Feb 08, 2017 07:50 PM

Central Government Again Tackles Problem of Local Exchanges

(Beijing) — There’s a reason why the Chinese have the saying “The mountains are high and the emperor is far away”: History is littered with examples of local government officials paying lip service to central authorities’ orders, if not disregarding the orders outright.

The latest example of this ancient proverb can be found in the long-running but often fruitless efforts of Beijing authorities to tame unruly and often poorly regulated exchanges that are backed by local governments.

A special task force overseen by the China Securities Regulatory Commission (CSRC), a ministry-level body that regulates the securities industry, is launching yet another nationwide cleanup campaign involving hundreds of over-the-counter (OTC) markets operated or supervised by local authorities that trade items as diverse as precious metals, wine and stamps.

In a statement on its website last month, the CSRC said a resurgence of banned or illicit trading had forced authorities into yet another round of inspections to try to bring the exchanges under control. Market manipulation, illegal futures trading and the swindling of investors were just some of the activities highlighted in a December document that the task force filed with authorities, including the central bank and Ministry of Public Security, and that was seen by Caixin.

Data presented at a meeting of the task force last month showed that more than 300 markets around the country were suspected of engaging in illegal activities. These included investors being allowed to leverage up to 50 times their margin deposits, and of “pump-and-dump” practices in commodity futures trading that left unsuspecting investors suffering heavy losses.

The task force includes officials from several government bodies, including the Ministry of Public Security, Ministry of Commerce, the People’s Bank of China, and the China Banking Regulatory Commission.

“The latest cleanup campaign will focus on regulatory problems and violations of the law that have re-emerged since the last inspection,” CSRC official Zhang Chao said at a briefing in January on fighting illegal futures trading, adding that some local exchanges had been found using a “smorgasbord of tricks.”

“Our goal is to protect the interests of investors, safeguard investors from financial risks, and maintain social stability,” he said.

Central authorities’ efforts to rein in illegal and unscrupulous activities on local government-backed exchanges date back to 2011, when the State Council, China’s cabinet, decided to form a task force to investigate and clean up local OTC markets that had been set up by local authorities and that were poorly regulated. The move followed a string of scandals involving price manipulation, embezzlement, and theft of investor funds.

But six years on, the task force has had little lasting impact, partly because it has no real teeth. It has no enforcement powers and can only make recommendations to local governments that often lack either the will or the way to clean up their exchanges. The CSRC doesn’t even appear to have statistics on the number of exchanges that now exist across the country.

The commission is the regulatory authority for the Shanghai and Shenzhen stock exchanges; the commodity exchanges in Shanghai, Dalian and Zhengzhou; the China Financial Futures Exchange, also in Shanghai; and the Beijing-based National Equities Exchange and Quotations, an OTC market for unlisted small companies and startups that’s become known as “the Third Board.”

But the CSRC has no direct control over the hundreds of local markets that have mushroomed over the last few years. These have all been approved by provincial or city governments that encouraged the development of local exchanges as platforms for fundraising by local companies, and as vehicles for well-connected entrepreneurs to make money. The tax paid on the profits made by the exchanges also became an important source of fiscal revenue for many local authorities.

“Some of the markets have played a positive role in boosting local economies,” the CSRC’s Zhang said. But he acknowledged that many of the exchanges had become platforms for illegal and risky activities such as futures trading and even outright fraud.

The regulatory environment is also poor. The OTC markets are overseen by the very same local governments that approved them. With economic growth and tax revenue taking priority over all else, this conflict of interest has played a key role in the unruly expansion of the exchanges and the proliferation of poorly regulated or illegal activities, said a general manager of a local commodities trading platform who spoke on condition of anonymity.

A source close to the task force told Caixin that pursuing investigations is extremely difficult because so many exchanges were approved by local leaders, and the exchanges are big contributors to local fiscal revenue. As a result, local governments have refused to cooperate with investigators.

Compounding the problems has been the lack of financial and regulatory expertise among local governments, leaving them ill-equipped to supervise the exchanges effectively.

One example of the conflict of interest and the risks to social stability from poor regulation and local government complicity is the Fanya Metals Exchange in southwest China’s Yunnan province. Set up in 2011 with the backing of the local authority, the obscure trading platform morphed into a Ponzi scheme that sucked in billions of yuan of investors’ money through a wealth management product that offered extraordinarily high annual returns of almost 14 percent at a time when bank-savings interest rates were less than 4%.

The scheme imploded in 2015, leaving about 220,000 investors facing combined losses of about 43 billion yuan ($6.3 billion). The local government’s previous support for the exchange plus its failure to regulate Fanya, investigate its collapse or detain its leaders prompted thousands of angry victims to take part in demonstrations demanding justice.

“Fanya channeled the funds it raised from investors across the country back to the province. That's what made the local government happy and why it protected the exchange,” a senior financial market regulator who asked not to be identified told Caixin.

This latest cleanup campaign could take half a year to complete, the January meeting of the task force was told. Regulators have vowed to shut down exchanges and hand the investigation of some local exchanges to public security authorities if their inspections uncover any criminal activity.

But that might be easier said than done, the source from the local trading platform told Caixin. “It would be very difficult to suddenly just shut down local trading venues,” he said, pointing to the potential disruption and the problems of dealing with thousands of disgruntled investors.

Cleaning up hundreds of local exchanges across the country is probably too much to expect, given the influence and resistance of local governments. But the central authorities have started making serious efforts to regulate and standardize the country’s 40 regional OTC equity markets where unlisted companies can sell shares or bonds.

Developing these exchanges has become a priority as the government tries to spur economic growth by giving small companies better access to funding. Shunned by most commercial lenders and unable to meet the strict capital requirements set by the formal stock exchanges in Shanghai and Shenzhen, smaller companies have traditionally been forced to turn to the “shadow banking” industry, where interest rates are far higher.

Recognizing the potential for regional equity exchanges to become a key channel for small and midsize enterprises to raise money, the State Council has issued a series of measures over the past few weeks to encourage their growth and improve their regulation.

On Jan. 26, the eve of the weeklong Chinese New Year holiday, the State Council released a notice on regulation of the OTC equity exchanges which included giving the CSRC greater policing powers.

While provincial-level governments will be responsible for market oversight and risk control, the CSRC will be in charge of formulating rules for issuing equity, according to the notice, which called on local authorities and central government departments to “work together to supervise” the markets.

The CSRC should put on record the list of institutions that operate the regional equity exchanges. Provinces with more than one equity exchange will have to merge them into one market that must be managed by a single institution.

New regulations have been in the works for several years. The commission issued a draft of planned new regulations covering regional equity markets for public consultation back in June 2015. People close to the watchdog told Caixin that the final regulations will be published soon.

But while the central government has taken concrete steps to improve oversight and regulation of the OTC regional equity markets, given their key role in supporting smaller companies, there appears to be little impetus for bringing to heel the hundreds of unruly and poorly regulated exchanges under the control of local authorities. For the CSRC and its task force, it will be a long march with no guarantee of victory.

Contact reporter Dong Tongjian (

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