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Asia-PacificSeptember 1 2016

The irresistible rise of Chinese fintech

China's fintech industry has grown at a rapid pace, in some cases leaving established tech giants of the West behind. Having cracked the domestic banking market, top Chinese fintech firms are already eyeing insurance and looking beyond the country's borders to continue their rapid ascent. Stefania Palma reports.
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Alipay embedded

Four-hundred million people. Or five times the population of Germany – the most populous country that lies entirely within Europe. That is the user base of Alipay, the online payments service offered by Ant Financial, the financial affiliate of Chinese e-commerce platform Alibaba. 

This offers but a glimpse of the scale of China’s fintech sector, which has ballooned in the past five years and has in some ways already left the tech giants of the West behind.

Beyond the borders 

A large unmet demand for credit, abundant venture capital-style funding and an enabling regulatory environment have contributed to the rapid development of China’s fintech scene. But now that some of the weaker fintech companies have gone out of business leaving borrowers and investors dry, Chinese regulators are tightening controls on the sector. This is likely to slow the market’s record-breaking growth. But Chinese fintech firms are already looking for new sources of growth in China’s underdeveloped insurance market and beyond China’s borders.

In just three years, China has grown to become the largest online alternative finance market in the world by transaction volume, at $101.7bn in 2015. The market has grown by more than 300% since 2013 and now dwarfs Western markets such as the UK, which stood at $4.5bn in 2015.  

While in the UK or US, fintech firms have focused mainly on foreign exchange, payments or small and medium-sized enterprise (SME) financing, Chinese fintech companies have challenged the local financial system as a whole. “In the West, the impact of fintechs has been relatively limited in terms of revenue and market share, with fintechs mostly nibbling around the edges of certain retail banking profit pools. In China, fintech has had a transformative impact,” says James Lloyd, Asia-Pacific fintech leader at EY. 

Outside China, fintech innovation tends to be driven by start-ups that are nimble, have an edge in customer experience or collaborate with incumbents. But in China, tech companies have driven development by moving directly into financial services, adds Mr Lloyd. 

And while China’s largest tech players have now established fully fledged online banks and insurers, the West’s giants such as Google, Amazon or Facebook still lag behind in terms of their fintech offering.

Out of the shadows 

A combination of enabling regulation and significant unmet credit demand has contributed to China’s fintech performance. Chinese financial regulators have consciously let shadow banking thrive in the past 10 years to create new ways of providing financial services outside of the traditional banking sector, which has historically failed to meet retail clients’ or SMEs’ credit demand to favour bigger corporate clients. 

Chinese fintech firms jumped on this opportunity and are leaving traditional banks behind both in terms of size – in some cases they have more end customers than banks – and in terms of innovation. “Implementing a new idea across [China's] large banks, with their huge number of platforms and amount of staff, is hard. They are not set up to be fast and nimble,” says Keith Pogson, global assurance leader, banking and capital markets at EY. “They are also fat and happy. There are no alarming trends in their numbers that suggest they will be taken out by fintech any time soon and they are still growing.” 

However, in just a decade, fintech giants such as e-commerce platform Alibaba, messaging and gaming firm Tencent and online search engine Baidu have disrupted key aspects of traditional banking such as lending, payments, securities trading and wealth management. 

Breaking the banks

Alibaba now has a separate finance arm called Ant Financial. It includes online payments service Alipay, online money market fund Yu’eBao, which had Rmb621bn ($93.24bn) in assets as of the end of 2015, and online bank MYbank. 

Tencent owns two of the most popular messaging applications in China – QQ and WeChat – which collectively have about 1.5 billion monthly active users. These applications also offer mobile wallets, which Tencent’s online bank WeBank uses to market its products. WeBank was the first web-based lender to launch in China. 

To keep up with Tencent and Alibaba, Baidu has moved aggressively into fintech in the past 12 months. In November 2015, Baidu announced a joint venture with China Citic Bank to set up online-only lender Baixin Bank – the first joint venture bank in China formed by an internet company and a traditional lender. 

“Financial services are a fast-growing vertical [market] for Baidu and one of the top five verticals by revenue. There are 100 million users who log into Baidu products daily. In addition to connecting people with information, we are expanding our offerings to also connect people with services,” says a Baidu spokesperson. 

In the peer-to-peer lending space, Shanghai Lujiazui International Financial Asset Exchange, also known as Lufax, has taken the market by storm. Controlled by insurer Ping An, Lufax lends to customers whose credit demand has not been met by banks, while offering investors returns of about 8% — an eye-catching proposition at a time when China’s one-year bank deposits yield about 3.25%. With inflation at 3%, real interest rates are even meeker. 

Lufax also links up Chinese firms looking to raise capital and high net worth individuals in the country. It sells equity products directly to mass-affluent clients before a company lists publicly. This provides local companies with an alternative to initial public offerings (IPOs) at a time when about 700 firms are waiting to go public and the queue to list in the mainland is about five years long. Lufax is essentially filling the gap left by China’s immature private banking sector, says Mr Pogson. 

