The eight core effects of the new asset management rules on private fund management

The People's Bank of China, the China Banking and Insurance Regulatory Commission, the China Securities Regulatory Commission and the State Administration of Foreign Exchange have recently jointly issued the Guiding Opinions on Regulating the Asset Management Business of Financial Institutions (the Guiding Opinions). The Guiding Opinions unify regulatory standards according to the type of product, and lay down requirements on investment scope, leverage constraints and information disclosure; they hold to the principle that products and investors must match, and strengthen the management of investor suitability; they make clear that asset management business may not promise principal or return, so ending implicit repayment; they tighten the requirements for investment in non-standardised credit assets and prohibit capital pools; and they classify and unify the requirements on liabilities and on tiered leverage, eliminate multi-layer nesting and curb channel business. The issue of the Guiding Opinions has undoubtedly caused no small tremor in the capital markets as a whole; as far as private funds are concerned, it clarifies the regulatory requirements in many areas that practice had left grey, and encourages and supports private institutions to carry on business in accordance with law. Minton's lawyers analyse briefly below the principal effects of the Guiding Opinions on the investment business of private funds.

1. Strengthening the awareness that the investor bears the investment risk, and ending guarantees, buy-backs and implicit repayment

Articles 2, 13 and other provisions of the Guiding Opinions already make clear the nature of asset management business: a financial service in which a private institution, commissioned by investors, invests and manages the entrusted assets (the private institution discharging towards investors the duties of honesty, good faith and diligence, and being entitled to a management fee and a performance fee), while investors should establish the basic investment awareness that they bear the risk themselves, and give up expectations of a floor, of guaranteed return, or of implicit repayment.

As for private institutions, the Guiding Opinions state that they may not provide any direct or indirect, express or implicit guarantee, buy-back or similar promise to bear risk on behalf of the non-standardised credit assets or equity assets in which an asset management product invests. At the same time the Guiding Opinions define the prohibited implicit repayment: "(1) the issuer or manager of an asset management product, in breach of the principle of determining net value truly and fairly, promises principal and return on the product; (2) by rolling issuance or other means, the principal, return and risk of an asset management product are made to shift between different investors, so achieving promised principal and return; (3) where an asset management product cannot be repaid on time or repayment is difficult, the financial institution issuing or managing it raises funds itself to pay, or entrusts another institution to pay on its behalf; (4) other circumstances identified by the financial regulatory authorities."

Anyone who provides implicit repayment in breach of the rules will be pursued for legal liability in accordance with law, and an external audit institution that fails in its duty of diligence in auditing will also be entered on the national credit information sharing platform and bear the consequences of joint sanctions.

2. Clarifying the standard for qualified investors and the amount required for a single product

Under article 5 of the Guiding Opinions, a qualified investor must have the corresponding ability to identify and to bear risk, and must invest not less than a certain amount in a single asset management product. The specific requirements are: A. at least two years' investment experience, plus (family net financial assets of not less than RMB 3 million, or family financial assets of not less than RMB 5 million, or average annual income of the individual of not less than RMB 400,000 over the last three years); B. a legal person entity whose net assets at the end of the most recent year are not less than RMB 10 million; C. other circumstances in which the financial regulatory authorities regard a person as a qualified investor.

The amounts a qualified investor must put into a single asset management product are: not less than RMB 300,000 for a fixed income product, not less than RMB 400,000 for a single mixed product, and not less than RMB 1 million for a single equity product or a single commodity and financial derivatives product. It should be noted that the Guiding Opinions also make clear that an investor may not use funds that are not its own, raised by borrowing or by issuing bonds, to invest in asset management products.

3. Strictly regulating investment management, prohibiting split sales and eliminating capital pool business

Besides prohibiting fraud and misleading means, the Guiding Opinions expressly forbid a private institution to sell, by splitting an asset management product, a product that does not match the investor's ability to identify and to bear risk; the composition of the assets in which each product invests must be clear and the risk identifiable.

On the other hand, under the Guiding Opinions a private institution must manage the funds of each asset management product separately, keep separate books and account for them separately, and may not carry on or take part in capital pool business marked by rolling issuance, pooled operation and separate pricing. At the same time a private institution should determine the term of the invested assets reasonably and strengthen the duration management of its products, so as to reduce the risk of maturity mismatch.

