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China's `Aircraft Carrier’ Can't Sink Wall Street

China's `Aircraft Carrier’ Can't Sink Wall Street

(Bloomberg Opinion) -- A planned merger between China’s two biggest brokerages is a sign that firms are worried about the impending arrival of wholly owned foreign competitors. They should be.

China has started the process of potentially merging Citic Securities Co. and CSC Financial Co., Bloomberg News reported Tuesday, citing people familiar with the matter. The two would have a combined market value of $67 billion, surpassing Goldman Sachs Group Inc. and Morgan Stanley.

At first glance, this display of angst might seem puzzling. Local brokerages dominate the market, and will be hard to dislodge. They control an industry that is far from robust, though, and that may be ripe for disruption from Wall Street banks that have an edge in structuring complex products and using leverage.

Much brokerage activity in China involves unsophisticated stock trading, where returns have been declining for years. Trading commissions slid to below 3 basis points, or 0.03%, in mid-2019, from 8 basis points in 2013. Online brokers charge even less. Proprietary trading, or income from investing in securities — largely frowned upon in the U.S. and Europe since the global financial crisis — makes up the bulk of revenue, followed by trading. Arranging share sales offers limited profit because of an unofficial pricing cap of 23 times earnings on most initial public offerings.

China's `Aircraft Carrier’ Can't Sink Wall Street

Consolidation is overdue. China has 130-odd brokerages, which mostly struggle to turn a profit. The entire industry’s combined assets are equal to those of just one U.S. bank, Goldman Sachs. And they are less profitable. Citic Securities, one of five local securities firms that account for a third of industry revenue, has a return on equity of 8%, compared with 11% for New York-based Goldman.

Authorities have called for the creation of “aircraft-carrier sized” brokerages that can compete with the Wall Street titans. That’s more easily said that done. Many of China’s brokerages are owned by provincial and local governments that are  loath to give up control, especially at the cheap valuations forced by this year’s coronavirus-induced sell-off. The Citic-CSC combination could be the first such creation. Besides being the biggest, Citic Securities is also the most international of China’s brokerages, having acquired Credit Agricole SA’s CLSA unit in 2012 and flirted with buying Bearn Stearns Cos. during the global financial crisis.

China’s securities firms don't have much time. Starting April 1, Beijing permitted foreign investment banks to own 100% of their China operations, allowing them to shake off irksome local partners. That further opens the market after the government let foreign securities firms take majority control of ventures in April 2018. So far, UBS Group AG, JPMorgan Chase & Co., Nomura Holdings Inc., Morgan Stanley and Goldman Sachs have been granted such approvals.

Until now foreign banks have mostly contented themselves with marketing their global connections to mainland Chinese customers — advising companies on overseas acquisitions, introducing institutional investors for offshore share offerings in New York or Hong Kong, or servicing rich individuals who have the wherewithal to access offshore investments. As China becomes more integrated with international markets, its domestic stocks and bonds will become more of a focus. Mainland Chinese equities are now included in the MSCI Emerging Markets Index and the country’s bonds have joined global benchmarks such as the Bloomberg Barclays series.

With 100% ownership, overseas banks will have the flexibility to inject capital and expand into high-value-added areas such as trading over-the-counter derivatives, margin lending and market-making — regulators permitting. Morgan Stanley plans to build out an onshore brokerage and market-making capability as the securities industry is expected to become more institutionalized, Wei Sun Christianson, who leads the firm’s China business, told Cathy Chan of Bloomberg News.

It’s a long game. Retail investors still accounted for 70%-80% of China’s stock market trading volume in 2018, compared with 60% in Japan, 40% in Hong Kong and 30% in South Korea, according to Goldman Sachs. China’s share has come down only gradually, from 87% in 2015. The local derivative markets remain largely out of reach for global institutions, with lack of confidence in the legal system a hindrance. Bond trading, a big moneymaker for banks in developed markets, is underdeveloped in China, where state-owned lenders rather than funds are the biggest holders.

Even so, the trend is clear. If China’s market opening remains on the same trajectory, even a fleet of aircraft carriers may not be enough to repel the invaders.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Nisha Gopalan is a Bloomberg Opinion columnist covering deals and banking. She previously worked for the Wall Street Journal and Dow Jones as an editor and a reporter.

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