Funding records 

In addition to a favourable regulatory environment and unmet credit demand, record-breaking volumes of venture capital-style funding have driven growth in Chinese fintech. According to Accenture, fintech investment in Asia-Pacific more than quadrupled in 2015 to $4.3bn and China accounted for 45% of this volume. 

China’s fintech investment skyrocketed from just above $600m in 2014 to almost $2.7bn in 2015, according to KPMG. In 2016, these private funding rounds accelerated. Ant Financial, Alibaba’s financial affiliate, stood out for raising $4.5bn in April 2016 in what it said was the largest private placement by an internet company globally. 

Lufax accumulated significant funding earlier in the year, with a $1.2bn private round in January. That same month, JD Finance, the finance arm of Chinese e-commerce platform JD.com, raised $1bn. “The company is still in its early stages and the financing will be used for general business development purposes,” says Josh Gartner, vice-president of international corporate affairs at JD.com. 

To Ian Pollari, global co-leader of KPMG’s fintech practice, this spurt in fintech investment shows incumbent Asia-Pacific banks and insurers are understanding the perks of investing in this sector. “One in four deals in global venture capital funding to fintech is coming from corporates,” he says. 

IPO talk 

But private funding rounds are no longer enough for the biggest fintech companies in China. The next step is an IPO. Here, Ant Financial is the talk of the market. It wants to list in Shanghai, and with a valuation of $60bn this could be the biggest IPO in the mainland since Agricultural Bank of China’s $22.1bn listing in 2010, according to Bloomberg. 

To Mr Pogson, the mainland’s five-year queue to IPO is holding Ant Financial’s deal back. “If the government agrees to the IPO and lets Ant Financial jump the queue then what does it mean for those that don’t get to jump the queue?” he asks. Nonetheless, the regulator still appears to be favourable to this listing, he adds. “The Chinese government will be more comfortable if the company is widely held. The control of [Alibaba chairman] Jack Ma and his limited circle of owners would be widened and there would be higher transparency,” says Mr Pogson. 

Zhong An, online insurer controlled by Ping An, is also in the queue to list in mainland China with a $2bn deal that is set to price before the end of 2016, according to Reuters. Lufax is also trying to go public, but on the Hong Kong Stock Exchange and in 2017. “There is a long queue in the mainland and the size of this thing will be huge. Lufax also wants international investors,” says Mr Pogson of Lufax's decision to opt for Hong Kong. 

Although there is a lot of expectation for these three IPOs, pundits suggest that inefficiencies that still characterise China's market might dampen demand for listings of smaller Chinese fintech firms. “It’s hard to get a handle on certain valuations in China; the market is undoubtedly more opaque than the US, for example,” says Mr Lloyd. In the US and Europe, regulators have pressured tech companies to disclose their public valuations, while mark-to-market mutual funds help understand their private valuations. The same system is not operating in China. 

Cracking down 

Low transparency in China’s fintech market is a byproduct of having had a loosely regulated market for the past decade. While this has facilitated the creation of giants such as Alibaba, weaker and smaller investment firms and online lenders have also mushroomed. In the past 12 months, more than 1000 online lenders have collapsed and end customers have shouldered some of the losses. In February, Chinese authorities arrested 21 executives of online platform Ezubo for allegedly defrauding investors of $7.6bn. 

To preempt potential social unrest following growing failures of weak investment firms and online lenders, and now that China has succeeded in developing local tech giants, Chinese regulators are starting to tighten their grip on the fintech market. A number of non-traditional lenders have been forced to shut down. Market participants also expect China to unveil tighter fintech regulation in the third quarter of 2016, which is one of the reasons why Lufax has postponed its IPO to 2017.  

Despite the current volatility, Mr Pollari is optimistic about improving transparency in China’s fintech sector. “Credit risk is the biggest challenge for the industry," he says. "Leading Chinese peer-to-peer lenders have charge-off ratios of 5% to 10% currently, with generally higher loss ratios at start-ups. [But] this will drop as their credit scoring becomes more sophisticated and as they enhance their underwriting capability through access to better credit data.”  

Bright insurance horizon 

While the sector is grappling with regulatory uncertainty, fintech firms are finding new sources of growth in the country’s underdeveloped insurance market. “As consumers move from rural to urban centres and as some additional 500million to 700 million Chinese enter the middle class, their demand for financial services such as insurance will substantially grow,” says Mr Pollari. 

Market growth is likely to be driven by insurance of goods and valuables and in health insurance, once Chinese private healthcare develops further, says Mr Pogson. 

New insurance trends particular to China are also emerging. The Confucian paradigm of the Chinese family, whereby children are responsible for their parents’ care, is not defining Chinese families as it used to. This is generating demand for new types of insurance products.

Meanwhile, Taikang Life Insurance and Ping An have also launched a retirement product whereby buying a policy of at least Rmb2m allows the buyer to access a Taikang retirement community and enjoy the use of a retirement home, elderly care and nursing services. Children can take out this policy for their parents.

