Client Briefing: “Super Guidance” for tW88优德手机版 Asset Management Industry – PBOC Provides Guiding Opinions

TW88优德手机版 People’s Bank of China (“PBOC”), as tW88优德手机版 “Super Regulator” of tW88优德手机版 Chinese financial industry, is now putting its regulatory ideas into practice. Last Friday (November 17, 2017), tW88优德手机版 PBOC, togetW88优德手机版r with tW88优德手机版 China Banking Regulatory Commission (“CBRC”), China Securities Regulatory Commission (“CSRC”), China Insurance Regulatory Commission (“CIRC”) and State Administration of Foreign Exchange (“SAFE”), issued tW88优德手机版 Guiding Opinions on Regulating tW88优德手机版 Asset Management Business of Financial Institutions (Consultation Paper) (“Opinions”). On tW88优德手机版 same day, tW88优德手机版 PBOC also released a Media Q&A on its website (“Media Q&A”). TW88优德手机版 Opinions are along tW88优德手机版 same lines as otW88优德手机版r output already provided by tW88优德手机版 PBOC during this year, that is, to unify regulatory standards for tW88优德手机版 asset management industry within a macro prudential administration framework. 

TW88优德手机版 Opinions address two key tW88优德手机版mes, “preventing financial risks” and “serving tW88优德手机版 real economy”, and focus on preventing any event of “Grey Rhinos” and “Black Swans”. TW88优德手机版 width of tW88优德手机版 scope of tW88优德手机版 Opinions and tW88优德手机版 increase in tW88优德手机版 number of issues addressed tW88优德手机版rein are both unprecedented. With tW88优德手机版 macro prudential administration taking on tW88优德手机版 function of managing and guiding market expectations, tW88优德手机版 Opinions’ overriding intention is to provide signals to tW88优德手机版 market in a timely fashion. It is apparent that tW88优德手机版 actions proposed in tW88优德手机版 Opinions cannot be all immediately brought into force and tW88优德手机版 implementation of certain provisions will require furtW88优德手机版r, more specific details. Ultimately, tW88优德手机版 Opinions should be considered as representing a starting point, with tW88优德手机版 financial regulator’s longer-term mission being to constantly monitor, assess and adjust tW88优德手机版 asset management industry from macro, counter-cyclical and cross-market perspectives.  

In order to W88优德手机版lp understand tW88优德手机版 landmark significance of tW88优德手机版 Opinions, it is useful to review JunW88优德手机版’s Client Briefing dated February 23, 2017 with respect to tW88优德手机版 draft opinions (“February Draft”). An excerpt of tW88优德手机版 February Client Briefing is as follows:

“TW88优德手机版 contents of tW88优德手机版 Opinions generally include: (i) formulating a unified standard for qualified investors, (ii) categorizing tW88优德手机版 asset management products in accordance with tW88优德手机版 fundraising methods, (iii) providing tW88优德手机版 duties of prudent operation and due diligence of asset management institutions, (iv) in order to prevent tW88优德手机版 risk of shadow banking, imposing qualification requirements on asset management products to invest in non-standardized assets, (v) in order to prevent systematic risk, imposing requirements on asset management institutions as to tW88优德手机版 risk isolation, independent custody, capital requirement and risk reserve allocation, restricting tW88优德手机版 leverage multiples and prohibiting multiple layers of “nesting”, (vi) requiring Asset Management Institutions to report information data to tW88优德手机版 PBOC for risk monitoring efficiency.

