How Yu'e Bao Arbitrages Financial Repression

In China, the government’s policy of capping deposit interest rates has set off a competition for the savings of the nation’s growing consumer base, spurring product innovation that takes advantage of regulatory conditions. Tech companies, well-positioned because of their strong presence in payments, e-commerce, and social networks, have entered the fray with online money market funds (MMFs). Leading the charge is Yu’e Bao, the fund created by ecommerce giant Alibaba’s payments arm, Alipay. As funds like Yu’e Bao navigate a new field, they are certain to face mounting business, liquidity, and regulatory risk.

How policy led to arbitrage and innovation

The government’s policy has traditionally been to set deposit yields instead of letting the market decide them to lock in the profits of state-owned banks and lower their funding costs. As a result of such financial repression and the added burden of inflation, savers often have to accept negative real returns on deposits, incentivizing them to seek other vehicles offering higher returns.

Consequently, many investors eschew bank deposits and even equity markets in favor of bank wealth management products (WMPs) and now online funds such as Yu’e Bao. WMPs are offered by banks, which pool the cash and deploy it into stocks and debt to generate higher yields than conventional deposits. Huaxia Bank introduced the first WMP in 2004, but the real prelude to this showdown occurred in June 2013, when Alibaba launched Yu’e Bao. The competition escalated this year, when Alibaba, Tencent, and eight other companies acquired licenses to jointly establish and operate five private banks (separate from the online MMFs).

China wants to gradually liberalize deposit rates and make them more competitive, but Yu’e Bao and other online MMFs have taken the initiative in providing higher returns. They have done so by letting savers put their money in funds that invest in the interbank market, where rates are driven by market forces—a form of regulatory arbitrage.

At this juncture, Yu’e bao has amassed upward of RMB ¥535 billion ($87 billion) since it launched last June. Though that represents only 0.5 percent of the RMB ¥113 trillion in total deposits, China’s increasingly diversified tech giants,[1] along with six other companies, have also launched online MMFs. This has in turn has triggered banks to counter with their own online funds, provoking a broad grassroots liberalization of interest rates.

Business and liquidity risks loom

As competitors and regulators have adjusted, challenges have emerged to tech MMFs’ business models and the liquidity of their holdings. This year, China’s central bank (the PBOC) eased credit conditions, slashing the interbank interest rates and consequently the returns that had made Yu’e Bao so attractive relative to bank deposits. To maintain its competitive yields, Yu’e Bao has allocated more assets to repurchase agreements and products with longer maturities, resulting in a maturity mismatch on its balance sheet.

This mismatch risk and the ability of Yu’e Bao investors to make withdrawals on the day of the request (in banking terms, a T+0 settlement basis) pose a serious problem: If a large number were to quickly withdraw their money, Yu’e Bao would face a classic bank run situation. It would be forced to sell assets at fire-sale prices to generate liquidity and cash. Losses would likely mount.

Chart 1: Yu'e Bao Returns vs. China Benchmark Deposit Rate, percent

Chart 2: Yu'e Bao Assets by Duration, percent

Sources: Alipay, Tianhong.

Notes: "Repo agreements" means assets held under resale agreements, and "bank deposits" refers to bank deposits and settlement reserves.  Alibaba for e-commerce, Tencent and Sina for social media, and Baidu for search.

Assessing the regulatory reaction and landscape

Like other regulatory arbitrageurs that are not disruptors in the strictest sense, Yu’e Bao and other online funds may face mounting regulation in addition to those risks as officials concerned about financial stability rein in their growth to a more temperate pace. As they act, regulators will have to juggle concerns that include continued rate reform, opposition from the banking industry, and the risk of stifling innovation in the tech sector.

So far, the PBOC seems to have taken the lead in regulating these MMFs, just as it has with WMPs and the broader shadow banking sector. Other agencies are also involved. For example, the PBOC oversees Alipay, which owns Yu’e Bao; securities regulator CSRC supervises Tianhong Asset Management, which manages Yu’e Bao’s assets; and the banking regulator, CBRC, is concerned with the banks in which those assets are invested.

Potential PBOC moves include requiring online MMFs to hold minimum reserves on their deposits. The PBOC is also considering placing limits on online consumer spending, which would affect how much cash flows into online funds. The central bank has already temporarily halted the use of virtual credit cards and QR codes for online shopping. While this does not directly affect online funds, it signals a desire to manage the pace of growth in such platforms.

To discern regulators’ general disposition toward online MMFs, one could also look to their stance on WMPs, which play a similar role in China’s markets. Regulators view WMPs as useful vehicles for advancing rate liberalization, providing savers with competitive returns, and preparing banks for change—but also as an experiment to be watched closely.

China has further to go in reforming its capital markets, and the path it takes could shape the future of online finance. Regulators are allowing the field to expand and pushing commercial banks to change as well, but they are likely to clamp down if risks to financial stability arise.