What lessons can securitization bring to Chinese style online finance?

How can you link securitisation and Chinese-style online finance? I struggled, and initially found it even difficult to fit both expressions into a single (sensible) paragraph.

To begin we need to clarify what this essay truly infers when mentioning abstractions such as online finance and securitisation. To keep it simple, I consider Chinese style online finance as everything that is and can be done with applications such as Alipay. 

Alipay is the leading Chinese third-party online payment platform. Alipay is so omnipresent that the author is unaware of any services that can’t be purchased with Alipay.

Securitisation, in this essay shall refer to a standard securitisation process commonly undertaken with commercial and residential mortgages or other types of corporate and consumer debt. A product example can be a standard mortgage-backed security, as popularised during the 2008-9 financial crisis.

The online finance industry is a space up for grabs. Dozens of online payment systems and hundreds of financial services platforms compete for the Chinese, as well as the global market. Technological innovation, globalization and market penetration of these services have not only outpaced any attempts at their regulation, but have effectively eliminated or even entirely pre-empted attempts at competition by any regulated banking group. Online finance has no queues and is instantaneous, direct and free to consumers. It is set up in minutes and comes with a variety of other features:

1、It effectively offers a (shadow) banking relationship with some of the most trusted, privately owned Chinese companies, namely Alibaba, Tencent and Baidu.

2、These quasi-bank accounts can be used to circumvent various payment and transfer limits, restrictions, fees and delays, as well as interest rate and investment caps, inherent in traditional bank accounts and payment media.

3、In addition the accounts are ideally suited to subvert checks and balances in the movement of money through the Chinese banking system, including capital controls, AML efforts and restrictions on the financing of illegal activities.

The disadvantages and risks to consumers in banking with a quasi- or non-regulated bank are obvious (the financial crisis of Wenzhou is likely the best Chinese example), but tend to be conveniently ignored by Chinese citizens who are accustomed to bailouts of even the most non-systemic entities.

In China, any venture that involves or is set up by government or the party is fairly likely to be systemic. A critical mass of citizens involved in a venture also tends to elevate the venture to systemic level (see the existence of zombie companies and bailouts of wealth management products in default). On the contrary in the US, even U.S. territory such as Puerto Rico is not considered systemic (neither was Lehman Brothers).

An event of failure of a somewhat significant (through either sheer size or government relations) online finance player is merely a question of time and the effects accompanying such an event are fairly obvious. First consumers are bailed out to an extent that they take no losses on principal. This is then followed by slews of corrective regulations, individually written by ‘relevant’ regulators at ‘relevant’ levels. However the interpretation, implementation and enforcement of any such regulation may lie with other ‘relevant’ authorities, be subject to existing and local regulation and therefore may significantly lag, as well as lack its original intention.

Regulation tends to be written at a national level, but implementation lies with provincial, city and even county level authorities. These authorities have the power to shape the interpretation and time the subsequent implementation of the local-level interpreted national level policies. In addition, in the Chinese regulatory environment a wealth of government/party bodies at various levels exist. Their respective duties and responsibilities aren’t clearly defined and they therefore end up fighting for authority and power. As a result, interpretation, implementation and enforcement of regulation are less than optimal.

In an attempt to pre-empt or at a minimum prepare for this situation, online finance should borrow extensively from lessons learned by securitisation efforts.

Securitisation of mortgages, as created by Lewis Ranieri, a person from roots as humble as those of Ma Yun , was navigated into being one of the most promising tools of modern finance. With the growth of the process and innovation within, (the potential for) moral hazard grew correspondingly. Not only did regulators miss the risks, but even the executors of securitisation business were blinded by apparently easy money and super-senior assets. Almost all institutions took on astronomical risk, until a mere price discovery process divided them into patsies and survivors.

While potentially profitable in the short term, it is as idiotic to

bank to hundreds of millions of mobile accounts without proper means of identification of individual users, as it was to create, sell and buy MBS made up of undocumented loans.

advertise MM funds (Money Market) in a way that encourages customers to compare them to CDs (Certificate of Deposit), as it was to sell or consider a MM fund, credit linked note or commercial paper as a riskless asset.

attempt to artificially increase asset prices, just as it was for

o Lehman Brothers to buy back stock to increase its cost of carry.

o Institutions to attempt to insist on marking assets at mark-to-model [Type 3] asset prices during the MBS trading freeze in 2008.

o Taxpayers to invest in the Chinese stock market during the present.

Securitisation led to the financial crisis, as market participants stopped to continuously critically evaluate their books of assets and the desirability of their business (relationships). In the absence of coherent regulation, regulatory guidance on, and enforcement of existing laws and regulation, participants failed to effectively self-regulate and turn down business.

At some point the force of the market and (in all likelihood the law, too) will strike back against those who don't spot moral hazard early.

Moral Hazard describes a situation in which a party A decides upon the amount of risk to take and some party B pays up when the risk materializes. 

At the benefit of short-term convenience and interest (not just for users, but also shadow bankers), online finance is ripe with similar moral hazard. Pre-emptive self-regulation, restraint and self-discipline by any player may improve its long-term competitive position (see the cases of Wells Fargo & J.P. Morgan), lessen problems of moral hazard and increase the eventual power of industry participants to influence and shape regulation.

Given the increasing state-ownership in the financial sector, state-owned competitors will find ways to make their offerings increasingly attractive, either through regulatory initiatives or by using their low cost of funding to eliminate direct competition through pricing. Pre and post financial crisis, securitisation markets countered pricing and access to customer issues, as well as regulatory issues and clampdowns through M&A (notably this also includes spinning off assets). Similarly, an online finance environment with several dozens of providers will not prevail and any regulatory clampdown will hasten M&A between online and offline players to reach levels of vertical as well as horizontal integration, which are currently only offered by Alipay and Tenpay. 

A key element to securitisation’s growth was the standardisation of individual (and relatively small) mortgages through the Fannie Mae and Freddie Mac guarantee processes. Online finance has a similar opportunity: Alipay has achieved a market leading position in China's online finance market and it may find it a desirable opportunity to clamp down on moral hazard on its platform, by joining with its competitors in truly enforcing a unified code of conduct on all their respective individual platforms. While this won't prevent regulatory action in the online finance space, it may set industry standards and help consumers of online finance to better identify weaknesses and issues of moral hazard on non-complicit platforms.

These lessons are merely examples and the rich history of securitisation is destined to offer many more lessons on a variety of issues that also concern online finance and extend far beyond mere payment platform services and may enable corporates, investors and regulators to build a more sustainable online finance industry.