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A Case Study of Misappropriation of Client Security Deposits by Chinese Securities Firms

After 2001, the Chinese securities market fell into a persistent downturn and investors increasingly withdrew their money from the stock market. A misappropriation scandal was exposed in a security firm that depended on a single-line profit model, did poorly in risk management, and faced an insufficient supply of funds. Between the end of 2003 and the first half of 2004, the industry-wide loss for several years on end led to the exposure of multiple, long-accumulating, risky practices. Breaches included misappropriation of client security deposits, noncompliance with CSRC rules in wealth management services, and market manipulation. For the first time after the establishment of the Chinese securities market, securities brokers faced an industry-wide crisis. Investors lost their confidence in the whole industry. Information about securities firms that received administrative disposition by the CSRC disclosed that misappropriation of security deposits was prevalent across the industry. Many brokers drove themselves to a hopeless situation with massive distressed debts as a result of such misappropriation.

In August 2002, Anshan Securities became the first broker to have its broker's license revoked. Later, Changjiang Securities, Xinhua Securities, and many others received administrative disposition. By the end of 2006, 30 securities firms received administrative disposition,[1] including Minfa Securities (for cumulative misappropriation of CNY 3.0085 billion in 68 unauthorized transfers between May 1997 and April 2004) and Dapeng Securities (for cumulative misappropriation of CNY 1.65 billion as of December 31,2004).

In this crisis, Southern Securities presented the most typical case. Southern Securities Corp. (formerly a limited company) was incorporated on December 21,1992, having a registered capital of CNY 1 billion. Its founding members included the Industrial and Commercial Bank of China (ICAC), the Agricultural Bank of China (ABC), Bank of China (BoC), China Construction Bank (CCB), Bank of Communications (BoComm), and the People's Insurance Company of China (PICC). More than 40 well-known Chinese enterprises also made capital contributions. After an increase of share capital in February 2001, Southern had a registered capital of CNY 3.45 billion, becoming a "giant" in the Chinese securities market. However, due to illegal practices and misappropriation, Southern shut down its business by order of the authorities in 2005. It misappropriated more than CNY 8 billion from individual investors, and owed large investors up to CNY 12 billion.

When the market was doing well in 2000, Southern Securities entered into many wealth management contracts paying guaranteed minimum rates of return. This led Southern to its first step in the increase of share capital, and also paved the way for massive indebtedness. After the second half of 2001, as the stock market slumped, Southern fell deeper in debt and rumors of its default started to spread. On January 19, 2002, Southern obtained the CSRC's approval for an increase in share capital and became a corporation.

In October 2003, a massive credibility crisis broke out against the corporation. Customers swarmed in to redeem principal and claim returns on wealth management contracts. Back then, client security deposits with Southern (amounts available in cash only) added up to about CNY 8 billion, which happened to be approximately the same amount as the wealth management contracts. Southern decided to misappropriate that money to repay the principal to customers who terminated wealth management contracts.

On January 2, 2004, the authorities took over Southern for misappropriation and other illegal practices. In February 2005, the People's Bank of China (PBC) offered a refinance plan worth more than CNY 8 billion to help Southern repay the misappropriated money and maintain functional operations in brokerage. But on April 29, 2005, the CSRC shut down Southern, separated out brokerage and investment banking, and repackaged it for public sale. On August 1, 2005, CCB Investment announced that it had acquired Southern's investment division, as well as 74 business offices, at a price of CNY 350 million. Later, on September 28, 2005, CCB Investment Securities Co. Ltd. was incorporated with a registered capital of CNY 1.5 billion. This regrouped and closed the curtain for Southern Securities.

In addition to Southern Securities, the PBC also offered refinance plans to Anshan, Xinhua, and Hantang, in the amounts of CNY 1.5 billion, 1.45 billion, and 4 billion, respectively, to help them repay misappropriated funds. This was an attempt to maintain social stability and shelter the securities market from systemic risk. In total, PBC's refinance plans for the debts owed by failed securities firms to individual investors were worth CNY 61.7 billion.6 According to a CSRC bulletin, between 2000 and 2005, many securities firms were shut down and placed into the hands of receivers for cash flow problems. Most of them misappropriated client security deposits. The list includes Southern, Deheng, Hengxin, Zhongfu, Hantang, Minf a, Liaoning, Dalian, Zhuhai, Anshan, Henan, Fuyou, Hainan, Xinhua, Yunnan, and Jiamusi, among others. Table 2.3 lists the preliminary statistics of these acts of misappropriation.

Case Study: The Influence of Margin Financing on Leverage in American Investment Banks As far as brokerage is concerned, services offered to large investors contribute to large profits in American and European securities

TABLE 2.3 Statistics of Misappropriation of Funds in Clients' Clearing Accounts (CNY in millions)

Guangdong Securities

6479.349

Hebei Securities

570.4588

Zhongke Securities

6319.809

Wuzhou Securities

409.70

Deheng Securities

3256.474

Kunlun Securities

327.20

Minfa Securities

3008.50

Taiyang Securities

322.80

Hantang Securities

2413.715

Northwest Securities

278.9655

Dapeng Securities

1650.00

Xing'an Securities

252.9267

Min'an Securities

577.00

Yunnan Securities

154.9859

Wuhan Securities

572.00

First Securities

about 100.00

Note: Security deposits are considered misappropriated if cash available or an overdraft is taken out of the account.

