Yu’e Bao: A Double-Edged Sword for Financial Innovation
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By Henry Hing Lee Chan

Yu’e Bao: A Double-Edged Sword for Financial Innovation

May. 10, 2017  |     |  0 comments

A tabulation of money market funds on March 31, 2017 shows that Alibaba’s Yu’e Bao is the world’s largest money market fund. Yu’e Bao, which in Chinese means “leftover treasure,” has USD 165.6 billion (RMB 1,140 billion) under management. In comparison, the second-place fund, JP Morgan’s US government money market fund, has USD 150 billion under management.

Yu’e Bao was set up in June 2013 by the Chinese tech giant, Alibaba, as a repository for leftover cash from online spending. The speedy growth of the fund highlights the pervasive role now played by technologies in people’s lives in China, which at the same time disrupts important erstwhile state-controlled economic pillars such as finance.

In June 2013, Alibaba’s third-party payment affiliate, Ant Financial (Alipay), moved into fund management when it spotted the growing cash balances in customers’ accounts that are used to pay for purchases ranging from food to appliances at the Alibaba e-commerce portal, Taobao. Ant Financial forged a strategic tie-up with the fund management company Tianhong Asset Management Co. and formed Tianhong Yu’e Bao Money Market Fund under the fund trading code: 000198.

Yu’e Bao operates by persuading Alipay customers to transfer their account balances into the fund. This not only allows Alipay to offer a return on the surplus funds of Taobao customers, but also encourages these customers to keep more funds indirectly at Alipay through Yu’e Bao and facilitate their future big ticket purchases at Taobao. This arrangement is like what US stockbrokers did with client funds in the 1970s. The clients’ excess funds were transferred into money market funds that were readily available to the clients anytime they needed their funds for trading purposes. Yu ‘e Bao was an instant success. By March 2014, or less than nine months after its launch, it had attracted 81 million investors with deposits of more than 500 billion RMB. By comparison, China’s A-share stock market only had 67 million investors after 23 years of operation.

The key factor behind Yu’e Bao’s initial success is its high interest rate. While ordinary demand deposits at major banks offer an annual interest rate of just 0.35 percent, and the one-year time-deposit rate was 3.3 percent p.a. in 2013, Yu’e Bao offers an annual rate of about 6 percent p.a. while still allowing deposits to be withdrawn at any time. The ability of Yu’e Bao to offer such a high rate is a combination of its ability to bargain with financial institutions as well as its pioneering application of financial analytics. Of course, the surge of the Shanghai interbank rate at the time of its launch also allowed it to offer higher rates.

Wang Dengfeng, a Tianhong fund manager who oversees the money market fund connected with Yu’e Bao, explained in a 2014 interview with China’s major business paper Caixin how Tianhong allocates Yu’e Bao funds and earns interest higher than the prevailing interbank rate: “We allocate investments and match maturities based on data analysis. At different stages a bank’s ability to take deposits varies. On one hand, there are banks that can only take, say, 10 billion yuan, but we have 11 billion yuan that needs to be taken care of. That is when we hit the limit of their deposit-taking ability. We can deal with other banks or lower the interest rates we charge. On the other hand, a larger size brings greater negotiating power. We can ask for higher interest rates.”

Many traditional banks have fought back by limiting the monthly transfer limit to RMB 50,000 to online money market platforms such as Yu’e Bao. They also launched similar products and raised their deposit interest rates. These banks have slowed the growth rate of Yu’e Bao after 2014 but their efforts to compete against online money market funds were apparently not too successful. The latest published information at April 27 on Yu’e Bao’s website reveals that it has more than 260 million investors.

There is a lingering doubt on who should be the final regulator of Chinese money market funds such as Yu’e Bao.