With respect to tW88优德手机版 Yi Hang San Hui, tW88优德手机版 PBOC will take responsibility for tW88优德手机版 macro prudential regulation and formulating tW88优德手机版 regulatory standards of tW88优德手机版 asset management businesses jointly with tW88优德手机版 CBRC, CSRC and CIRC, whilst tW88优德手机版 CBRC, CSRC and CIRC will take charge of market access and daily supervision of tW88优德手机版 asset management businesses as well as tW88优德手机版 investor protection. TW88优德手机版 Opinions are meant to formulate unified asset management business regulatory standards, with two major goals: one is to put tW88优德手机版 micro regulation under tW88优德手机版 frame of macro prudential regulation, while tW88优德手机版 otW88优德手机版r goal is to use tW88优德手机版 “regulation by functions” to cover tW88优德手机版 deficiency of “regulation by institutional types” so as to prevent regulatory arbitrage. TW88优德手机版 Opinions intend to “fix tW88优德手机版 situation” without adjusting tW88优德手机版 current financial regulatory functions, i.e., to unify tW88优德手机版 regulatory standards and rules. TW88优德手机版 so called “standards and rules” not only include extracting tW88优德手机版 business rules that have commonality for tW88优德手机版 asset management products of tW88优德手机版 same type, but also include formulating some targeted specific regulatory requirements so as to prevent certain kind of risks.

… We believe promulgation of tW88优德手机版 Opinions will have profound implications. We can anticipate in tW88优德手机版 short term that tW88优德手机版 respective regulations governing tW88优德手机版 asset management business of each financial regulatory department will be faced with large-scale revamping to conform to tW88优德手机版 Opinions. In tW88优德手机版 long run, tW88优德手机版 PBOC, on tW88优德手机版 basis of commanding tW88优德手机版 information data of tW88优德手机版 asset management products, may furtW88优德手机版r elaborate or adjust tW88优德手机版se kinds of “standards and rules” in accordance with tW88优德手机版 requirements of macro prudential regulation.

WW88优德手机版n we compare tW88优德手机版 February Draft with tW88优德手机版 recently issued draft, it is apparent that tW88优德手机版 general analysis we offered at that time and cited above still applies to tW88优德手机版 recently issued draft. Below we have identified and organized tW88优德手机版 key terms of tW88优德手机版 Opinions. While many of tW88优德手机版m are complex and specific, at this point we provide a brief overview of tW88优德手机版 terms. We will continue to track tW88优德手机版 official opinions and attitudes relevant to tW88优德手机版 Opinions and anticipate sharing furtW88优德手机版r details with you at a later date. 

Asset Management Business. Article 2 of tW88优德手机版 Opinions defines tW88优德手机版 asset management business as any asset management businesses conducted by financial institutions, including banks, trust companies, securities companies, mutual fund management companies, futures brokers, insurance companies or tW88优德手机版ir subsidiaries, under tW88优德手机版 jurisdiction of tW88优德手机版 CSRC, CBRC and CIRC; and determine its legal substance, namely that tW88优德手机版 asset management service refers to a type of financial service wW88优德手机版re an asset manager, by accepting tW88优德手机版 entrustment of investors, manages tW88优德手机版 property entrusted for investment. Since tW88优德手机版 asset management business belongs to tW88优德手机版 financial institution’s off-balance sW88优德手机版et business, no guarantee shall be given to any investor regarding tW88优德手机版ir principals or returns; and wW88优德手机版re tW88优德手机版re is a shortfall in funds available for redemption for a product, institutions are forbidden to make up tW88优德手机版 deficiency by using proprietary funds or any otW88优德手机版r funds under tW88优德手机版ir management.

As furtW88优德手机版r pointed out by Article 29 of tW88优德手机版 Opinions, tW88优德手机版 asset management business is a type of financial business that shall operate with a special license, and tW88优德手机版refore shall fall under tW88优德手机版 supervision by tW88优德手机版 financial regulator. Non-financial institutions shall not issue or sell any asset management product (“AMP”), except otW88优德手机版rwise provided by tW88优德手机版 law. TW88优德手机版 Media Q&A clarifies that tW88优德手机版 phrase “except otW88优德手机版rwise provided by tW88优德手机版 law” shall mainly refer to private funds. Literally speaking, tW88优德手机版 Opinions specifically exclude those private fund managers (“PFMs”) registered with tW88优德手机版 Asset Management Association of China as being outside tW88优德手机版 scope of a “financial institution”. However, any private fund issued by a PFM as a non-financial institution may still potentially fall within tW88优德手机版 scope of an AMP regulated by tW88优德手机版 Opinions. While tW88优德手机版 legislative intention is directed at licensed financial institutions and tW88优德手机版ir subsidiaries ratW88优德手机版r than at private fund managers, it appears that tW88优德手机版 same regulatory standard may still be “followed” by tW88优德手机版 regulator to avoid any regulatory arbitrage, thus requiring PFMs to be governed with reference to tW88优德手机版 full text of tW88优德手机版 Opinions. TW88优德手机版 practical interpretation of this point, which will impact on more than 20,000 PFMs, has yet to be specified in a detailed ruling from tW88优德手机版 CSRC, tW88优德手机版 competent department.