Source: CSRC web page, csrc.gov.cn/pub/zjhpublic.

brokerage houses. Large investors are wooed by investment banks because financially capable large investors engage in block trading, which results in generous commissions for investment banks. As brokers, investment banks are allowed to use client assets (such as cash and securities) in margin accounts to offer financing services (e.g., asset-backed financing and hypothecation). Investment banks thereby benefit by diversifying sources of revenue.

These services offered to professional investors, known as prime brokerage, are very common in American and European financial markets. Targeted clients are usually hedge funds and private equity firms that manage a wealth of assets. Hedge funds prefer investment banks to commercial banks because of more favorable terms, a wider range of collateral options (which helps improve liquidity), and well-established reputations for expertise and good practice.

Margin financing bears much resemblance to the epidemic of misappropriation of security deposits in the Chinese capital market prior to 2005. Securities firms use margin financing to access clients' cash and securities, facilitating their own business and indirectly increasing their financial leverage. Margin financing helps bring about high capital efficiency by the same principle commercial bank loans follow. For securities firms, cash or securities are always available in the account, which can be used to satisfy the needs of borrowers. Securities firms can increase the turnover rate for higher capital efficiency. They can also benefit by earning a profit and by charging fees for services. However, much like a bank run on commercial banks, securities firms with liquidity problems inevitably suffer fatal blows when clients line up to withdraw their assets for safety concerns, because of rearrangement of clients' cash and securities. This was one trigger in the 2008 financial crisis in the United States, in addition to the underlying cause of the industry-wide loss in the Chinese securities industry in the early 2000s.

Professionals and academics are still in heated debate about the causes of the 2008 financial crisis. They point to a wide range of factors, from the federal government's low interest rate policy since 9-11 to financial derivatives (considered to have gone too far). Those criticisms and accusations are warranted. But prime brokerage helped securities firms increase their financial leverage in a disguised way, and finally gave these companies a devastating blow when liquidity problems worsened in the market.

Bear Stearns was founded in 1923 and was once the fifth-largest investment bank on Wall Street. It maintained a wide range of activities, including corporate financing services, M&A advisory services, securities research, private client services, asset management, and custody services, as well as sales and trading of securities, FX, futures, derivatives, and fixed-income products. It also provided hedge funds, brokers, and investment advisors with financing, securities lending and clearing services, and technical solutions. Its prime brokerage clients included Renaissance Technologies, D. E. Shaw, and other hedge fund giants. As one of the main players, Bear Stearns once made quite a profit in the CDO market.

When the U.S. home mortgage market started to respond to rising interest rates, mortgage default rates increased significantly. In June 2007, affected by the widening subprime mortgage crisis and the sharp fall in value of ABS, CDOs, and other bonds, Bear Stearns announced the liquidation of two hedge funds, which marked the start of the countdown to the collapse of the company. As subprime mortgage-related assets further depreciated, Bear Stearns still held a large number of positions in the sub-prime mortgage market. It was faced with liquidity strains as a result of significant devaluation of CDO collateral. As the problem got worse, Bear Stearns' prime brokerage clients started to withdraw cash assets from their Bear Stearns accounts. In March 2008, Renaissance Technologies, a hedge fund widely known for its quantitative investments, withdrew USD 5 billion. Other funds followed suit. Within two days, up to USD 17 billion was withdrawn from Bear Stearns. Having failed to get an extension on loans from the market counterparty, Bear Sterns could not borrow from the repossession market due to liquidity problems. The situation was hopeless. In the final act, with the federal government's help, J.P. Morgan Chase acquired the company.

The fall of Bear Stearns was due to heavy investment in nonperforming loan-related derivatives that resulted in asset depreciation. However, the sudden withdrawal of considerable assets by major institutional investor clients at a crucial moment hastened the collapse of the company, which had lost its borrowing power. One underlying cause of a run on investment banks is prime brokerage. Securities firms make use of clients' cash and securities to offer asset-backed financing and hypothecation services. In this way, clients' assets are used in a disguised form to help securities firms facilitate their business and greatly increase their invisible leverage. It can be beneficial in a booming market. But if the securities firm faces liquidity problems, clients may soon line up to withdraw the assets they deposited in the securities firm. They rush to do so for better asset security and in consideration of "first come, first served" rules. In regard of an established long-term relationship, some clients refrain from withdrawing their assets, but they usually ask for higher margins, which can make matters even worse. As securities are rehypothecated, the securities firm has to turn to the repossession market, commercial paper market, or mutual fund market. However, borrowing money in these markets would be difficult because of spreading rumors. The only remaining option is to realize other available assets, despite huge losses. In Bear Stearns's case specifically, the company suffered severe depreciation of portfolio securities, leaving it with no choice but to accept J.P. Morgan Chase's acquisition offer. The collapse of Lehman Brothers was a similar story. In the end, the clearing bank's margin call for cash became their last straw.

  • [1] Xia (2006).
 
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