Feb 27, 2014 06:51 PM

Closer Look: So Who Stops a Run on Yu E Bao Accounts?

(Beijing) – Yu E Bao has encountered little criticism since it was launched in June, but recent remarks by a CCTV commentator, who compared it to a vampire sucking blood out of banks, were met with a strong backlash. This ranged from a reasonable rebuttal to name-calling.

What should have been a chance to rationally review the Internet investment product offered by the online payment company Alipay has been wasted. Most of the people who have critical views of Yu E Bao are keeping their thoughts to themselves, but more than one voice should be heard.

The upside of Yu E Bao requires little discussion. What merits attention more at the moment is whether it is flawed and who should act to solve the problem. There are many questions for which we do not yet have answers. They include whether Yu E Bao is exploiting loopholes in the legal and regulatory systems, whether it has adequately alerted investors about risks, and how it should be regulated.

Quite a few financial experts have said in private they are concerned about risks associated with Yu E Bao. In eight months, it has grown to more than 400 billion yuan, with a yield of more than 6 percent.

It is offered by Internet payment service Alipay, overseen by the central bank, relies on a public investment fund supervised by the securities regulator, and invests primarily in interbank loans watched by the banking regulator.

So which one of the three regulators should be in charge of regulating Yu E Bao? So far this question has not been answered.

From Alipay to Yu E Bao

Without Yu E Bao, the combined amount of funds in Alipay accounts and those entrusted to Alipay before a transaction is completed would have grown to more than 100 billion yuan a day in the second half of last year.

Under the central bank's regulation, Alipay gets to collect all the interest payments on the funds in the accounts and cannot share them with Alipay users. Assuming an annual interest rate of 5 percent, which is common for interbank loans, Alipay could have made 5 billion yuan a year in extra profit by just doing nothing.

Why did Alipay bother to launch Yu E Bao and burden itself with a constant worry about liquidity management?

The answer lies in a central bank regulation that obligates third-party payment companies to have registered capital of at least 10 percent of the money they handle for clients on a daily basis. For Alipay, that means it needs to have a registered capital of at least 10 billion yuan. That is far more than the 500 million yuan it has now.

Increasing registered capital significantly apparently required Zhejiang Alibaba E-commerce Co., Alipay's parent, to look for more capital from outside investors. The company is 40 percent owned by employees and the rest held by outside investors.

Increasing outside investors' holdings or inviting new investors would dilute the employees' stake to the disadvantage of company founders. That is why Alipay went to the trouble of developing Yu E Bao. With all the money out of Alipay accounts and into Yu E Bao – which it does not own – Alipay no longer faced the registered capital question.

It is worth noting that the responsibility to regulate Alipay itself was never clearly defined. In principle, the central bank should be in charge, but it does not have a way to check up on Alipay's management. Nor does the Industrial Bank of China, where all the funds in Alipay accounts are kept, have any effective supervision or control over the flow of money in and out of the accounts.

Who Stops a Run?

Yu E Bao has inherited Alipay's problem with regulation. Judging by how Yu E Bao allocates investments, the banking regulator should be concerned because more than 80 percent of its capital is lent to banks under a type of agreement that disadvantages banks.

As a defense, many banks have rushed out their own investment services, but they hardly generate any profit. The banking regulator has remained aloof, saying that Yu E Bao is more closely tied to securities regulation.

The China Securities Regulatory Commission has indeed taken action to strengthen the regulation of Yu E Bao and the like. It is mulling requiring fund management companies to hold more capital in reserve to hedge against risk, a move that analysts say is targeted primarily at money market funds that invest heavily in interbank loans.

This will undoubtedly increase the operating costs of fund companies, forcing them to perhaps reduce the fund's yield. A falling yield would trigger a hike in redemption requests, which may set in motion a vicious cycle that sees more and more people withdraw their money.

No investment is immune from loss, however safe Yu E Bao is made to look. There have been times money market funds have had to close because of heavy losses. If there is ever a run on Yu E Bao, what countermeasures can it take to calm investors and which regulatory body should respond? These are some of the questions that the government must answer.

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