Was China’s $97 million settlement for Citadel Securities politically motivated?

Citadel Securities agreed to a whopping settlement from China’s financial regulator, while some domestic firms escaped with wrist slaps. What does this mean for the growing number of foreign players entering China’s financial markets?

 

Chicago-based trading firm Citadel Securities agreed last month to pay a $97 million settlement for alleged trading irregularities during a 2015 market rout in China. When Chinese markets crashed in the summer of that year, government officials and state media were quick to blame algorithmic high-frequency trading (高频交易 gāopín jiāoyì), for which Citadel Securities is well known.

The settlement for Citadel Securities ends a five-year probe by the China Securities Regulatory Commission (CSRC) into trading activities that also implicated four domestic institutional investors, including Fuanda Fund, CITIC Futures, Qianshi Capital, and Guoxin Futures (link in Chinese). According to a somewhat opaque statement released by the CSRC on January 20, the settlement for Citadel Securities was “based on differing circumstances, such as the amount of money made through the suspected illegal acts,” per the Financial Times. Bloomberg reported that “the regulator has ended [the] investigation into suspected account and asset management rule violations.”

In addition to Citadel Securities and the four domestic investment firms, three local brokerages that facilitated the trades for Citadel Securities were fined an additional 416 million yuan ($60 million) for margin financing violations and short selling. The CSRC later cleared the brokerages but issued fines totaling 15.2 million yuan ($2.1 million) on four domestic firms involved in the probe.

The $97 million settlement for Citadel Securities is “more than 40 times the combined” fee paid by domestic firms implicated in the probe, according to the FT, and four times the $22 million settlement Goldman Sachs paid for similar 2015 trading infractions.

While the Citadel Securities case seems to show unfair treatment of foreign entities, other cases in recent years indicate that domestic players are far from getting a free pass. In 2017, the CSRC fined Chinese investor Táng Hànbó 唐汉博 and associates 1.2 billion yuan ($174 million) for stock manipulation. The CSRC also fined Chinese investor Xiān Yán 鲜言 3.5 billion yuan ($540 million), and a court sentenced hedge fund manager Xú Xiáng 徐翔 to over five years in prison for alleged market manipulation. According to the Financial Times, Xian’s punishment was the largest administrative fine that the CSRC has levied to date.

Algorithmic trading and short selling under scrutiny since 2015

The Citadel Securities investigation and broader scrutiny of trading practices in Chinese financial markets followed the 2015 market correction that saw more than $5 trillion of value evaporate from Chinese A-share markets. Between June and July alone, A-shares on the Shanghai Stock Exchange lost 32 percent of their value. By August 2015, stock prices had plummeted a total of 43 percent. The Chinese government attempted to slow the crash by buying shares and barring majority shareholders of companies from selling their stakes, but these measures were largely insufficient.

The two behaviors that regulators have blamed over the years for large-scale market corrections are algorithmic trading and illegal margin lending. While algorithmic trading is nothing new in New York, London, and other mature markets, as of 2015, it was still a relatively new and misunderstood practice in China, and the CSRC only began deeper scrutiny of the practice after the market turbulence of that year. Similarly, margin lending, which allows people to trade stocks using borrowed money, can lead to excess volatility in the market if creditors call in their loans all at the same time, forcing borrowers to sell their stock holdings at steep losses, thus causing a self-reinforcing negative feedback loop whereby more creditors seek repayment just as borrowers become less able to come up with the needed cash.

Given the vagueness of the CSRC statements made in relation to the settlement and the non-specificity of Chinese court rulings in general, it is difficult to know exactly which actions by Citadel Securities ran afoul of Chinese laws, regulations, or guidelines. But it’s safe to say, based on the reputation of Citadel Securities for high-speed, algorithmic trading in other markets, that this played a role in its plight in China.

Fines on the rise

While CSRC fines reached a record $1.59 billion in 2018, according to official data, the level of fines in China pales in comparison with the many billions of dollars that U.S. and U.K. regulators dole out from a seemingly ever-wider array of regulatory bodies. Nonetheless, fines in China are up 42.3 percent compared with 2017 and more than 3,000 percent compared with five years ago. Indeed, China has made keeping market manipulators at bay a top priority as it seeks first and foremost to protect its domestic retail investors, and second to attract foreign capital.

Fines are rapidly increasing in China’s finance industry as it opens up to the world. Data from the Financial Times; chart by Caroline Stetson.

 

Nearly a third of trust and wealth management companies were punished by regulators in 2019 for shadow banking and illegal real estate investment, among other infractions, although fines for these firms totaled only $3.2 million and beg the question whether they are actually intended to curb aberrant behavior or function as a largely administrative fee.

Ultimately for Citadel Securities, agreeing to the settlement was the only way to resume its expansion into China’s $45 trillion financial market. As China accelerates its financial opening program in 2020, including allowing foreign firms to own up to 100 percent of their China-based operations (compared with the 49 percent cap that has prevailed for many years), the differences in regulatory treatment of domestic and foreign firms will reveal how genuine the opening is, or if it is merely politically motivated opportunism. Caveat investor.

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Correction: All references to “Citadel” have been changed to “Citadel Securities”. All references to the Citadel Securities “fine” have been corrected to “settlement”.