Abstract: In this article, the author discusses the emerging challenge associated with unlicensed online brokerages and points out illegal cross-border trading should be subject to regulation.
Recently, Chinese media reported that the country’s Personal Information Protection Law will come into effect soon. On the same day, two cross-border Internet brokerage companies that are registered overseas, hold overseas financial licenses, but are not licensed in China, saw their shares fall 21% and 12% respectively. It is also a problem that some institutions in China hold regionally or locally issued financial or quasi-financial licenses but carry out business nationwide. Similarly, some financial products that are designed to be sold to specific groups of people are displayed on the digital platforms and sold indiscriminately online. How to enforce geographical boundaries of financial licenses and regulatory rules applicable to certain customer groups in the digital world requires in-depth research by all stakeholders.
I. THE ISSUE OF CROSS-BORDER AND CROSS-REGION SERVICES
1. Cross-border financial services
The General Agreement on Trade in Services (GATS) covers financial services and distinguishes between four modes of supplying services that are all applicable to financial services: cross-border supply, consumption abroad, commercial presence, and presence of natural persons. Specifically, cross-border supply refers to situations where financial institutions that provide products and services are in one territory while customers and investors are in another. Enabled by Fintech, this mode of supply has expanded rapidly and has become a hot issue in free trade policy discussions as well as a new challenge facing regulators.
Under the GATS, barring a few exceptions, China has not approved of cross-border supply of financial services. According to the Schedule of Specific Commitments on Services List of Article II MFN Exemptions of the Protocol on the Accession of the People's Republic of China, commitments to the cross-border supply of financial services are restricted to certain insurance and insurance-related services, securities, and financial information and data services. Insurance and insurance-related services are unbound except for a) reinsurance; b) international marine, aviation, and transport insurance; and c) brokerage for large scale commercial risks, international marine, aviation, and transport insurance, and reinsurance. For securities, services are unbound except for the following: Foreign securities firms may engage directly (without Chinese intermediary) in B share business. Banking and other financial services (excluding insurance and securities) are unbound except for the following: Provision and transfer of financial information, and financial data processing and related software by suppliers of other financial services; Advisory, intermediation and other auxiliary financial services on all activities, including credit reference and analysis, investment and portfolio research and advice, advice on acquisitions and on corporate restructuring and strategy.
Since 2021, Hainan Free Trade Port has expanded the scope of cross-border financial services in the mode of cross-border supply. On July 26, 2021, the Ministry of Commerce issued Special Administrative Measures for Cross-Border Service Trade at Hainan Free Trade Port (Negative List) (2021 Edition) that applies to the Hainan Free Trade Port with a geographic scope of the whole island of Hainan.
Compared to GATS commitments, the Negative List has expanded the provision of securities services in the form of cross-border supply as follows: (1) Overseas securities institutions that have been approved to obtain the qualifications for the business of domestically listed foreign shares (B shares) can engage in the brokerage business of B shares by signing an agency agreement with domestic securities institutions, or by other methods prescribed by the stock exchange; (2) Overseas securities institutions that have obtained the qualification for the business of domestically listed foreign stocks can act as lead underwriters, deputy lead underwriters and international affairs coordinators for domestically listed foreign stocks; (3) An approved qualified domestic institutional investor (QDII) which conducts overseas securities investment business is allowed to entrust overseas securities service institutions to buy and sell securities on behalf of them; (4) An approved QDII can entrust qualified overseas investment advisors to make overseas securities investment; (5) Overseas assets custodian entrusted by the customer to take charge of overseas assets custody business shall meet legal conditions. Moreover, the Negative List also specifies the services that are not allowed to be conducted in the form of cross-border supply. For example, domestic institutions and individuals shall not engage in the issuance and trading of overseas securities without approval or registration.
