Ep. 46: Futu, Tiger, and the Trillion-Dollar Overseas Online Brokerage Business from China

Transcript

(Y: Ying-Ying Lu; R: Rui Ma)

[0:00] R: In March of this year, two Chinese fintech unicorn startups went IPO in quick succession. One was 富途 Futu, which can be translated as the “path to riches,” and the other was Tiger Brokers.

Y: Both are online brokerages that help Chinese people invest in securities outside of mainland China — primarily equities listed in Hong Kong and the United States.

R: Both of them raised money via primary shares as well as concurrent private placements, netting well over $100mm each in proceeds, and debuted at a roughly billion dollar valuation.

Y: And both of them count strategic corporate investors amongst their largest shareholders, Tencent in the case of Futu, and Xiaomi as well as Interactive Brokers in the case of Tiger.

R: There are even more similarities between these two companies, but what you’re probably asking now is, what exactly is this online overseas brokerage business, and why is it thriving? Or at least, why is it thriving enough to give birth to not one but two public companies in the same month?

Y: We’ve been wanting to cover these two players for a while, especially since it’s become more and more obvious that US-listed Chinese equities seem to be more volatile than their NASDAQ or NYSE peers.

R: Indeed, some even think that they trade more like their A-share counterparts, which is to say, not always driven by fundamentals, with extreme price fluctuations that are often blamed on an irrational and largely retail investor base.

Y: Could the rise of these overseas online brokerages have something to do with it? If so, why would that be the case? And what can we expect for the future? If you’ve already got or are thinking of getting some exposure to US-listed Chinese equities, you’ll definitely want to listen to the rest of this episode!

[2:20] R: Hi everyone! We are TechBuzz China by Pandaily, powered by the Sinica Podcast Network! We are a biweekly podcast focused on giving you a peek into what’s buzzing within the tech community in China.

Y: We uncover and contextualize unique insights, perspectives and takeaways on headline tech news that don’t always make it into English language coverage. So you can be smarter about the world of China tech. TechBuzz China is a part of Pandaily.com, an English language site that tells you “everything about China’s innovation.” I’m one of your two co-hosts, Ying-Ying Lu.

R: And I’m your other co-host, Rui Ma. We’d like to acknowledge our partners DealStreetAsia and SupChina, creator of the Sinica Podcast Network!

Y: In addition to TechBuzz, you can also find Sinica which covers current affairs, NuVoices as well as Ta for Ta on women, the business-oriented ChinaEconTalk, and the Caixin-Sinica Business Brief from China’s leading business magazine.

R: Speaking of DealStreetAsia, their annual private equity and venture capital conference, Asia PE-VC Summit, is set to take place on the 17th & 18th of September this year. To register, go to their website at dealstreetasia.com!

Y: And finally, as always, thank you for writing in and tweeting at us with your feedback. We love hearing from you and are always looking for ways to improve. If you like what you hear, please give us a rating or review on iTunes or wherever you get your podcast!

[4:00] R: By the way, before we get started here, we highly recommend you take a listen to Techbuzz Episode 40, which talks about Shanghai’s newest Technology Innovation Board, but also provides a pretty complete history, if we may say so ourselves, on the Chinese stock market and its various exchanges.

Y: If you know nothing about the Chinese stock market, this is definitely a good time to press pause and listen to Episode 40. You see, the two markets are very different. The US is an application-based system, while China is approval based. The US is dominated by institutional investors, while China is still mostly a retail market.

R: And although that episode is primarily told from the perspective of companies looking to list and why they might want to choose to IPO overseas, the end result is that the domestic Chinese stock markets are not really attracting the best quality companies, not even the ones from China.

Y: And so naturally in the search for quality assets, it follows that there must be incredible demand for foreign-listed securities, especially those in the US on the NASDAQ or NYSE, and also those listed in Hong Kong, the fourth largest exchange in the world.

R: As securities brokerages increasingly moved online and became more tech-driven and more global, of course this slice of trading volume has increased exponentially. But also once-in-a-decade events such as the US listing of Alibaba in 2014 really helped kick this trend into high gear.

Y: So how big is this market really? Well, everyone pretty much quotes the Oliver Wyman report on the “wealth-tech” industry, so we’ve included the link in our transcript. A few key statistics jump out — in terms of online wealth management, China already accounts for 22% of global assets at over $1Tr dollars. In terms of online securities trading, by 2017, China already accounted for over one-third of the global volume at nearly $13Tr dollars.

