Money market reform in ChinaJ.P. Morgan Global Liquidity

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Table of contents

Money market reform in China Page 04

Growth of the money market fund industry in China Page 05

Comparison of money market fund guidelines Page 07

Conclusion Page 11

4 MONEY MARKET REFORM IN CHINA

IN BRIEF • New China Securities Regulatory Commission (CSRC) guidelines deliver the most

significant changes to the rules governing Chinese money market funds (MMFs) since the industry was established in 2004.

• The new rules, which bring Chinese guidelines more in line with their Western counterparts, aim to make the money market fund industry more robust and transparent while minimizing its exposure to systemic risks.

• For retail funds, the new guidelines will increase liquidity while reducing credit and interest rate risk. However, the rules will also negatively impact fund yields and the ability of fund managers to outperform their peers.

• For institutional-focused funds with AAA ratings, the impact of the new CSRC guidelines will be negligible; that is because rating agency guidelines already have significantly tighter restrictions than the new guidelines.

INTRODUCTION

In December 2015, the China Securities Regulatory Commission1 announced the introduction of new guidelines2 for domestic money market funds (Exhibit 1). These guidelines, which came into force on February 1, 2016, represent the most significant and comprehensive changes to the rules governing Chinese money market funds since the industry was established in 2004. The new guidelines aim to reduce risk, increase liquidity, improve disclosure and encourage more proactive credit control by the fund manager. They also should help improve standardization and availability of information, and bring Chinese money market funds more closely in line with Western money market fund guidelines.

The new guidelines represent the most comprehensive changes to the rules governing Chinese money market funds since the industry was established in 2004

EXHIBIT 1 | KEY ELEMENTS OF NEW CSRC GUIDELINES

Safety• Tighter WAM/WAL3 limits• Stricter concentration

limits Liquidity

• Liquidity requirement • Redemption fee • Liquidity support

Stress tests• Independent credit

assessment • Frequent stress tests

NAV• Negative deviation limits

and actions • Positive deviation limits

and actions

Disclosure• Improved marketing

materials • Improved disclosure

requirement

Innovation • Broader investment scope • Product innovation

Source: China International Fund Management Co., Ltd, J.P. Morgan Asset Management; data as of June 30, 2016.

AIDAN SHEVLIN, CFAManaging DirectorHead of Asia Pacific Liquidity Fund ManagementJ.P. Morgan Asset Management

Money market reform in China

1 The China Securities Regulatory Commission (CSRC) is a ministerial-level public institution, directly under the State Council, that provides regulatory functions over China’s securities and futures markets.

2 Source: CSRC, Order No. 120; data as of 2015.3 WAM = Weighted Average Maturity, WAL = Weighted Average Life.

J .P. MORGAN ASSET MANAGEMENT 5

The first Chinese fund manager opened for business in mid-2001. In August 2004, the CSRC published its first set of money market fund guidelines,4 triggering the start of the money market fund industry in China.

From the outset, money market funds served as a key channel for investors to take advantage of market-driven yields that were higher than those offered by bank deposits. Initially, the pace of industry growth was slow, but a combination of improved investor awareness, a growing number of funds and a wider range of distribution methods dramatically increased the appeal of money market funds to both retail and institutional investors.

The number of money market funds doubled between December 2011 and December 2013 and had doubled again by the end of 2015 (Exhibit 2). Between 2011 and 2015, money market fund assets under management (AUM) rose 14-fold to CNY 4.6 trillion (USD 704 billion), accounting for roughly 55% of the Chinese mutual fund industry’s total AUM (Exhibit 3, next page). Globally, renminbi money market funds now account for 13% of global money market fund assets,5 up from just 0.5% in 2010.

4 Source: CSRC, Order No. 78; data as of 2004.5 Source: Crane Data, ICI; data as of December 31, 2015.

Between 2011 and 2015, the number of Chinese money market funds increased to 239 and Chinese money market fund assets under management rose 14-fold to CNY 4.6 trillion (USD 704 billion)

EXHIBIT 2 | NUMBER OF CHINESE MONEY MARKET FUNDS AVAILABLE; CHINESE FUND INDUSTRY AUM

0

40

80

120

160

200

240

280

2005 2007 2009 2011 2013 2015

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

2005 2007 2009 2011 2013 2015

QDII

Alternatives

Bonds

Money markets

Balanced

Equity

CNY

billi

on

Source: Wind Information Co., Ltd, J.P. Morgan Asset Management; data as of June 30, 2016.

