CHINA: Global custody market expected to open near $1 billion, grow to $1 trillion

With equal parts eagerness and patience, non-Chinese banks are preparing for the opening of China's global custody market, estimated to be as big as $1 billion from day one.

Executives at global asset servicing banks describe three big asset classes in China in need of global custody; at the moment, only one is open to non-Chinese firms.

Some non-Chinese custodians are handling assets being invested in the country by overseas institutional investors that have been certified by the Chinese government as qualified foreign institutional investors, or QFII.

Two areas that are on the cusp of opening up are assets owned by Chinese institutions such as insurance companies and state banks, and assets of the country's national pension fund. These are the assets non-Chinese banks most covet.

Eventually, the size of China's global custody market — excluding QFII assets — could reach $1 trillion, according to executives at non-Chinese banks working to get a foothold in the country. That figure can be reached by adding the assets of China's insurance companies and state banks with its state pension fund assets and foreign reserves, which alone are now estimated to be in excess of $500 billion.

As part of their continued efforts to liberalize and modernize the economy, Chinese authorities earlier this year decided that Chinese insurance companies may apply for designation as qualified domestic institutional investors, or QDIIs. As a QDII, a company is allowed to invest some of its assets overseas.

So far, according to executives in the global asset servicing business, one company has applied. K.K. Tse, executive vice president, Asia Pacific, at State Street Corp. in Hong Kong said the insurer is the only one to issue a request for proposals for a global custodian. He and other executives wouldn't name the company.

State Street, JPMorgan Chase & Co., Northern Trust Corp., Citigroup Inc., HSBC PLC, Bank of New York and ABN AMRO Mellon Global Securities Services BV — a joint venture between ABN AMRO Bank NV and Mellon Corp. — are among the leaders in laying the groundwork to access the QDII global custody market in China.

"It's difficult to work out actual sizes" of investment pools that will need servicing, said Laurence Bailey, a senior vice president at JPMorgan Investor Services Asia Pacific, Sydney. "It's not huge, but everybody is feeling they need to be there because China can move so quickly."

In fact, executives familiar with the situation said although the insurance company that issued the RFP for a global custodian has not yet received government approval to invest overseas, it will move fast to do so once the government gives it the all-clear.

"Entities want to get all their ducks in a row before they file the (QDII) application," said one executive at a non-Chinese bank, who asked not to be named. "They'll go through the RFP and everything else so that all the partners and players are in line before they go ahead and get the QDII approval. Then once they get approval, they'll move very quickly to place assets overseas."

Only Chinese banks are allowed to handle domestic custody — assets invested in China's stock markets or mutual funds. But some non-Chinese banks, such as Standard Chartered PLC, London, which has a long history in China, are providing custody services for foreign investors investing in B shares, the part of the country's equity market open to non-Chinese.

Darwin Doo, head of institutional banking, China, at Standard Chartered in Hong Kong, said that area of custody opened up in 2002.

"We got the regulators and the market to have a more open approach to the custodian," he said. "So what we can do is provide custody services to foreigners who come into China to invest."

Most institutions seeking a piece of the China pie have set up joint ventures with Chinese banks or other investment firms.

"Although we hope to be able to open a representative office in Beijing next year, pending regulatory approval, we have been working with some Chinese institutions since 2002," said Kevin Tan, senior vice president chief representative for China at Northern Trust in Chicago. "The law requires that we have a representative office open for two years before we can apply to have a branch office. Only after we have a branch office will we be able to bid directly. For now we can respond to RFPs, provided we have partnered with a domestic institution."

State Street, which has been working in China for four years, also hopes to open a representative office next year, according to Mr. Tse.

"We have been working with ICBC (Industrial and Commercial Bank of China, Beijing) for the last four years, helping them get up to speed to provide basic custody services for the local market and the pension fund business," he explained. "However, we have found it difficult to translate this hard work into a revenue stream. It's good will."

Bank of New York opened a representative office last year, while JPMorgan did so a few years ago.

"About three years ago we set up strategic alliances with a number of state banks primarily on education and technical exchanges," JPMorgan's Mr. Bailey explained. "The bank as a whole is certainly looking at opportunities in China, but we've not taken strategic stakes in any one particular bank at the moment."

