For five years, starting in 2001, the Chinese stock market headed down. Investors pulled out their money; brokerages went bankrupt. Then the Chinese government instituted a series of far-reaching reforms and the market started to rebound, quickly regaining the territory it had lost, and hitting record highs.
That was the good news, but rising trading volumes, tighter regulations, new securities products and the threat of competition from tech-savvy foreign firms are pressuring Chinese brokerages to upgrade their systems.
Last year, the stock market more than doubled. By press time, so far this year it is already up by about a thirddespite a 9 percent drop on Feb. 27. The benchmark Shanghai Composite Index hit a new record of 3,720.53 on April 24, with total trading volume of CHY204 billion ($26.4 billion).
Some Chinese brokerages are struggling. "The sharply increasing trading volume is the single biggest challenge," says Lucy Chen, an analyst with Shanghai's Haitong Securities. "Peak trading volume has reached around CHY100 billion ($12 billion) per day, many times higher than the couple of billion a few years ago," she says. "The result is that transactions were delayed, and some systems even crashed during peak trading hours."
In mid-January, trading systems in the Beijing branches of China Merchants Securities shut down for three hours when trading volumes jumped from CHY3 billion to CHY150 billion ($388 million to $19 billion). China Merchants has over 52 branches in more than 25 cities in mainland China and is partly owned by state-owned China Merchants Group.
China Merchants blames the problems on software upgrades. "All of our branches are now using an upgraded trading system, which was launched early this year," says China Merchants spokeswoman Hu Lin. "We believe the problem was caused by the fact that the new system was still in the testing phase at that time."
China Merchants used an outside vendor to upgrade the system, which took a year to build, Hu says. The final cost came in at twice the original budget, she says, but declines to give specific numbers. However, the new platform can handle the higher volumes, she adds. "Our trading system is now the biggest in China," she says. "Even on April 17, when both Shanghai and Shenzhen market turnover hit a combined peak of CHY280 billion ($36 billion), our system was running smoothly and still had more than 55 percent in spare capacity," she says.
Other brokerages also suffered shutdowns or slowdowns. For example, customers of Shanghai-based Shenyin & Wanguo Securities, one of the oldest and largest securities companies in China, complained that the firm's trading systems faltered every few minutes over the course of a day. Shenyin & Wanguo officials decline to comment.
"For China Merchants and Shenyin, the troubles were definitely caused by systems that were too old to deal with the new market," says Yang Qingfeng, director of the research center at China Computerworld Research (CCR). "Management, backup disaster and capacity limitations are all factors that could cause system troubles." With the market rebounding, brokerages have good reason to upgrade their systems, he says.
"Most brokerage trading systems in China can deal with volumes of no more than CHY9 million ($1.1 million)," says Xu Mingbo, vice president of Shenzhen-based Kingdom Technology, one of China's biggest domestic financial software developers and system integrators. "That's because those were the peak volumes back in 2002, when the bear market was just getting started."
Upgrade Urgency
As the market continued its long downward slide, there was little reason to upgrade the systems. "Those companies who were not sensitive to the changes in the market didn't work on their systems, so they have problems," Xu says. Like China Merchants however, some brokerages saw the winds shifting and invested in better systems, he says. "Guosen Securities, China Jianyin Investment Securities and Citic Securities are all good examples," he says. "They increased the capacity of their trading systems in the early to middle part of last year by investing heavily in technology."
According to Xu, an up-to-date core system for a large Chinese securities firm typically costs between CHY30 million and CHY40 million ($3.9 million and $5.2 million). Some brokerages still aren't investing enough, he says. A trading system not only affects a brokerage's image and reputation. "It also affects the customers' financial returns, social harmony, and stability," Xu says.
The Chinese government places a high premium on social harmony, given the fast pace of change in society in recent years, and the perceived growth of economic inequality. As a result, the government has repeatedly bailed out failing brokerages and other financial institutions to avoid panic and maintain faith in the country's financial system.
For most firms, rising trading volumes are enough of a motivator to invest in technology. But China's brokerages are being hit with a perfect storm of industry-shaking events.
The Shanghai Stock Exchange is expected to launch a next-generation trading system late this year. Brokerages that don't take advantage of its new capabilities will lose customers to those who do, says CCR's Yang.
China is also getting ready to start trading index futures later this year. Previously, only commodities futures were legally traded in China, but the laws were recently changed and the new China Financial Futures Exchange opened in Shanghai last fall.
Fang Shisheng, a senior consultant in the futures department of the Shanghai Orient Securities Company, says that he expects index futures to do well in China, given the large numbers of investors in the country.