Growth of the money market fund industry in China

6 MONEY MARKET REFORM IN CHINA

Globally, renminbi money market funds now account for 13% of global money market fund assets vs. just 0.5% in 2010

EXHIBIT 3 | CHINE SE FUND INDUSTRY AND G LO BAL M O NE Y MARKE T FUND INDUSTRY

Equity, 8.4%QDII, 0.7% Others, 7.0%Korea, 1.5%

Australia, 6.0%

U.S. 51.1%

Bonds, 8.4%

Money markets,54.8%

Balanced, 27.4%

Alternatives, 0.3%

China, 12.7%

Ireland, 9.4%

France, 6.3%

Luxembourg, 6.0%

Chinese fund industry (market share) Global money market fund industry (domicile)

Source: Crane Data, ICI, J.P. Morgan Asset Management; data as of June 30, 2016.

The Chinese money market fund industry remains dominated by retail investors, who typically focus on a fund’s yield, size and ease of purchase when deciding which funds to buy.

The industry is highly concentrated; the top 15 funds hold over 60% of assets under management. Historically, given limited distribution methods, fund managers typically focused on performance as their key differentiator.

Over the years, a niche, AAA rated money market fund industry developed to serve the needs of more-risk-averse investors, including local companies and multinationals operating in China. While these investors appreciate the benefits of higher, market-driven yields, they do not want to compromise liquidity and security.

Growth of the money market fund industry in China (continued)

J .P. MORGAN ASSET MANAGEMENT 7

Western money market fund guidelines

Preservation of capital and liquidity have long been the primary objectives of money market funds. With those goals in mind, Western regulators, rating agencies and the leading trade association, the Institutional Money Market Funds Association (IMMFA), generally consider five key criteria when establishing money market fund guidelines: duration, credit ratings, instrument type, concentration and risk monitoring. These relate to the key risks faced by money market funds.

Chinese money market fund guidelines When the CSRC designed the first renminbi money market fund guidelines in 2004, the Chinese regulator looked to follow the same basic template as Western guidelines. However, while the CSRC’s original guidelines did reference the five key criteria for money market funds (as listed above), the restrictions it imposed on the industry were relatively loose and interpretations of its guidelines were similarly relaxed. In short, fund managers typically focused on yield at the expense of liquidity and security.

In recent years, the CSRC has modified and fine-tuned the guidelines on several occasions to reduce misinterpretation and improve oversight. Its latest iteration (Exhibit 4), which represents the most significant and detailed change since the publication of the original guidelines, aims to make the money market fund industry more robust while minimizing its exposure to systemic risks. This goal is especially critical at a time of increasing credit and liquidity risk.

The new CSRC guidelines aim to make the money market fund industry more robust while minimizing its exposure to systemic risks

EXHIBIT 4 | CSRC ORIGINAL AND NEW GUIDELINES: A DETAILED COMPARISON

KEY GUIDELINE ORIGINAL CSRC GUIDELINES NEW CSRC GUIDELINES

Weighted average maturity (WAM) 180 days 120 days

Weighted average life (WAL) N/A 240 days

Maximum maturity • Bonds: 397 days• Term deposits, repo & T-bills: 1 year• Floating rate note: max 20% if tenor > 397 days

• Bonds: 397 days• Term deposits & repo: 1 year• Floating rate note: max 20% if tenor > 397 days

Minimum credit quality • Short term: A-1 (domestic ratings) • Long term: AAA (domestic ratings)

Long term: AA+ (domestic ratings)

Minimum liquidity requirements N/A • Min of 5% in daily liquidity• Min of 10% in weekly liquidity• Max 30% in term deposits, repo & corporate

investments with maturities > 10 days

Repo/reverse repo concentrations • Repo: max 20% • Reverse repo: max 100%

• Repo: max 20% • Reverse Repo: max 100%

Corporate issuer concentrations 10% per corporate issuer 10% per corporate issuer

Time deposit concentration • Total 30%• 30% per issuer with custody license • 5% per issuer without custody license

• Max 30% (excluding redeemable term deposits)• 20% per bank with custody license • 5% per bank without custody license

Monitoring, reporting & stress tests • Action required if NAV deviation +/- 0.5%• Quarterly reporting

• Action required if NAV deviation +/- 0.25%• Manager discretion on reporting frequency• Conduct regular stress tests

Source: CSRC, Order No. 78 and Order No. 120; data as of 2004 and 2015, respectively.