4. Further quantifying the qualification requirements for practitioners

At the time a private fund manager registers and files, comparatively high requirements are already imposed on the qualifications of its senior officers, and professional practitioners with industry experience are favoured for such posts. The Guiding Opinions go further, requiring that everyone engaged in asset management business should have the necessary professional knowledge, industry experience and management ability, and should fully understand the relevant laws and regulations, the regulatory provisions, and the legal relationships, transaction structures, principal risks and risk control methods of asset management products.

At the same time a private institution must establish and improve, correspondingly, a system for the qualification, training, appraisal and accountability of its asset management personnel. This is a further compulsory system, over and above the eight risk control and internal control systems that a private fund manager must have in place when it registers and files, and private institutions should complete it promptly and so raise their own standards of risk control and internal control.

5. Mandatory custody of asset management products

As to custody, the Asset Management Association of China had always advocated placing products in the custody of a professional institution, but until the Guiding Opinions there was no hard requirement. The Guiding Opinions now make clear that "after the issue of these Opinions, the assets of an asset management product issued by a financial institution shall be held in independent custody by a third-party institution with custody qualifications, unless laws or administrative regulations provide otherwise", so that once the transition period expires (at the end of 2020) every private fund manager must place the assets of its products in independent custody with a qualified third party.

6. A requirement to accrue a risk reserve

In the operation and management of private institutions, the Guiding Opinions for the first time compel the accrual of a risk reserve: it provides that a risk reserve shall be accrued at 10 per cent of the management fee income from asset management products, or that operational risk capital or a corresponding capital reserve shall be measured as required. Accrual may stop once the balance of the reserve reaches 1 per cent of the balance of the product.

It should be noted that the risk reserve is chiefly used to make good loss caused to the property of an asset management product, or to investors, by a financial institution's breach of law or regulation, breach of the product agreement, operational error or technical failure. It is not for a private institution to pay on the investor's behalf when a product cannot be repaid on time or repayment is difficult.

7. Eliminating multi-layer nesting and curbing channel business

The Guiding Opinions allow an asset management product to invest in one further layer of asset management product, but place limits on the product so invested: only an asset management product investing in publicly offered securities investment funds is permitted, so that multi-layer nesting is ended and its scope confined.

Where a private institution invests an asset management product in a product issued by another institution, and so entrusts the funds of its own product to that institution to invest, the institution entrusted must be one with professional investment ability and qualifications, supervised by the financial regulatory authorities. As the entrusting institution, the private institution should carry out due diligence on the institution entrusted, operate a list-based system of management, and clearly provide the standards and procedure for admission, the duties and obligations, the management during the term, the mechanism for preventing conflicts of interest, the disclosure obligations and the exit mechanism; and it is not relieved of its own liability by entrusting investment to another. With this, the use of nesting to evade regulatory requirements on investment scope, leverage constraints and the like has been exposed and formally rejected.

8. Clarifying the requirements for using artificial intelligence in investment advisory business

The Guiding Opinions first make clear that holding an investment advisory qualification is the precondition for using artificial intelligence in advisory business, and that a non-financial institution may not use robo-advisory to go beyond its business scope by another route, or to change its business scope, so as to carry on asset management business. At the same time, like any other business, robo-advisory must strictly observe the general rules on investor suitability, investment scope, information disclosure and risk isolation.

According to the investment strategy of different products, a private institution should develop a corresponding artificial intelligence algorithm or programmatic trading. Where a defect in the algorithm model, such as homogeneity of algorithms, an error in programming, or insufficient depth in the use of data, or an abnormality in the system, produces a herd effect or affects the stable operation of the financial markets, the private institution should promptly intervene manually, and compulsorily adjust or terminate the artificial intelligence business. Where a private institution causes loss to investors through breach of law or regulation or through improper management, it shall bear liability in damages in accordance with law.

After the issue of the Guiding Opinions the supporting rules of the financial regulatory authorities will be drafted and issued one after another, to work together and be implemented together. Minton's lawyers will continue to analyse the relevant provisions and policies briefly for readers, and look forward to their attention.