The risks associated with the popular Yu'ebao and its ilk demand serious attention

Yu'ebao is now the hottest online piggy bank in China. It is essentially an online money market fund at Alibaba managed by Tianhong Asset Management Corporation that offers daily settlement of interest at up to 6.76 percent annualized, 27 times higher than that of bank accounts.

The fund's rising yield since last July further heated the popularity of Yu'ebao and drew billions of yuan from millions of investors. Yu'ebao held 100 billion yuan ($16.1 billion, 11.5 billion euros) in November, six months after its launch, and 400 billion yuan in February. The fever has also fueled money market funds as a whole, sending assets under management to over 1 trillion yuan from 303.8 billion yuan in nine months, accounting for one third of the total assets under management of China's fund sector.

The success of Yu'ebao is not accidental but a mixed result of special timing in interest rate liberalization and the favorable environment for financial innovation. On the one hand, interest rates in the interbank market have been fueled by tightening liquidity since October, leading to a surge in interbank Shibor rates especially before the Chinese New Year. For example, one-week Shibor rates soared to 8.84 percent in December, and 5.36 percent in February. Yu'ebao yields, 90 percent of which come from negotiated deposits, have thus surged.

On the other hand, deposit rates remain regulated in China despite the recent liberalization of loan rates, so banks can only offer limited upside to depositors. Yu'ebao has leveraged the concept of money market funds providing rates linked to Shibor and of transaction accounts offering daily settlement.

High yield with perfect liquidity has made Yu'ebao an unbeatable product, draining 400 billion yuan from banks in just a few clicks. Rapid expansion of Yu'ebao has in a sense quickened the pace of interest rate liberalization, pushed banks to face challenges of rate hikes, encouraged financial innovation and encouraged the development of Internet finance.

However, with all the advantages come risks, and proper regulation and supervision is needed so there are no large system fluctuations and to protect consumers.

There are serious liquidity risks with Yu'ebao, and the Internet exacerbates such risks. With Yu'ebao, the risks are mainly the result of its aggressive T+0 terms in transactions, significant maturity mismatches between assets and liabilities, and loose risk management. Specifically, Yu'ebao offers aggressive T+0 terms in transactions, but money market funds run on a T+1 basis, which implies Yu'ebao is responsible for paying one day in advance for daily settlement.

The one-day time difference could pose serious problems for Yu'ebao in the case of a bank run despite its efforts in January to set caps for withdrawals, 50,000 yuan being the daily limit, and 200,000 yuan being the monthly limit.

A significant mismatch in maturity in liabilities and assets is another problem. About 90 percent of Yu'ebao's assets are allocated on contract deposit with maturity of seven days, two weeks and one month. The rest is put into longer-term bonds with higher yields. Daily settlement at T+0 terms suggests that a large flow of withdrawals that exceeds provisions could quickly drain Yu'ebao of liquidity and cause immediate defaults. With Yu'ebao's aggressive risk-taking, it uses its own model to estimate cash needs and keeps 5 percent of estimated fund outflows as extra provision; in the case of banks, the reserve requirement is 20 percent .

Furthermore, as an Internet financial product, liquidity risks associated with Yu'ebao could be amplified and spread quickly online. When Yu'ebao's yield ticked to zero on Feb 12, the result of a technical error, there was panic among depositors, and that led to a quick outflow of funds.

The absence of any clear framework for regulation and supervision is also worrying. Despite the rapid expansion of Internet finance, there is still no regulatory body to supervise it. Yu'ebao's money market fund settlement account is supervised by the China Securities Regulatory Commission, and its provision account is supervised by the People's Bank of China. Money transferred between these two accounts lacks any clear supervision. In addition, accounts at Yu'ebao can be topped up through various channels, which are essentially deposit-taking activities but not regulated by the People's Bank of China.

A lack of supervision also results in a lack of transparency in disclosure and insufficient investor education. Information published by Yu'ebao on its website only highlights its past yields and account opening procedures, insufficient for investors to fully understand the fund's underlying assets and associated risks.

Fund size, investment scope, management strategy and risk assessment are not mentioned. Insufficient public information regarding the fund may mislead investors who are less averse to risk and cause unexpected losses when things go wrong.

There are also cyber security concerns. The loose identity verification mechanism of Yu'ebao has led to several cases of unauthorized transfers from victims' accounts to those of criminals.

Yu'ebao provides two lessons for China at its current stage of capital market development. First, supervision needs to catch up with innovation quickly in a fast-moving modern society. Yu'ebao presents serious exposure to risks especially given its rapid expansion, which may trigger systematic risks in the financial sector. Instead of shutting down Yu'ebao and similar products, regulations and supervision should move quickly to cover the risks associated with them.

The China Securities Regulatory Commission, the People's Bank of China, the China Banking Regulatory Committee, the China Insurance Regulatory Commission and the Ministry of Industry and Information Technology should set up a joint supervisory committee for comprehensive cross-board supervision.

Stricter due diligence should be required to minimize potential risks of illegal deals through Yu'ebao.

Furthermore, capital requirements for payment and provision accounts should be clearly addressed. For example, loss provision requirements for money market funds now set at 10 percent of accrued management fee with a cap of 1 percent of assets under management should be raised to discourage aggressive risk-taking behavior like that of Yu'ebao.

In fact, the China Securities Regulatory Commission adopted a measure in 2011 requiring loss provisions to cover 200 percent of accrued interests, but it has not been well implemented. In this case, the loss provisions required for Yu'ebao will have to rise to about 2 billion yuan from the current 100 million yuan, which will promote Yu'ebao's healthy development.

Apart from loss provisions, zero punitive deductions for the earlier withdrawal of negotiated deposits should be revised to ensure stability of the banking system in liquidity management.

Finally, a regulatory framework on consumer protection of Internet finance should be set up urgently to clearly identify the responsibilities and obligations of product providers, fully disclose product information, structure, returns and risks, set up an insurance system, and set up an arbitration body to handle disputes.

Authorities have been forced to liberalize interest rates at the behest of the markets, posing challenges to banks' capacity for more efficient management, faced with rising deposit rates and a narrower interest spread. The long-awaited deposit insurance system is urgently needed to lower risks in the financial sector.

The author is head of research and chief economist at Haitong International Securities based in Hong Kong. The views do not necessarily reflect those of China Daily.

(China Daily European Weekly 05/09/2014 page12)