R: Yes, these are not billion-dollar markets but trillion with a capital T. And they are still growing very fast. In the next few years, Chinese offshore financial assets – consisting of equities, fixed income, insurance and alternative assets – will grow at a compound annual rate of 28 percent to reach $2.1 trillion by 2022, more than triple what it was in 2017.

Y: And even more specific and segmented than that is the Chinese overseas online retail securities market, which was already about $300Bn in 2017, and is expected to more than quadruple to $1.4Tr by 2022. And by then, over 50 million Chinese are expected to have overseas investments, representing 10% of their total investable assets. That’s still very low compared to 40% in the UK and 20% in the US and Japan, by the way.

[7:17] R: Now you see why everyone is jumping in! It shouldn’t surprise anyone anymore that not one but two companies went IPO in this space last quarter. But aside from the fact that Chinese people are generating wealth at an unprecedented rate and that the penetration of their overseas investment is still very low, what else accounts for this extremely high growth rate in overseas online brokerages?

Y: Well, there’s the do-it-yourself attitude of millennials, so they’re not generally looking for traditional securities firms with advisors and such, but also because since Chinese investors are overwhelmingly retail — recall that about 80% of the volume in China can be attributed to individual investors — online brokerages are great at providing the news, reports, analytical tools, and community features necessary to make investment decisions and trades in a mobile-friendly format.

[8:14] R: OK, now that we have the market opportunity out of the way, let’s talk a bit about the two companies. First up, Futu. Founded in 2011 by Tencent employee number 18 李华, aka Leaf Li, Futu is your typical startup story of the entrepreneur scratching his own itch. You see, as Tencent’s first new grad hire, Li joined Tencent pre-IPO and then got into Hong Kong stocks because well, that’s where Tencent ended up being listed.

Y: By the time he was 30, he already had financial freedom, and so he decided to pursue his passion, which at this point had become stock investing. He found the systems used for trading Hong Kong securities to be archaic and not user-friendly, so he was intent on making his own. When he tried to get investment from Tencent CEO Pony Ma, he was initially met with some resistance.

R: The field was already pretty crowded, there were lots of trading software companies in China, with everyone wanting to be China’s Bloomberg, and a few had even managed to get listed by 2012. But when a huge bull market hit Hong Kong in 2014 after a long lull, Li found his opportunity: help mainlanders trade in Hong Kong. Becoming Bloomberg was no longer sexy — it was time to create China’s Charles Schwab.

Y: After eight years in the trenches, whether or not Futu has been successful is still too early to say. The company went public in mid-March of this year, pricing at the high end of its range, raising $90mm USD and up by much as 46% in its first day of trading, making it the fifth best performing IPO as of its debut date this year. Pretty respectable but significantly smaller than the rumored $300mm raise in its confidential filing last year.

R: But let’s not forget that it did hold a concurrent private placement of $70mm to private equity firm General Atlantic, which means that its total amount raised is about $160mm.

Y: So not quite the rumored $300mm, it’s true, but still a pretty substantial infusion of cash. Pretty respectable.

[10:39] R: The founding story of Tiger Brokers is eerily similar. Tianhua Wu was a graduate of Tsinghua University’s Computer Science department, and went to work for Netease early on as an engineering lead on its search engine initiative. Same as with Li, Wu received stock options for his work and really got into US equities because that’s where Netease was listed, on the NASDAQ.

Y: Like Li, he also felt that the software and online brokerages he was using to trade were not up to par and not localized for his needs as a Chinese user. By 2014, at age 30, he decided to quit his job at Netease and start Tiger Brokers, also to solve his own problems.

R: And just like Futu, Tiger, also known as UP Fintech, priced above its expected range but in a downsized IPO, raising $104mm. It rose 37% in its first day of trading, although if you had bought in at that price, you would have seen your fortunes decline by about the same percentage as of now, since the company is worth just over $600mm today, down significantly from its billion dollar debut.

Y: Futu, on the other hand, is down just barely 10% from its IPO price and is currently worth almost twice as much as Tiger in market cap.

R: Well, one of the main reasons is that Futu is a profitable company, whereas Tiger is massively unprofitable. Which is curious because they have a similar — and actually relatively simple — business model: they charge a commission on trade executions, and provide margin financing. To support their customers, both provide market data, news, research, and their own suite of analytical tools.

