Cover Story: Chinese Brokerages’ Dual Roles in Bond Market Sparks Concern for Conflicts of Interest That Raises Systemic Risk

China’s securities brokerages are thriving in the bond market, but a surge in the fixed-income sector has sparked concerns over regulatory loopholes and conflicts of interest [para. 1][para. 5]. In recent years, the fixed-income market has become pivotal for Chinese brokerages, with bonds constituting 65% to 70% of their holdings. As of January 2023, brokerages held about 4.5 trillion yuan ($632.2 billion) in bonds [para. 2]. Leading brokerages like Citic Securities and Guotai Junan now manage bond advisory services worth hundreds of billions of yuan. Citic Securities, for instance, had a business scale of 450 billion yuan by the end of 2023 [para. 3].

These advisory services predominantly cater to small and medium-sized banks, which have increasingly outsourced their bond investments since around 2010 [para. 4]. However, despite their success, brokerages face criticism for potential conflicts of interest and opaque operations, especially in mixing asset management with investment activities [para. 5]. Comparisons are drawn to the post-2008 financial crisis measures in the U.S., where the Volcker Rule was introduced to restrict proprietary trading [para. 6]. Critics argue for similar regulations in China to close regulatory loopholes and prevent risky practices [para. 6].

The rapid growth in fixed-income operations has led to aggressive strategies that may expose small and medium-sized banks to significant risks. A sudden downturn in the bond market could result in substantial losses for these banks [para. 7]. In response, the National Association of Financial Market Institutional Investors (NAFMII) has intensified oversight, issuing disciplinary actions against more than 40 institutions for violations in bond holding and trading. Investigations uncovered illegal practices like account lending and benefit transmission among small and medium-sized financial institutions [para. 8]. NAFMII has also launched self-discipline investigations into six financial institutions over issues related to illegal holding and lending of bond accounts [para. 10].

China’s brokerages have traditionally focused on managing their own funds and selling bonds, functioning as major underwriters and market makers [para. 12]. To expand their influence in the bond market, brokerages have targeted small and medium-sized banks as clients, implementing off-balance-sheet institutions to manage transactions and capital more flexibly [para. 13]. Over the past decade, major brokerages have expanded their roles to dominate the bond market. However, their increasing reliance on proprietary investments, which by 2023 accounted for almost 30% of brokerage revenue, has blurred lines between proprietary and asset management activities [para. 16].

The market sees the increasing dependence on proprietary investment as problematic. For instance, Haitong International Securities Group in Hong Kong suffered heavy losses after investing in U.S. dollar bonds issued by Chinese real estate companies, highlighting the dangers of excessive reliance on proprietary investment [para. 17]. Regulators have started scrutinizing brokerage practices more rigorously, with the Beijing Securities Regulatory Administration ordering CICC to increase compliance checks in response to conflicts of interest [para. 20].

The bond advisory business model typically involves three approaches: brokerages providing advisory services to banks, outsourcing asset management, or selling trust products through banks [para. 21]. The opacity of off-balance-sheet operations poses significant risks, as brokerages can shift losses or risks to other financial institutions, potentially destabilizing the market [para. 22]. The rapid growth of these services has made fixed-income departments quasi-asset management operations, yet without the same regulatory oversight [para. 23].

Illegal practices, such as account lending and price manipulation, have been unveiled, with institutions leveraging complex chains to obscure transactions, creating obstacles for regulatory oversight [para. 27][para. 28]. For instance, four rural commercial banks in Jiangsu province were found manipulating market prices [para. 32]. Experts call for stronger regulations and clearer distinctions between proprietary and client funds to prevent conflicts of interest [para. 34]. To ensure market integrity, brokerages are urged to follow robust internal controls and maintain clear operational boundaries [para. 37]. The consensus is that brokerages should return to their core role as capital intermediaries [para. 39].