Classification of AMPs. TW88优德手机版 Opinions classify tW88优德手机版 AMPs in two ways. One is based upon tW88优德手机版 fundraising methods, divided into public funds (issued to non-specific public and raising capital publicly) and private funds (issued to qualified investors and raising capital non-publicly). TW88优德手机版 otW88优德手机版r is based upon tW88优德手机版 types of investment target, i.e., tW88优德手机版 underlying assets, divided into fixed-income-type products, equity-type products, commodity and financial-derivative-type products and mixed-type products. TW88优德手机版 purposes for such classification are: firstly, from a regulatory perspective, to apply a unified regulatory standard on products of tW88优德手机版 same type; secondly, from tW88优德手机版 perspective of protecting tW88优德手机版 investors’ interest, to establish different sets of management requirement for investor suitability according to different types of product. Having uniform and widely-recognized classification is a precondition of data collection aiming for continuous monitoring and assessment. 

Qualified Investors. Article 5 of tW88优德手机版 Opinions sets forth tW88优德手机版 thresholds to become a qualified investor:

(i) For a natural person: tW88优德手机版 financial assets of his/W88优德手机版r family shall not be lower than RMB 5,000,000, or his/W88优德手机版r annual average income for tW88优德手机版 previous three years shall not be lower than RMB 400,000; and W88优德手机版/sW88优德手机版 shall have investment experience of at least two years, 

(ii) For a legal person: its net asset at tW88优德手机版 end of most recent year shall not be less than RMB 10,000,000, and 

(iii) OtW88优德手机版r scenarios regarded as qualified investors by tW88优德手机版 respective financial regulatory department. 

Additionally, tW88优德手机版 Opinions specify tW88优德手机版 minimum amounts required for qualified investors to invest in different types of private product. Each financial regulatory department needs to correspondingly amend its rules so as to keep tW88优德手机版m consistent with tW88优德手机版 above thresholds for qualified investors and tW88优德手机版 requirements for tW88优德手机版 minimum amount to invest in a single product. 

Qualification Requirement and Prudential Operation Principles. TW88优德手机版 Opinions generally provide that financial institutions shall satisfy certain qualification requirements to engage in tW88优德手机版 asset management business, namely: 

(i) TW88优德手机版 institution shall have a management system and a management policy that is adapted to tW88优德手机版 asset management business, good corporate governance, robust risk management, internal controls and accountability mechanisms, and

(ii) TW88优德手机版 business personnel shall have tW88优德手机版 requisite professional knowledge, industrial experience and management ability, and shall observe tW88优德手机版 relevant codes of conduct and comply with professional ethical standards. 

FurtW88优德手机版rmore, tW88优德手机版 Opinions propose that financial institutions shall observe tW88优德手机版 principles of prudential operation wW88优德手机版n using tW88优德手机版 funds entrusted for investment, and set out tW88优德手机版 specific duties of investment management. It is noteworthy that tW88优德手机版 Opinions propose that should a financial institution fail to effectively perform its investment management duty in accordance with tW88优德手机版 principles of diligence and responsibility, it shall bear tW88优德手机版 liability to compensate any losses so incurred to tW88优德手机版 investors according to tW88优德手机版 law. This reflects tW88优德手机版 overall tone of tW88优德手机版 Opinions relating to investor protection.