China’s alternative finance models ($)

Filling the gaps 

Baidu finds China’s insurance market so promising that it launched two joint ventures in the sector in the space of seven months. Pending regulatory approval, Baidu is set to launch online-only insurance company Bai An as a joint venture with global insurer Allianz and Chinese investment manager Hillhouse Capital. Bai An will focus on scenario-based products, which Baidu can sell together with travel packages, restaurant bookings or other lifestyle products users search for and buy on its platform. 

Subject to approval from the China Insurance Regulatory Commission (CIRC), Baidu will also set up an online auto insurer – the first in the country – together with China Pacific Property Insurance to tap into China’s growing auto market. Passenger-vehicle sales are growing quarter on quarter and auto purchases are one of Baidu’s most popular searches. The CIRC expects China’s auto insurance market to almost double by 2021. 

The other reason why growth in China’s online insurance market looks promising is because traditional insurance companies tend to be more innovative, especially compared with traditional Chinese banks. Instead of suffering fintech disintermediation, Chinese insurers have jumped into fintech themselves. A case in point is Zhong An – China’s first online-only insurer, set up in 2013 – which is a joint venture between insurer Ping An, Alibaba and Tencent. 

“Zhong An is a noteworthy example of established players coming together to deliver scaled growth,” says Mr Pollari. Zhong An accumulated 369 million customers in just two years since its creation and has so far underwritten 600 million policies. 

The online insurer also took the top spot in KPMG’s and H2 Venture’s 2015 top 100 fintech firms ranking. This year's ranking features seven Chinese companies, while only one made the list in 2014. 

Going global 

After having grown considerably at home, the biggest Chinese fintech firms are starting to eye foreign markets for investment and expanding their customer base. 

In December 2015, Alipay signed a partnership with German mobile payments company Wirecard that allows Chinese tourists to pay European retailers with Alipay. This could be an entry point into one of the biggest markets for outbound Chinese tourism as Alipay works towards reaching 2 billion customers by 2020. 

“Following Chinese consumers (including tourists) is an efficient route to market – but how will they fare in direct competition with international players? I think we can expect to see more and more strategic partnerships,” says Mr Lloyd. 

Chinese fintech firms are also targeting foreign markets for investment. With the goal to generate half of the company’s revenues overseas, Alibaba acquired Singaporean e-commerce platform Lazada for $1bn in April 2016. Lazada operates in Indonesia, Malaysia, the Philippines, Singapore, Thailand and Vietnam. With this deal, Alibaba is targeting one of the fastest growing and youngest regions in the world.

Sending signals 

Meanwhile, both Baidu and JD.com have invested in California-based online lender ZestFinance to apply its credit scoring technology to their own risk assessment processes. While traditional banks rely on 20 to 30 variables to screen a borrower, ZestFinance’s technology can analyse 70,000 different 'signals' to assess a person's credit-worthiness. This is crucial to Chinese fintech firms, which focus on lending to retail clients and SMEs that tend to have limited or no credit histories. 

Baidu and ZestFinance data scientists are working in Sunnyvale, California to turn Baidu’s search, location and payment data into credit scoring decisions. Zest Finance will use Baidu’s funding, which remains undisclosed, to advance its underwriting technology platform for this type of research.

China fintech charts

Meanwhile, JD Finance launched a joint venture with the US lender that applies ZestFinance's technology to JD.com’s consumer data in order to provide credit scoring services to companies in China and create credit scores from scratch. JD Finance also invested in ZestFinance to support this type of research for the Chinese market. 

“Our unique ability to analyse and process messy data to make accurate credit decisions is very valuable to the Chinese credit market, where a centralised credit scoring system has yet to emerge,” says Douglas Merrill, chief executive at ZestFinance and former Google chief information officer. Indeed, today fewer than 25% of Chinese citizens have credit histories. 

Reciprocal affair? 

As China’s top fintech companies start expanding abroad, the question of whether their products will be transferable to other jurisdictions is becoming more and more pertinent. Mr Lloyd believes they are and that Western tech companies are even looking to learn from Chinese competitors. He gives messaging application WeChat's success as an example. “It has hundreds of millions of customers and many have attached financial credentials to it,” he says. 

But Chinese firms might still face challenges abroad in the form of competition with local fintech firms, regulation and consumer expectations and taste. Indeed, Western regulators have been more stringent on their fintech sectors than in China's case since they are not as comfortable with the idea of the end customer potentially bearing the brunt of a failed online lender. 

What is more, not all firms and regulators in the West might be ready to open up their doors to Chinese fintech companies considering China has been quite protective of its own fintech industry. 

“There have long been restrictions on foreign ownership in China in ‘sensitive industries’ such as internet and telecommunications companies. For example, foreign investors have been precluded from investing in WeBank after China’s banking regulator expressed concerns about foreign ownership,” says Mr Lloyd. 

As with many aspects of China’s economy, the fintech sector has grown to unprecedented size and competitiveness in record time. The price to pay has been poor transparency and bankruptcies among online lenders. Now, tightening regulation is shaking up the market and the sector might no longer grow at breakneck pace. But tightening regulation is also symptomatic of a maturing market, which is what China’s fintech industry needs to make the significant results achieved so far sustainable. 

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