Y: Pretty much like every other online brokerage. But Tiger has a -131% net margin, which is pretty ugly when you compare it to Futu’s net margin in the high teens.

R: Part of the reason is that 77% of its revenues come from commissions, as compared to just half or so of Futu’s revenues. Tiger is also extremely aggressive with its pricing, charging as low as $0.39 for a 100-share trade.

Y: So even though it supposedly has an almost 60% market share in terms of trading volume for Chinese investors trading US equities, its revenues are only about one-third of Futu’s. I guess this is consistent with their corporate narrative that they want to become the E-Trade of China. Futu, on the other hand, has about half of its revenues coming from its margin lending business, which is undoubtedly much more profitable than just clearing trades.

R: However, even though Tiger’s first quarter results also showed that it was pushing to grow its margin lending business, expenses also went up as headcount almost doubled. Commissions were also not as large as expected because investors were more cautious and made less trades in the US markets.

[13:44] Y: Aside from a different revenue structure, Futu may also benefit from its close affiliation with Tencent. I guess Pony eventually decided that it was worth betting on his former employee after all, and so became the second largest shareholder, continuing to own about one-third of the company post-IPO. Other owners, by the way, include Matrix China at 5% and Sequoia at 3.5%.

R: Tencent is so closely affiliated with Futu that if you go to their website at www.futu5.com, the word Tencent shows up in a little speech bubble on the very logo of the company itself, with the words 战略投资 or “strategic investment” right below it. It kind of makes sense, because Chinese fintech has been so fraught with fraud in recent years that for sure it would help to lean on the credibility of such an established brand as Tencent to make customers feel at ease. You are asking them to deposit their hard-earned cash into your accounts, after all.

Y: Tiger, by the way, is also funded by not one, but two corporates. Its second largest shareholder is Xiaomi but more importantly, it boasts the largest online brokerage firm Interactive Brokers as an investor at 8%. And, in almost every press piece it is also mentioned that Jim Rogers is also an investor, although his holdings aren’t large enough to show up in the prospectus.

R: Jim Rogers, by the way, is uber-famous in China. If you haven’t heard of him, look him up. He’s known for having founded the Quantum Fund with George Soros, retiring and traveling around the world, becoming a television commentator and then moving to Asia in the early 2000s. In China stock-picking circles, he’s revered somewhere not too far below Warren Buffett.

[15:38] Y: But OK, so everyone’s got great financial and strategic backers. But just how many customers did that get these guys? At the time of IPO, Futu boasted over 5.6mm users, which sounds impressive, until you consider the fact that like most other Chinese products, only a very small number of users pay. In Futu’s case, that’s a little over 2% at 133,000 people who have actual assets in their trading accounts.

R: Tiger doesn’t fare much better, with just 81,000 customers with deposits, or 5% of its nearly 1.6mm registered users. Trading volume though, for both, was basically $120Bn last year. Which could mean that the average Tiger user is more active than the average Futu user.

Y: Maybe so. In either case, both brokerages boast very young user demographics, a feat which fellow US brokerage unicorn Robinhood has used to propel itself to sky-high valuations. Futu’s average client is only 34 years old and almost half of them work in IT, internet or financial services, with 97% of paying customers remaining on the platform since the beginning of 2017.

R: If you think that’s impressive, consider that Tiger has an even younger client base with over 70% under the age of 35 and over 85% making more than $40,000 per year. That’s not bad by American standards and definitely considered high earners by Chinese standards.

[17:23] Y: Those are the highlights of these companies, the ones usually mentioned in press releases. But there are so. many. risks.

R: I know, reading the Risks section of both companies’ prospectuses makes me wonder what exactly is not at risk.

Y: For example, Futu tells us that its online onboarding process is not kosher with the Hong Kong Securities and Futures Commission, AKA the HKSFC. It’s also not sure it needs a brokerage license in China, seeing that it provides brokerage businesses to Chinese customers and actively markets there, although strictly speaking, it does not conduct business on the mainland.

R: In the same vein, Tiger in its prospectus disclosed that the Chinese Securities Regulatory Commission, or CSRC, AKA China’s SEC, sent out a notice expressly warning that no companies have been approved for providing overseas trading services to Chinese citizens back in 2016. Tiger apparently promptly communicated with the CSRC and got their blessing after removing the words “securities” and “stock” from their PRC entity, but same as Futu, while both companies are technically using foreign entities and foreign licenses to trade, it’s possible that the CSRC may step in and make additional requirements of them.