In terms of the latest international practice, even within the framework of the CPTPP that features a relatively high level of openness in service trade, even though service providers are allowed to provide cross-border financial services without commercial presence in other countries, they are still required to complete cross-border financial service provider registration in the host country or obtain authorization from competent authority of that country.
Case 1: Cross-border online brokerages
Some overseas securities firms that haven’t obtained relevant licenses from China but only held overseas licenses use Internet platforms to provide overseas securities investment services to investors within China. For example, trading services for stocks listed in the US and Hong Kong fall into the category of "cross-border supply". There has been a rapid rise in cross-border Internet brokerage customers, and most of them are from China.
For example, according to media reports, 80% of accounts of a brokerage registered in the Cayman Islands were opened by mainland clients while the ratio is 55% for another brokerage registered in Hong Kong. Given their business nature, cross-border Internet brokerages are driving without a driver’s license in China, engaging in illegal financial activities. It has nothing to do with whether the capital account is fully convertible.
Case 2: Foreign exchange margin
Foreign exchange margin trading is illegal in China. In 1994, the regulatory authority issued the Notice on Strictly Investigating and Punishing Illegal Foreign Exchange Futures and Foreign Exchange Margin Trading Activities, which stated that institutions shall not conduct foreign exchange margin trading without authorization, and no entity or individual may participate in foreign exchange margin trading. No domestic entity is allowed to provide this product in China. As foreign exchange margin trading is legal in many countries, some Chinese and foreign companies that hold overseas financial licenses, use digital platforms to attract customers in China and carry out foreign exchange margin business in the form of cross-border supply. Such activities are strongly cracked down and penalized by China’s foreign exchange authority.
Trading platforms for digital currency, digital asset, overseas stock indexes and precious metal derivatives are similar cross-border models.
At the same time, China’s financial institutions such as securities firms dare not provide services in the form of cross-border supply in the United States. That is something that regulatory authorities, judicial practitioners and scholars in China should reflect on.
2. Cross-regional financial services within borders
Online lending. Since 2016, many commercial banks in China have started to issue loans jointly with Internet platforms, leading to a surge in cross-regional lending across the country. In response, China Banking and Insurance Regulatory Commission (CBIRC) has released several rules since 2020, prohibiting local banks from engaging in online lending beyond their place of registration. This problem is also seen in online deposit business.
Digitally equipped, financial institutions today have the technical capacity to engage in cross-regional business. This draws forth the question of whether all financial institutions, including village banks, should be allowed to expand their business online across the country.
Regulation of offline financial services also face similar challenges. For example, some of the exchanges established under the approval of local governments actually operate and open offices in other places such as capital-intensive first-tier cities including Beijing, Shanghai, Guangzhou and Shenzhen, even though legally they do not have access to these markets. An example would be an exchange approved by local financial regulators in Province A operating on a long-term basis in Province B. A possible scenario, should this exchange default on its financial products, would be that Province B asserts that the irregularity should be handled by Province A which approved the establishment of the exchange, while Province A insists that this is beyond its scope of responsibility since the default happened in Province B.
II. PUBLICLY AVAILABLE FINANCIAL PRODUCTS
1. Deposits on third-party Internet platforms
The deposit business on third-party Internet platforms has brought many risks and challenges. In terms of business models, such platforms not only display deposit products from multiple banks, but also provide customers with a purchase interface. The entire process is finished via the platform. The platform has the authority to display deposit products and perform operations, and it can also acquire customers and data. Some platforms even restrict customers from using other business channels. Customers can acquire account balance information, and deposit and withdraw funds only on such platforms, and cannot operate on banks’ self-operated platforms (such as mobile banking, online banking, etc.). Furthermore, the platforms can shield certain products from the regulators’ radar.