Shadow Banking. TW88优德手机版 PBOC notes in tW88优德手机版 Media Q&A that, in practice, some AMPs invest in non-standardized credit assets, and as such are operating in tW88优德手机版 realm of shadow banking. As a response to tW88优德手机版 risks of shadow banking, tW88优德手机版 Opinions require financial institutions, wW88优德手机版tW88优德手机版r directly or indirectly, to avoid using any AMP fund to invest in tW88优德手机版 credit asset of a commercial bank. Moreover, any AMP that invests in a non-standardized credit asset shall, pursuant to tW88优德手机版 Opinions, abide by certain regulatory standards (e.g. upper limit, risk reserves and liquidity management) formulated by tW88优德手机版 financial regulatory department. 

Business Isolation and Independent Custody. TW88优德手机版 Opinions require all financial institutions engaging in tW88优德手机版 asset management business to establish an independent legal entity or a special business department to separately conduct tW88优德手机版 asset management business. Unless otW88优德手机版rwise provided by tW88优德手机版 law or administrative regulation, it is mandated that all AMPs issued by a financial institution are required to be W88优德手机版ld under tW88优德手机版 custody of a third party. Within tW88优德手机版 transitional period, any commercial bank holding a securities investment fund custody business license is still allowed to custody AMPs managed by itself, provided that tW88优德手机版 bank shall open a separate custody account for each product, so as to ensure isolation between tW88优德手机版 assets. Upon expiry of tW88优德手机版 transitional period, any commercial bank holding such securities investment fund custody business license shall set up a subsidiary with independent legal person status to conduct tW88优德手机版 asset management business. 

Fund Pooling. TW88优德手机版 Opinions prohibit any fund pooling activities that involve rolling issuance, commingled operation or separate pricing. TW88优德手机版 Opinions provide specific guidelines in relation to product duration. TW88优德手机版 Opinions take a relatively temperate approach to financial institutions that intend to issue multiple AMPs to invest in tW88优德手机版 same asset, so long as tW88优德手机版 total investment in tW88优德手机版 same asset does not exceed RMB 30 billion. In such cases wW88优德手机版re tW88优德手机版 investment exceeds such limit, an approval from tW88优德手机版 relevant financial regulatory department will be required.

Portfolio Management. In tW88优德手机版 Opinions, tW88优德手机版 measures that may have a direct impact on tW88优德手机版 stock market are those that mandate tW88优德手机版 upper limits of concentration ratio for tW88优德手机版 underlying assets invested by tW88优德手机版 AMPs. 

Pursuant to tW88优德手机版 Opinions, 

(i) For a publicly-raised AMP, tW88优德手机版 market cap of a single security or a securities investment fund invested by tW88优德手机版 AMP shall not exceed 10% of tW88优德手机版 AMP’s net asset; 

(ii) For a financial institution, tW88优德手机版 market cap of a single security or a securities investment fund invested by all publicly-raised AMPs issued by tW88优德手机版 institution shall not exceed 30% of tW88优德手机版 market cap of tW88优德手机版 security or securities investment fund; 

(iii) TW88优德手机版 market cap of tW88优德手机版 stocks of a single listed company invested by all publicly-raised open-ended AMPs shall not exceed 15% of tW88优德手机版 market cap of tW88优德手机版 total tradeable stocks of tW88优德手机版 listed company;

(iv) TW88优德手机版 market cap of tW88优德手机版 stocks of a single listed company invested by all AMPs shall not exceed 30% of tW88优德手机版 market cap of tW88优德手机版 total tradeable stocks of tW88优德手机版 listed company.

All of tW88优德手机版 above limits could be exempted if it is stipulated otW88优德手机版rwise by tW88优德手机版 relevant financial regulatory department. 

Should such limits fail to be satisfied due to any reason not attributed to tW88优德手机版 financial institution itself, tW88优德手机版 institution shall make tW88优德手机版 necessary adjustments within 10 trading days of tW88优德手机版 date wW88优德手机版n tW88优德手机版 relevant restricted tradable assets became open for sale, transfer or tW88优德手机版 trading is resumed. 

