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Chinese Depository System Reform

Faced with the persistent problem of misappropriation, which presented a real threat to the survival and development of the securities industry, the Chinese regulatory authorities were determined to put an end to such misappropriation from the source. In addition to having a separate depository, high-risk brokers are mandated to place clients' security deposits in escrow. After being put into the hands of the administrative receiver in 2004, Southern Securities became the first brokerage house subject to the escrow mode. Section 139 of the Securities Act (revised in 2005) provides that "the funds in a securities firm client's clearing account should be deposited into a separate account in the client's name with a commercial bank." The Act offers a legal basis for the escrow depository system by specifying that security deposits are the property of clients, instead of a liability of the securities firm. This helps protect investors' interests. The revised Securities Act also provides that "a securities firm shall not regard the funds and securities in a client's clearing account as its own assets. It is prohibited to misappropriate such funds and securities in any form. Such funds and securities shall not be included in the assets of a securities firm when it goes into bankruptcy or liquidation. Except for the collection of the client's debts or other circumstances as provided by law, such funds and securities shall not be seized, frozen, deducted or subject to any enforcement order." There is an additional provision that "the funds in a securities firm client's clearing account should be deposited into a separate account in the client's name with a commercial bank." This also expressly establishes the commercial bank's status as custodian.

In the escrow mode, a custodian bank opens a separate security deposit account in the investor's name, as instructed by the investor. The bank connects such an account with the investor's securities trading capital ledger and bank settlement account. Securities firms no longer provide clients with capital deposit and withdrawal services. With the money outside of the securities clearing account to be directed into the bank settlement account only, the investor can only access a security deposit via bank-securities account transfers. In this way, security deposits are placed in closed operation. The custodian bank opens a general account for the securities firm to hold all the security deposits paid by clients. The securities firm may open any number of subaccounts with any branch of the bank for business needs. That account only pays money upon an investor's withdrawal request, or for securities trading and related commissions and fees. This follows the principle that "the broker manages securities and the bank manages money." Securities firms serve clients in securities trading, shares management, and securities clearing and settlement. Custodian banks manage general account and subsidiary ledgers of security deposits. They also offer clients deposit and withdrawal services. They provide securities firms with clearing and settlement support for corporate capital settlement between securities firms and the depository and clearing company and OTC settlement participants, keeping securities firms' capital separate from clients' security deposits.[1]

The escrow depository system enables investors to check their capital balance with either the custodian bank or the security firm. The bank sends out a statement on a regular basis to the investor for the capital management account and offers inquiry services on the balance in the account, as well as the (capital) information of the capital account with the securities firm. Securities regulators can oversee the investor's security deposits by comparing business data from the securities firm and capital management account data from the custodian bank. Investors can also monitor their security deposits by comparing capital data from the bank against that from the securities firm. Such escrow arrangements help build a firewall between securities firms and clients' money, eliminating the opportunity for securities firms to misappropriate clients' security deposits.

The escrow depository system has proved to be as effective as expected. Although the Chinese stock market had an abrupt fall in 2008 (SSE composite index slumped from over 6,000 to 1,600), no securities firm filed for bankruptcy. Among other factors, the overall improvement initiative for brokers, with institutional measures for security deposits in particular, can take credit for that.[2]

  • [1] Hou, Lijuan, and Xiaoxian (2007).
  • [2] Xiaoqiu (2010).
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