The hidden risks of third-party Internet platforms selling deposit products include: First, it is an illegal financial activity without approval. It is not a "running a red light" issue of whether the interest rates are allowed, but the deposit business itself is an "unregistered car" on the road. Second, local banks could take advantage of the Internet platforms to break regional and regulatory constraints they are subject to. By cooperating with Internet platforms, local banks could absorb deposits and issue loans across the country, which actually deviates from their business positioning of serving the local area. Some of the banks even owe most of their deposits to accounts opened in other places. Third, small and middle-sized banks add to asset-related risks when they raise the deposit rates in disguised forms via Internet platforms. Fourth, the deposit products on the platforms offered by high-risk small and medium-sized commercial banks accounted for almost half of the deposits of the whole country (to a certain extent exhibiting the effect of "bad money driving out good", or the lemon market effect).
Financial regulators have already taken timely measures to pull things back on track. In January 2021, CBIRC and the People’s Bank of China (PBC) issued a notice stating that commercial banks are not allowed to conduct fixed-term deposit and time-or-demand optional deposit business through non-self-operated online platforms, with all outstanding deposits on the platforms automatically withdrawn upon maturity. Platforms, together with local banks, are prohibited from absorbing deposits from accounts opened in places other than where they are registered, while commercial banks are also asked to remove cross-regional deposit services from their self-operated platforms.
The question here is whether it is necessary to establish a deposit broker license, and can Internet platform companies use this license to conduct deposit business? Let’s have a look at foreign practices. Take the United States as an example. Bank regulatory agencies enforce very strict regulation on brokered deposit. They believe that it is neither safe nor sound for banks to absorb deposits from intermediaries.
First, it could drive high-risk investment activities among banks; second, some high-risk banks may absorb deposits from third-party Internet platforms on a large scale to quench thirst by drinking poison, adding to the loss of deposit insurance funds; and third, such deposits are unstable.
In a number of bank failure cases, acquirers were unwilling to accept deposits from intermediaries or pay a premium to such deposits. Therefore, in regulatory practice, regulators have put forward tight regulatory requirements for banks’ receiving deposits from intermediaries (setting higher deposit insurance rates, limiting banks with insufficient capital to absorb brokered deposits, etc.).
The Federal Deposit Insurance Corporation (FDIC) refined its definition on deposit broker on December 15, 2020. Under the proposed rule, third-party technology companies would meet the ‘‘facilitation’’ prong of the ‘‘deposit broker’’ definition by, while engaged in business, engaging in any one, or more than one, of the following activities: A) The person has legal authority, contractual or otherwise, to close the account or move the third party’s funds to another insured depository institution; B) The person provides assistance or is involved in setting rates, fees, terms, or conditions for the deposit account; C) The person is acting, directly or indirectly, with respect to the placement of deposits, as an intermediary between a third party that is placing deposits on behalf of a depositor and an insured depository institution, other than in a purely administrative capacity.
Speaking of China’s legal provisions and actual conditions, Article 8 of the Regulations on the Administration of Savings stipulates that “no unit or individual is allowed to handle deposit business except for depository institutions”, and Article 12 stipulates that “with the approval of the local branch of the People’s Bank of China, depository institutions can set up depository agencies". It is an illegal financial activity for third-party platforms to carry out deposit business without approval. At the same time, given the reality regarding corporate governance of small- and medium-sized banks, external constraints, micro-supervision, investor suitability and risk resolution mechanisms, it’s not yet time to allow brokered deposits in China.
Some market players have suggested excluding deposits from Internet-based sales of financial products. In its report Customer Suitability in the Retail Sale of Financial Products and Services, the Bank for International Settlements (BIS) has excluded deposits in the definition of “investment products” when discussing information disclosure and suitability management in terms of banks recommending “investment products” to retail customers.
2. Distribution of publicly offered funds by Internet platforms
At present, most of the Internet platforms engage in sales of investment funds by having their subsidies licensed for this business, and some of them also work with independent distributors. In August 2020, China Securities Regulatory Commission (CSRC) issued Provisions on Issues concerning the Implementation of Measures for the Supervision and Administration of Distributors of Publicly Offered Securities Investment Funds, which has laid out further stipulations to standardize the practice whereby fund managers and distributors rent space on third-party online platforms for the sales of products.
