through listings or acquisitions. The stringent requirements have hindered Chinese securities companies, especially the small and medium-sized ones, to go global. For example, Chinese brokers need to have net capital of no less than 3 billion yuan and a market share of no less than the industry's average level in core business. They should also have had a BBB rating or above for their last two ratings (and an A for at least one rating), and need to have been profitable for at least two of the previous three years. Because of these barriers, securities companies are looking for lower thresholds.

Still, there are other challenges for them to expand their presence abroad, including their current level of profitability, professional standards and competitiveness. Opening the market to foreign investors can help drive up the level of services and products because of their international experience.

The futures market is another business area that Chinese securities firms can explore. Lack of variety in futures products, limited income source and limited financing channel of futures companies are big challenges for the market. There are only 28 commodity futures products and one financial futures product (CSI 300 index futures) in China, which highlights a shortage of product variety compared with overseas markets.

The development and innovation of new product varieties is now a development focus. Research into crude-oil futures, treasury bond futures, commodity indices and options, carbon futures, and the establishment of an international infrastructure finance trading center have started. Trial trading of treasury-bond futures has also been officially launched on the China Financial Futures Exchange.

Additionally, the China Securities Regulatory Commission has taken a series of measures to alleviate price wars and promote business innovation; In April last year a commission official voiced support for the listing of futures companies, saying the financial indicators of more than 10 such companies had reached the requirements for main-board listing at the end of 2011. All these reflect the determination of the regulatory authorities to advocate further development in the futures industry, providing enormous market opportunities.

Reform measures already in place or to be introduced will help domestic securities companies transform their businesses to become more diversified and innovative, which in turn will promote long-term growth.

However, the survival of securities companies, particularly the small and medium-sized ones, will be challenging as a result of intensified competition and declining performance. Finding the right talent, offering the right products to the market and robust risk management are crucial to their success.

The authors are partners of KPMG China. The views do not necessarily reflect those of China Daily.