Comparison of money market fund guidelines

8 MONEY MARKET REFORM IN CHINA

The new guidelines will have a substantial impact on fund managers, investors and domestic financial markets (Exhibit 5). Importantly, fund managers will have much less freedom to interpret this iteration of the CSRC rules. Although we expect a wider range of instruments and issuers in money market funds, fund managers are now more responsible for assessing the credit quality of issuers they purchase and for protecting their funds against adverse market movements. For investors, fund yields will be lower, but fund volatility will also decline, while liquidity, credit quality and disclosure will improve significantly. Trading volumes and demand for short-maturity securities should increase, although demand for issuance by riskier borrowers should decline.

Comparison of money market fund guidelines (continued)

For investors, fund yields will be lower, but fund volatility will also decline, while liquidity, credit quality and disclosure will improve significantly

EXHIBIT 5 | IMPLICATIONS OF NEW CSRC GUIDELINES

GUIDELINE CRITERIA POTENTIAL IMPLICATIONS

Duration • Reducing maximum duration to 120 days for all funds will reduce interest rate risk, create a level playing field and bring funds closer in line with global limits

• Introduction of a 240 day weighted average life limit will also reduce liquidity risks

Ratings • Focus on long-term ratings improves ratings granularity

• The reduction of minimum credit rating from AAA to AA+ will have a negligible increase in risk

• Short-term A-1 rating requirement is removed; this closes the loophole that allowed investments in AA- securities with long-term rates

• CSRC is encouraging fund managers to establish and strengthen their credit rating systems

Instrument types • Clarifies the range of securities funds cannot invest in

• Allows for investment in new securities (such as negotiated certificates of deposit) if they meet the criteria

Liquidity & concentration

• Introduction of minimum daily and weekly liquidity requirements will reduce liquidity risk

• Overnight liquid assets include cash, government bonds, People’s Bank of China T-bills and policy bank bonds

• Weekly liquid assets include cash, government bonds, People’s Bank of China T-bills, policy bank bonds and other securities maturing within five working days

• A maximum of 30% in illiquid instruments will improve fund liquidity

• Issuer and instrument concentration limits remain unchanged

Risk monitoring • Stricter NAV monitoring limits require rectification within five days if NAV falls below -0.25bps and rectification within two days if NAV falls below -50bps; otherwise float the NAV or close the fund

• Introduce a discretionary 1% redemption if 5 day liquidity falls below 5% and fund has a negative NAV

• Introduction of stress tests to ensure funds can cope with extreme risk scenarios

Source: China International Fund Management Co., Ltd, J.P. Morgan Asset Management; data as of June 30, 2016.

J .P. MORGAN ASSET MANAGEMENT 9

Comparison of money market fund guidelines (continued)

Rating agency guidelines

Although the new CSRC guidelines more closely resemble their Western counterparts, a substantial gap remains between the two standards (Exhibit 6); this highlights the continued benefits of using tighter rating agency guidelines for investors whose priorities are liquidity and security.

Though the new CSRC guidelines more closely resemble their Western counterparts, a substantial gap remains between the two standards EXHIBIT 6 | CSRC GUIDELINES, FITCH CHINESE AAA GUIDELINES AND IMMFA INTERNATIONAL CODE GUIDELINES: A DETAILED COMPARISON

KEY GUIDELINE NEW CSRC GUIDELINES FITCH RMB GUIDELINES IMMFA CODE GUIDELINES

Weighted average maturity (WAM) 120 days 75 days 60 days

Weighted average life (WAL) 240 days 120 days 120 days

Maximum maturity • Bonds: 397 days• Term deposits & repo: 1 year• Floating rate note: max 20% if

tenor > 397 days

• Bonds: 397 days• Term deposits & repo: 1 year• Floating rate note: max 2 years

Fixed rate note & Floating rate note: 397 days

Minimum credit quality Long term: AA+ (domestic ratings) • Long term: A- or short term: F2 (international rating)

• Min 50% rated F1 (international rating)