First, fund managers and distributors, when renting space from third-party online platforms for fund sales, shall clearly inform investors of the entity providing fund distribution services while observing the principles of independence, technological security and data confidentiality. They shall undertake business in strict accordance with applicable laws, regulations and rules, and assess the compliance and safety of third-party online platforms on a continuous basis. They shall report to regulators within 10 days since the signing of the service agreement.
Second, third-party online platforms, in their capacity as fund service providers providing information technology systems, shall register with the CSRC. Their role is limited to the provision of online sites for business operation and other IT services, and they shall not engage in any fund sales or collect, transmit or retain any fund trading information of investors.
These regulations further clarify the boundary between licensed fund distributors and non-licensed online platforms as well as the requirements on their collaboration. They also help solve the compliance issues as a result of non-licensed online platforms having their subsidiaries licensed for fund distribution business.
3. Sale of banks’ wealth management products on Internet platforms
The CBIRC released the Interim Measures for the Administration of Sale of Wealth Management Products by Wealth Management Companies in May 2021. Currently, the sale of banks’ wealth management products is limited to bank-based wealth management subsidiaries and the financial institutions in the banking sector that accept public deposits; no licenses have been issued to non-bank institutions that sell wealth management products.
Can Internet platform firms engage in the sale of wealth management products? Considering that investors are having a different grasp of financial products provided by banks and non-banks, prudence is a must at this stage.
4. Sale of insurance products on Internet platforms
According to the Measures for the Regulation of the Internet Insurance Business amended and issued in December 2020, non-insurance institutions shall not conduct online insurance business. This prohibition includes but is not limited to providing advisory services on insurance products, comparing insurance products, calculating premiums, price quoting and comparison, designing insurance portfolios, handling insurance procedures on behalf of prospective insureds, and collecting premiums by way of proxy. The document also stipulates that Internet firms shall hold an insurance license in order to engage in insurance operations. Therefore, Internet platforms shall not directly engage in insurance business unless appropriately licensed, or it would be deemed illegal.
In reality, the Internet platforms might not obtain licenses, but usually, their subsidiaries would hold insurance brokerage and agency licenses, and sell insurance products on the platforms. To be specific, a licensed subsidiary can set up an exclusive page on the app of an Internet platform as a showroom for various insurance products.
III. ONLINE SALE OF PRIVATE INVESTMENT PRODUCTS TO NON-SPECIFIC INDIVIDUALS
1. Online display and sale of trust products
After China tightened regulations on the deposit business on third-party Internet platforms, media reported that some Internet platforms, in their business collaboration with licensed firms, displayed/sold trust products to non-specific users.
For example, in the mobile application of one Internet platform, after clicking on “high-end wealth management” in the wealth management section, any viewer can see the trust products provided by a trust company. At the bottom of the page, it shows an inconspicuous note that reads, “The trust products are sold by ×× Trust Co.”. Click on a trust product, a redirecting page showing “Redirecting to ×× trust section” would briefly pop up, and an inconspicuous disclaimer would appear at the lower part of the page, asserting that “products of this section are provided and sold by ×× Trust”. Then you enter into the sale page, where you can check the details and sale documents of the products. Click “buy”, and the page will get you to the verification of qualified investors, payment, etc. After an investigation by the regulatory authority, the platform concerned has removed these trust products.
According to the Measures for the Administration of Trust Companies' Trust Plans of Assembled Funds released in 2007, when recommending a trust plan, a trust company shall not conduct public marketing and publicity activities. The indiscriminate public marketing of trust products is illegal and should be punished.
2. Online display and sale of private asset management plans and funds
License is required for the commissioned sale of private asset management plans (by securities companies, fund management companies, futures companies and their subsidiaries) and private equity products.