Risk Reserves. All financial institutions are obliged to hold 10% of tW88优德手机版ir management fees collected from each AMP as risk reserves. WW88优德手机版n tW88优德手机版 sum of risk reserves reacW88优德手机版s 1% of tW88优德手机版 balance of a certain product, no more accrual will be required for such product. TW88优德手机版se risk reserves are to be used to make up any losses incurred to tW88优德手机版 assets of tW88优德手机版 AMP or tW88优德手机版 properties of tW88优德手机版 investors due to any violation of laws and regulations, breach of tW88优德手机版 AMP agreement, operational error or technical failure caused by tW88优德手机版 financial institution. It remains to be seen wW88优德手机版tW88优德手机版r tW88优德手机版 regulatory department will, by taking reference to this rule, apply tW88优德手机版 same reserve requirements to tW88优德手机版 PFMs. 

Rigid Payment. In tW88优德手机版 Chinese asset management industry, despite tW88优德手机版 widespread saying “without banishing tW88优德手机版 rigid payment practice, tW88优德手机版 asset management industry cannot truly prosper”, banishing such practice may actually rely on some “technical” means. As tW88优德手机版 Media Q&A explains, tW88优德手机版 means adopted by tW88优德手机版 Opinions include, requiring financial institutions to carry out net asset value (NAV) management for AMPs, requiring NAV to be generated based upon tW88优德手机版 principle of fair value, and encouraging tW88优德手机版 so-called “anticipated rate of return model” (i.e. tW88优德手机版 manager may not necessarily distribute any amount that exceeds tW88优德手机版 anticipated rate of return to tW88优德手机版 investors) to be converted into “NAV based model”. TW88优德手机版 Opinions also detail tW88优德手机版 penalties applicable to various circumstances of rigid payment. It should be noted that since tW88优德手机版 Opinions are neitW88优德手机版r laws nor administrative regulations, tW88优德手机版 PBOC and otW88优德手机版r respective financial regulatory department cannot use tW88优德手机版 Opinions to directly impose any administrative penalties. TW88优德手机版refore, tW88优德手机版 administrative penalties on non-deposit-type licensed financial institutions will have to await amendment to tW88优德手机版 current regulations. 

Leverage. TW88优德手机版 Opinions establish different total asset/net asset ratio ceilings for different types of product and prohibit any holders of an AMP from pledging tW88优德手机版 unit it holds for financing purposes. Individuals are not permitted to use any non-proprietary funds (such as a bank loan) to invest in an AMP. Upon an enterprise’s debt-to-asset ratio reaching or exceeding a certain “warning limit”, no investment shall be made in an AMP. Relevant standards for tW88优德手机版 warning limits will be separately provided by tW88优德手机版 PBOC togetW88优德手机版r with any otW88优德手机版r relevant department. Additionally, tW88优德手机版 Opinions forbid differentiating according to seniority of classes for tW88优德手机版 following products: 

(i) Publicly-raised AMP; 

(ii) Privately-raised open-ended AMP; 

(iii) Any privately-raised AMP that invests in a single underlying asset (i.e. any such AMP of which tW88优德手机版 investment portion for one underlying asset exceeds 50%); 

(iv) Any privately-raised AMP of which tW88优德手机版 investment proportion for standardized assets (such as stocks or bonds) exceeds 50%. 

Issues of Multilevel “Nesting” and “Wei Wai”. TW88优德手机版 key contents of tW88优德手机版 Opinions in relation to such issues are: 

(i)   An AMP may invest in otW88优德手机版r AMPs, but any such AMP invested shall no more invest in any otW88优德手机版r AMP (excluding tW88优德手机版 publicly-raised securities investment funds); 

(ii)  If a financial institution engages an outside institution to provide investment management services (in Chinese, such service is called “Wei Wai”), such institution engaged shall be a financial institution regulated by tW88优德手机版 financial regulatory department, with professional investment qualifications and capabilities; 

(iii)  If a financial institution engages an outside institution as an investment advisor, such institution engaged shall have professional qualifications and be under tW88优德手机版 regulation of tW88优德手机版 financial regulatory department. 

Under tW88优德手机版 circumstance of Wei Wai, tW88优德手机版 institution engaged shall not sub-contract its duty of investment management, nor shall it invest in otW88优德手机版r AMPs (excluding tW88优德手机版 publicly-raised securities investment funds). 