Yu’e Bao continues to offer higher than regular market rates to its investors. The latest 7-day yield on April 27 is 3.959 percent p.a., a rate that is significantly higher than the prevailing Shanghai overnight loan rate of 2.8 percent p.a. and the seven-day rate of 2.9 percent p.a., and is comparable to the one-month rate of 4.0161 percent p.a.

The minimum size of Yu’e Bao transactions is RMB 1.00 (less than 15 US cents), an amount so miniscule that it demonstrates the ability of modern technology to bring down financial transaction costs to the erstwhile impossible sub-cent level. According to Alibaba’s blog, Alizila, the clear majority of Yu’e Bao users are under the age of 30. One in seven are from rural China, where low-income families use Yu’e Bao as a low-cost wealth management tool.

It is fair to say that Yu’e Bao has helped the sub-30s and rural populations to save more and improve their access to financial services. The dramatic reduction of transaction costs and the use of big data analytics to predict fund flows has improved the operation of the economy.

The sheer size of Yu’e Bao has also brought out unpleasant issues of liquidity concentration and regulatory arbitrage. The ability of Yu’e Bao to negotiate interest rates that are higher than market rates with financial institutions is clearly a result of its control of a good size of market liquidity. This advantage is particularly apparent when the fund deals with smaller institutions. A report issued by China International Capital Corporation in 2015 estimated that the online money market fund will shave off 0.15 percent from banks’ net-interest margin by the end of 2016. The traditional banks now face the prospect of competition for retail deposits from online money market funds and smaller institutions must source their funding from these funds rather than the public. As Chinese regulators still provide an effective guarantee on financial institutions despite the introduction of deposit insurance, this liquidity concentration presents a systemic risk.

It should also be noted that Chinese money market funds enjoy more latitude in taking investment risks than their European or US counterparts. The range of instruments that Chinese money market funds can use include negotiable certificates of deposit and lower quality AA+ corporate bonds. The liquidity requirements for assets held by Chinese money market funds are also less stringent than in the US or Europe. The yield of the second-place JP Morgan US government money market fund clearly demonstrates how different regulatory regimes affects the fund yield. Its April 27 website shows a yield of only 0.02 percent p.a. year-to-date, a level much lower than the prevailing interbank Fed fund rate of 0.25 percent. While Yu’e Bao can offer above the interbank yield, US money market funds can only provide below the interbank yield. As yield is correlated to risk in the financial market, many observers are worried over the risk that Chinese money market funds such as Yu’e Bao potentially carry.

There is a lingering doubt on who should be the final regulator of Chinese money market funds such as Yu’e Bao. The People’s Bank of China oversees Alipay and the China Securities Regulatory Commission supervises Tianhong and the funds it manages. The China Banking Regulatory Commission must pay attention to the fund because banks play a key role in Yu’e Bao’s investments. The issue of multiple regulators on one entity naturally raises the issue of regulatory lapses and arbitrage. Concerns over the issues of liquidity risk of Chinese money market funds and regulatory arbitrage are reasonable.

The success of Yu’e Bao is a double-edged sword for financial innovation. It is a product of technology innovation that significantly improves the efficiency of financial transactions and bring the erstwhile unprofitable financial service within the reach of earlier underserved groups. However, its unchecked growth could backfire if the product and institutions are too loosely monitored and regulated. The risk is particularly high in China under its implicit state-guaranteed financial system.

While many people maintain that innovation should be left alone and allow society to self-adjust based on market forces, the spread of anti-establishment thinking in many developed countries around the world has casted doubt on such recommendations. The speed of innovation is unprecedented and the time of adjustment is now too short in many cases. This does not mean that we are calling for a slowdown of innovation nor are we calling for unnecessary government intervention on innovation. What we think of as the prudent move is an examination of innovation on prevailing government regulations to ensure a fair playing field for new entrants and existing players. This not only preserves the benefits of innovation, but also prevents the issue of regulatory arbitrage that could backfire on economic and social system stability. In the end, innovation needs a stable social and macro-economic environment to deliver its benefits to the people.

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