According to the Measures for the Administration of the Private Asset Management Business of Securities and Futures Business Institutions released by the regulatory authority in 2018, securities and futures institutions may sell private asset management plans on their own or entrust sale or promotion of the plans to a qualified agency.
According to the Measures for the Administration of the Fundraising of Private Investment Funds released by the Asset Management Association of China in 2016, institutions that register at the association as managers of private investment funds can raise funds on their own; institutions that have registered at the regulatory authority, obtained the qualifications for selling these funds, and become members of the association can raise funds under the entrustment of the managers. No other institutions or individuals shall engage in fundraising of private investment funds. The Measures for the Supervision and Administration of Distributors of Publicly Offered Securities Investment Funds, issued by the regulatory authority in 2020, stipulates the conditions of qualification for fund sales and clarifies that the term "independent fund distributor" means an institution that specializes in the business of sale of publicly offered funds and private securities investment funds.
Private asset management plans and funds could be promoted but only to specific individuals. The Interim Provisions on the Administration of Private Asset Management Plans of Securities and Futures Companies allow these institutions to market their products on official websites or mobile apps that have built-in functions to limit users to specific registered individuals. The Asset Management Association of China stipulates the procedures to identify the online specific individuals in the Measures for the Administration of the Fundraising of Private Investment Funds—that before recommending private investment funds to investors, procedures should be set up to identify the online specific individuals, and investors should promise that they meet the standards of qualified investors.
In practice, some online platforms would work with its subsidiary independent fund sale institutions and private fund management firms, targeting individual investors, display and sell private asset management plans and private investment funds, primarily in two models:
Model One: Open the app of the Internet platform, click "High-end Wealth Management" on the homepage and you’ll see the page redirecting, saying “You are entering into the sale platform of XX Fund". Users have to go through three steps—real name verification, risk evaluation, and qualified investor declaration—to gain access to the product page. Afterwards, to finish the payment and contract signing, users must submit qualified investor proof like asset certificates. Some Internet platforms prohibit conservative users from browsing products that exceed their risk identification and risk tolerance capabilities.
Model Two: Some apps allow users to access the product page and browse product information as long as they identify themselves to be qualified investors. They will be able to proceed with purchases after completing the qualified investor certification. Whether such a model could effectively block out unintended users remains dubious. Some investors reported that after they went offline before completing the verifications, they got calls from the platform and were told that the platform could help fabricate asset certificates and other materials to facilitate the reviews.
IV. CIVIL AND CRIMINAL LIABILITIES OF RELEVANT ILLEGAL FINANCIAL ACTIVITIES
Third-party Internet platforms that provide financial services without the approval of the financial regulatory authority or are in breach of regulations may be held liable for civil infringement, administrative violation, or more seriously, criminal offence.
Civil infringement.
According to Article 1197 of the Civil Code, a network service provider who knows or should have known that a network user has infringed upon the civil-law rights and interests of another person by using its network services but fails to take necessary measures, shall assume joint and several liability with the network user. For instance, a third-party Internet platform that knows or should have known that certain financial institution is high-risk or offers illegal products but still provides services to help it conduct financial business or sell and display financial products, shall assume joint liability with the institution for the damage inflicted on investors. Third-party Internet platforms that initiate illegal financial activities on their own shall be subject to liability for breach of contract or tort.
Administrative violation. Main cases include:
(1) Entity that constitutes illegal fundraising will be ordered to suspend business and have their business permits, business license or registration certificate revoked; its legal representatives or principal persons in charge, directly responsible persons in charge and other directly responsible persons shall be warned and fined more than 500,000 and less than 5,000,000 RMB.