• Long term: A or equivalent• Short term: A-1 or equivalent

Minimum liquidity requirements • Min of 5% in daily liquidity• Min of 10% in weekly liquidity

• Min of 10% in daily liquidity• Min of 25% in weekly liquidity

• Min of 10% in daily liquidity• Min of 20% in weekly liquidity

Repo/reverse repo concentrations • Repo: max 20% • Reverse repo: max 100%

• Repo: not allowed• Reverse repo: max 100%• Max 25% per stock exchange repo• Max 20% in IB repo; max 10% per

counterparty

• Repo: not allowed• Reverse repo: max 100%• Max 10% per overnight repo

Maximum issuer & issue concentrations

10% per corporate issuer • 5% per corporate issuer• 100% in govt issuers & 25% per

issue• 50% in policy banks & 15% per

issue• 15% per Big Five bank & 15% per

issue

• 5% per issuer• Max 10% per issuer 5 working days• 100% per high quality government

Time deposit concentration • Max 30% (ex-redeemable term deposits)

• 20% per bank with custody license,

• 5% per bank without custody license

• Max 30% (ex-redeemable term deposits) 15% per bank with custody license,

• 5% per bank without custody license

• 5% per term deposit counterparty• Max 10% per term deposit

counterparty < 5 days

Monitoring, reporting & stress tests

• Action if NAV deviation +/- 0.25%• Manager discretion on public

reporting• Conduct regular stress tests

Action if NAV deviation +/- 0.50% Action if NAV deviation +/- 0.50%

Source: CSRC, Fitch Ratings, IMMFA, J.P. Morgan Asset Management; data as of June 30, 2016.

10 MONEY MARKET REFORM IN CHINA

The domestic AAA money market fund guidelines offered by international rating agencies in China (Exhibit 7) remain significantly tighter than the CSRC guidelines, while also taking account of the unique characteristics of local financial markets. These include relatively opaque monetary policy, unique instruments such as stock exchange repo, and a more limited range of issuers relative to Western markets—all of which can have a meaningful impact on local market liquidity and volatility.

Fitch’s domestic Chinese money market fund guidelines remain more restrictive EXHIBIT 7 | C SRC AND FITCH GUDELINE S: A CO MPARIS O N O N FIVE KE Y CRITERIA

CSRC CRITERIA FITCH

• WAM: 120 day• WAL: 240 days

DURATION • WAM: 75 day• WAL: 120 days

AA+ (domestic scale) CREDIT RATING A-/F-2 (international scale)

• Overnight: > 5%• 1 week: > 10%• Illiquid securities < 30%

LIQUIDITY• Overnight: > 10%• 1 week: > 20%• Illiquid securities < 20%

Repo: < 20% INSTRUMENTS Repo not allowed

• Stress tests• Triggers for reporting

MONITORING • Weekly agency monitoring• Annual on-site visits

Source: CSRC, Fitch Ratings; data as of June 30, 2016.

Under Fitch Ratings, for example, durations are shorter, concentrations are tighter, the range of approved instruments is constrained, and credit quality limits are significantly stricter. These restrictions do limit the ability of funds to outperform. But they also address the key challenges of credit risk and liquidity risk that face Chinese institutional investors.

Comparison of money market fund guidelines (continued)

J .P. MORGAN ASSET MANAGEMENT 11

Conclusion

The new CSRC guidelines represent an important milestone in what is still the relatively brief history of money market funds in China. In the dozen years since the industry was launched, MMFs have become a very important asset class, exposing investors to the benefits of interest rate liberalization and market pricing, helping to broaden and deepen investment markets, stimulating new avenues of distribution and reducing the market’s dependence on commercial banks. The proliferation of money market funds and the rapid growth of assets under management underline their importance to both retail and institutional investors.

For institutional-focused funds with AAA ratings, the impact of the new guidelines will be negligible; that is because rating agency guidelines have significantly tighter restrictions. For the much larger retail money market fund sector, the new guidelines will increase liquidity while reducing credit and interest rate risk. They will also improve disclosure standards and encourage more proactive credit control by the fund manager. However, the rules will also negatively impact fund yields and the ability of fund managers to outperform their peers.

In sum, the latest iteration of the CSRC money market fund guidelines delivers significant change. The new guidelines encourage a more robust investment process and address the key challenges facing China’s domestic money market fund industry. By any measure, that is no small accomplishment.

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