Some have taken equity stakes in state-owned banks. One example: HSBC, which acquired a 19.9% stake in China's fifth-largest bank, the Bank of Communications Ltd., Beijing, in August. But Mr. Bailey said few firms were going that far because of the risks involved.

"The challenge in taking a minority stake in a state bank or insurance company is trying to work out what value that adds" to the acquirer, he said. "If you can't have a real say in it and the financial records are slightly different than Western standards … people have been a little cautious."

China being China, executives in asset servicing said that although the steps they are taking to be approved to provide global custody services stem from indications from Chinese regulators, there are no set guidelines.

"There's been no public announcements or set rules via which foreign players can apply for the (custody) business," said Mr. Doo at Standard Chartered. "The banking regulations have not been set out."

Compounding the problem, he said, is bureaucracy. Up to three regulators can have a say in the matter: the China Banking Regulatory Commission; the China Securities Regulatory Commission; and the China Insurance Regulatory Commission.

Then there is the issue of nationalism, which is very strong in China.

"The government says, ‘State Street, you are welcome to come,' but they also want the local provider to do the business," said Mr. Tse.

"The political risk is that the government uses local providers. It's hard to compete against" huge state-owned institutions such as ICBC, which has 40,000 branches and 400,000 employees, he added. "For our business you need huge scale to be meaningful."

Similarly, when it comes to handling the assets of the National Council for Social Security Fund of China — the national pension plan, which has assets estimated at between $18 billion and $20 billion — non-Chinese providers are "circling around, and we hope to have a chance at that business, but I'm not too sure whether (the government) would decide to use a local bank to protect so-called national interests," Mr. Tse said. "If they go local, would that bank then subcontract to the likes of State Street?"

He contrasted the situation in China with that in Taiwan, where government officials "very much want to have global players."

Despite these risks, the big players in global custody are spending a lot of time and money making sure they have the right connections and relationships in place when the gates open.

"It's very much a relationship-driven market," said one asset-servicing executive, who asked not to be named. "It's called ‘guanxi' — who you know and what you know. That really drives the decision to hire or fire. So it's very important we establish a physical presence in China to be able to build the types of networks and connections necessary to build a business there."

Mr. Bailey said his firm recently hosted an informational meeting with a Chinese insurance company to help officials from the company better understand offshore investing.

"The biggest challenge for us and other custodians is that regulators have been reviewing what's best for China and its insurance companies, reviewing best practices around the world," he explained. "But sometimes you take what you think are the best bits from each country and when you put them together, it's not a portable solution. So insurance companies have been taking advantage of the opportunities that have been offered to them."

Similarly, Northern Trust's Mr. Tan, who will move to Beijing when the firm opens its representative office there, said he and other Northern Trust officials have spoken at industry conferences, including one organized by China's Central Depository for Fixed Income.

He said he is planning to hire Chinese staff in Beijing "to lay the foundation for our sales people and relationship managers from other locations to come in and provide servicing or sell products. The staff of the representative office by law will not be allowed to provide any operational or revenue-generating services, just the foundation and facility."

State Street is taking a different tack.

"Unlike many companies, we're not putting a lot of capital into China," Mr. Tse said. "It's myself and a couple of staff in Hong Kong who fly to Beijing and Shanghai regularly. The reputation we're building has helped, and so far we're quite glad to have done it."

Much of the work being done by non-Chinese banks is helping local custodians stay as current as possible on best practices in the industry. The non-Chinese bank executives are betting that helping local custodians do their job better will help their own banks down the road in capturing both global custody mandates and domestic custody — if and when the government allows it.

Regardless of their method or the business they are trying to capture, non-Chinese banks are taking a long view of the market and its potential opportunities.

Mr. Tse said that given China's 1.3 billion population, a burgeoning middle class and the quick adoption of modern investment — and pension — management techniques, China's mutual fund and pension industry will be one of the world's largest within 10 years.

"It's a very long-term market," said Nadine Chakar, chief executive officer of ABN AMRO-Mellon, based in Amsterdam. "Both Mellon and ABN AMRO, and through them ABN AMRO-Mellon, are very engaged in China. We view that as the next frontier."

She said she is close to closing one joint venture — which she declined to detail — that is likely to provide ABN AMRO Mellon with a small revenue stream. But she sees more opportunity years down the road.

"There are opportunities that are not going to materialize in the next two or three years, so we're taking a long-term approach," she said.