(2) Failure to fulfill the obligation of prevention and treatment of information allegedly related to illegal fundraising. According to Article 34 of the Regulation on the Prevention and Treatment of Illegal Fundraising, an Internet information service provider who fails to perform its obligation to prevent and properly treat information allegedly related to illegal fund-raising shall be instructed to rectify itself and warned by authorities in charge, and its illegal gains will be confiscated; if the entity refuses to correct or the circumstances are especially serious, a fine of 100,000 up to 500,000 RMB shall be imposed. Based on the graveness of the case, they can be ordered to suspend related businesses, suspend business for rectification, shut down their websites, or have their relevant business permits or business licenses revoked. Directly responsible persons in charge and other directly responsible persons shall be subject to a fine of more than 10,000 and less than 100,000 RMB.
(3) Violations of consumers’ privacy rights and legitimate rights and interests shall be punished in accordance with the relevant provisions of the Law on Protection of Consumer Rights and Interests as well as Measures for Protecting Financial Consumers’ Rights and Interests.
(4) Violations of regulations against money laundering shall be punished in accordance with applicable provisions.
Criminal offence. Relevant charges include:
(1) Illegal absorption of public deposits, which can lead to a maximum sentence of more than 10-year imprisonment with fine; a unit that commits the crime shall be fined, and directly responsible persons in charge and other directly responsible persons shall be punished according to previous provision.
(2) Fund-raising fraud, which carries no less than seven years of imprisonment or life imprisonment, and a fine or confiscation of property; a unit responsible for the crime shall be fined, and directly responsible persons in charge and other directly responsible persons shall be punished according to previous provision.
(3) Illegal business operation, which is punishable by a maximum sentence of more than five-year imprisonment and a fine of not less than one time but not more than five times the illegal gains or confiscation of property.
(4) False advertising, which carries imprisonment of not more than two years or criminal detention in addition to a fine, or a fine only.
V. CONCLUSION
Licensed operation of the financial sector is a must. Financial products are “exclusive commodities” that should be offered only to certain buyers (the concept of a qualified investor).
Financial licenses have national boundaries. For financial businesses that are prohibited to domestic and foreign investors and have not been open to the foreign businesses, overseas institutions should not run them within China’s borders. For financial businesses that have been open to the foreign institutions, they must be conducted in accordance with the laws and regulations under relevant domestic licenses. It is illegal for overseas institutions to engage in financial businesses within China that are prohibited and not open to the foreign firms or conduct businesses in China with only overseas licenses. Likewise, domestic financial institutions with a regional license are not allowed to operate across the country. National financial licenses can only be granted by central financial regulators.
Certain financial products or services can only be provided for specific individuals. In the digital era, this requirement should also be implemented without compromise, meaning that indiscriminate selling across the Internet should not be allowed. Private investment products sold to non-specific individuals/part of the Internet should meet the following requirements: (1) The sale of such products should be carried out under license. When unlicensed Internet platforms directly display, introduce or promote private investment products rather than showing them on the page of licensed institutions, such behavior should be judged as illegal selling of financial products, strictly investigated, and penalized. (2) The requirement that products can be displayed only to specific individuals should not be loosened. Private investment products should not be promoted in an undifferentiated way over the Internet. In other words, not everyone but specific individuals can have access to them. Thus rules to define online “specific individuals” should be prudent. (3) In the purchasing process, qualified investor verification is essential. Online and offline verifications should be consistent. The responsibilities of financial institutions vis-à-vis commission agents should be well-defined. Leading financial firms and platform companies should play a bigger role in the evolution of market rules and maintenance of market order.
In the digital environment, regulators need to work on setting the geographical and customer boundaries for financial licenses. Functional regulation should be implemented to prevent regulatory bodies from passing the buck by claiming that it is not their responsibility since they did not grant the license or by using the excuse that they are understaffed. It is imperative to nip the illegal acts of Internet platforms in the bud since they could quickly spread and expand around the Internet. Such acts must be strictly penalized while relevant departments and individuals shall be held liable for criminal and civil violations in accordance with law.
Digital finance should develop more vibrantly and steadily to play a bigger role in serving the real economy, promoting the reform and opening up of the financial sector, and maintaining financial stability and security.