Regulators may allow trading of stock index futures, covering the country's top 300 listed firms, as early as this summer. In February, the China Financial Futures Exchange held a meeting for major brokerages and financial technology vendors to talk about system upgrades and risk management.
"Index futures are a little bit different from commodity futures," says Chen Jun, spokesman for SunGard Kingstar. "They require more risk management and concurrent performance because of huge turnover volumes." SunGard Kingstar is a Shanghai-based financial software vendor recently acquired by SunGard Data Systems.
Chen says that Kingstar noticed the different demands when clients were running simulated index futures trading in early 2005, in preparation for the new regulations. To handle these demands, Kingstar developed the V6 futures trading platform, which comes with an enhanced risk management function, more capacity, higher speeds and can be used for both commodity and index futures trading, he says. SunGard Kingstar currently claims more than 85 percent of Chinese brokerages as customers, as well as the Shanghai Futures Exchange and the Dalian Commodity Exchange.
Risky Business
With the rise in the stock markets, it can be easy to ignore the risk management problems that still exist in China, says Fraser Howie, co-author of Privatizing China: The Stock Markets and Their Role in Corporate Reform. "Because the market has been rallying so strongly in China the assumption is now all our problems are gone," he says. "If anything, bull markets always bring out the worst in risk management."
The biggest problems date to when the Chinese markets started heading downwards in 2001 and Chinese brokerages resorted to illegal behaviorincluding investing in the stock market on their own behalf using client moneyin an attempt to bring in revenues and stave off bankruptcy. Since then, the government has taken steps to make client money less accessible and to discourage other dishonest practices in the markets. For example, client money is now held in separate accounts.
But that doesn't mean that the new rules are foolproof. Without adequate oversight, individual managers will still find ways to get around the restrictions. "There have been some mechanical improvements in the money flow," Howie says. "It's much harder to get hold of customer funds, but it's still common. Ultimately, how do you stop it?"
Fu Qiang, manager of marketing strategy at SYWG BNP Paribas Asset Management, a Shanghai-based joint venture between Shenying & Wanguo Securities and BNP Paribas Asset Management SAS based in Paris, says he is also concerned about this. "This year, separately managed accounts for private funds will be launched, and I'm afraid the badly managed brokerages will take this opportunity to abuse client money," he says.
Better oversight can help address these problems. For large brokerages, this means automated monitoring systems. "A system with stricter supervision can more or less control the problem," says Kingdom Technology's Xu.
Greater competition would also encourage better management practices at listed companies, allowing independent risk managers to have more sway, Howie says.
China has over 111 registered securities companies, including seven joint ventures with foreign investors like Goldman Sachs and UBS Group, according to the China Securities Regulatory Commission (CSRC). Foreign securities companies can only own up to 33 percent of a joint venture, and foreign asset management firms up to 49 percent of a joint venture, according to the regulations.
Given the relatively small size of typical Chinese brokerages, and the fragmentation of the market, the Chinese securities industry has been less attractive to foreign vendors than, for example, the banking sector.
In addition, with the country's low labor costs, many firms have been building systems in-house, says Simon Freeman, worldwide director of financial markets at Hewlett-Packard, based in London. However, the rise in the stock market has driven growth in demand for HP's products and services, for the most part through local vendors and partners, he says. For example, many brokerages are using HP hardware, the Shanghai Stock Exchange runs on HP's Open VMS servers, and the Shenzhen Stock Exchange is a NonStop client, he says.
The Foreign Factor
Another growing pool of securities industry customers in China is foreign firms moving into the country. "They're looking to replicate best practices and standards," Freeman says. When foreign firms move in by way of joint ventures, they bring the technology with them to local firms, as well as some capital infusions. However, brokerages can also draw on the revenues from the commissions from all the new trading that the growing stock market is attracting, to invest in new technology, experts say.
"Last year's good earnings, along with the government policy to combine some small securities companies, will give them enough capital capacity to do so," says CCR's Yang. "I am confident that there will be growing spending on securities companies' IT systems this year."
Chinese brokerages are increasingly looking to the capital markets for funding by going public. Currently, only four China brokerages are listedHong Yuan Securities, Citic Securities, Shaanxi International Trust and Investments, and Anxin Trust & Investment. In January, Haitong Securities, China's second-largest domestic brokerage by registered capital, received approval from regulators to list on the Shanghai Stock Exchange.
According to the state-owned Xinhua news service, as of the end of 2006, a total of 13 securities companies, including China Merchants Securities, Guotai Junan Securities, and China International Capital, had met the IPO requirement of posting a profit for three consecutive years.
Wang Fangqing contributed to this report.