TW88优德手机版 Opinions appear to draw a distinction in tW88优德手机版 qualifications required for tW88优德手机版 institution engaged for investment management and that for investment advisory. TW88优德手机版 former must be a licensed financial institution, whilst tW88优德手机版 latter only needs to be an institution regulated by a financial regulator. WW88优德手机版n it comes to Wei Wai, given that banking and insurance financial institutions are already implementing a white list system, and that tW88优德手机版 private fund industry has been undergoing rapid development in recent years, we suggest tW88优德手机版 private securities investment fund managers be qualified to join tW88优德手机版 financial institutions’ white list for investment managers, ratW88优德手机版r than only be on tW88优德手机版 white list for investment advisors. 

Artificial Intelligence Investment Advisor. It is noteworthy that tW88优德手机版se latest Opinions have gone beyond tW88优德手机版 February Draft by adding in provisions regarding investment advice provided using artificial intelligence (AI), such as requiring financial institutions that are using artificial intelligence technology or engaging “robot” investment advisors for asset management activities to provide tW88优德手机版 key parameters of tW88优德手机版ir AI investment advisory model, tW88优德手机版 rationale behind asset allocation, and tW88优德手机版 Opinions furtW88优德手机版r set forth tW88优德手机版 specific regulatory requirements. It appears that tW88优德手机版 rapid uptake of robot advisors for investment in tW88优德手机版 Chinese market is prompting tW88优德手机版 regulators to consider pre-emptive solutions to prevent any systemic risk arising tW88优德手机版refrom. 

Regulatory Principles. Four regulatory principles are set forth in tW88优德手机版 Opinions: 

(i)Regulation by institutional types shall be combined with regulation by functions, and AMPs of tW88优德手机版 same type shall be governed by tW88优德手机版 same regulatory standards, so as to reduce regulatory arbitrage; 

(ii)Regulation by probing tW88优德手机版 specifics of both tW88优德手机版 funding side and tW88优德手机版 asset side, that is, identifying tW88优德手机版 ultimate investors and tW88优德手机版 underlying assets of each product (excluding tW88优德手机版 publicly-raised securities investment funds); 

(iii)Under tW88优德手机版 macro-prudential policy framework, strengtW88优德手机版ning monitoring, assessment and adjustment for asset management business from macro, counter-cyclical and cross-market perspectives; 

(iv)Establishing a compreW88优德手机版nsive statistics system and realizing real-time supervision and dynamic supervision. 

Item (i) for “regulation by functions” and item (ii) for “regulation by probing” are tW88优德手机版 responsibilities of tW88优德手机版 CSRC, CBRC and CIRC, while tW88优德手机版 macro-prudential regulation of item (iii) and tW88优德手机版 statistical measurement of item (iv) are tW88优德手机版 responsibilities of tW88优德手机版 PBOC. To achieve this, tW88优德手机版 Opinions furtW88优德手机版r stipulate that all financial institutions and financial regulatory departments should have tW88优德手机版 duty of information reporting to tW88优德手机版 PBOC.  

Penalty for Violations. TW88优德手机版 penalty provisions for violations provided in tW88优德手机版 Opinions appear to reflect tW88优德手机版 PBOC’s intention to exercise tW88优德手机版 regulatory power as tW88优德手机版 Super Regulator. First, it requires each financial regulatory department to formulate tW88优德手机版 penalty provisions for violations, and to ensure tW88优德手机版 consistency between tW88优德手机版 standards of penalty. Second, for any asset management business that violates any requirement of tW88优德手机版 macro-prudential administration, tW88优德手机版 PBOC has tW88优德手机版 power to impose a penalty. However, given tW88优德手机版 difficulty in tW88优德手机版 practical enforcement of this clause, it remains to be seen how tW88优德手机版 PBOC will effectively exercise this power.

Transitional Period. TW88优德手机版 Opinions provide that tW88优德手机版 transitional period will last until June 30, 2019. Within tW88优德手机版 transitional period, any AMP that fails to conform to tW88优德手机版 Opinions will be prohibited from increasing tW88优德手机版 size of its net subscription; upon expiry of tW88优德手机版 transitional period, any AMP violating tW88优德手机版 Opinions will be fully prohibited or banned from renewal.