Y: But the common risk both companies share is that of the issue of foreign exchange. Under current rules, the State Administration of Foreign Exchange, affectionately abbreviated as SAFE, strictly limits each Chinese citizen’s conversion from RMB to any other foreign currency to the equivalent of $50,000 USD per year.

R: In the past two years especially, converting currency has become extremely strict if almost impossible, as you must provide documented proof for why you need the funds, and only a few use cases are accepted, such as traveling abroad.

Y: Investing directly into foreign stock markets is, very simply, prohibited. And while neither Tiger nor Futu engage in any currency conversion activities on behalf of their customers, they do not have any control of the methods in which their clients are getting their monies exchanged, which means that if their clients are using shady avenues or misreporting their intentions, Futu or Tiger could be involved in the investigations. And in March 2016, Tiger was inspected by the relevant authorities for exactly these reasons.

R: It doesn’t seem like the authorities are paying too much attention these days though, probably because the market is still so small, but as it grows, there’s no telling what extra burdensome policies the companies may have to put in place in order to satisfy regulatory oversight.

Y: And according to the founder of Futu, 95% of their clients’ assets are already parked overseas and so not subject to China’s foreign exchange restrictions. But again, if those clients did so illicitly, the brokerages could still be investigated.

[20:43] R: Finally, another issue that has popped up has been that of IPO share allocations. Tiger has started an underwriting business in order to get allocations of IPO shares for its clients. It was listed as an underwriter in its own IPO, of course, but also most recently for Yunji, a membership-based social e-commerce platform in China that went public just last month. For this deal, many clients did not get their promised allocation and took to social media to complain of fraud.

Y: It’s unclear exactly what happened there, and Tiger blames it on Yunji’s last minute decision to downsize its IPO, but a slew of negative press came out, and the fact that Tiger essentially relies on Interactive Brokers for all of its US equities execution came to light, and was declared its Achilles’ heel.

R: Tiger is just a “paper tiger,” the media headlines screamed. It’s not a brokerage as much as it is just a sales channel for Interactive Brokers. This isn’t really news, since its own prospectus calls it an “introducing broker” for IB, but I guess for many of its retail customers, this came as a shock.

Y: Tiger’s CEO fought back, however, and said that all Chinese brokerages who support trading of US-listed securities use Interactive Brokers as their backend, because it is so difficult to procure a license in America. It’s just that others don’t disclose this.

R: I believe him. While Futu’s prospectus does disclose that it aggregates client orders and collaborate with a “qualified third-party brokerage company for execution and settlement,” it doesn’t say which firm that is. It may very well be IB.

Y: It’s also not super clear just how much investors think this is a key competitive advantage, because when Futu announced that it obtained a FINRA license to clear trades in the US just this week, the stock did go up, but only by a tepid 4%. Maybe no one really cares if you are simply an introducing broker or a full-fledged one. As long as you own the customer.

R: This does, however, highlight a key difference in the two markets when it comes to IPOs, because in China, retail investors can access IPO shares by maintaining a certain minimum asset value in their trading account for the few weeks before the IPO, which ranges from a few hundred to $1500 USD depending on the exchange. Whereas in the US, these shares are generally unavailable to you unless you are a high-net-worth individual.

Y: In China, as long as you fulfill the asset requirement, which is designed to be accessible, you can then enter a lottery for the shares available and wait to see how your luck plays out. You don’t even need to have the funds ready or locked up before the transaction. Once you’ve won the lottery, you get until 3PM that day to wire the funds.

R: Most Chinese investors consider this a guaranteed winning trade. That is, you basically can’t lose money on the IPO. There is no lock-up involved, so you can sell as soon as you like, but most people will choose to hold for at least a few weeks because on average, new IPOs in China tend to at least triple in value in its first ten days of trading. No joke, that’s the average scenario.

Y: Now, most IPOs in the US also experience a first day pop, but not always. Sometimes, you get very lucky and see the 66% pop that recent IPO Zoom Technologies experienced. Other times, you get an Uber, which had a drop in price on its first day instead.

[24:39] R: Now guess which companies Tiger Brokers offered to its clients at IPO? Well, Sogou, iQiyi, Huya, Pinduoduo, Bilibili, 360 Finance, Tencent Music, Yunji, and more. Many of the recent US-listed Chinese companies, of course, but also companies such as Zoom, which it claims to have been the only online brokerage to get IPO allocation for.

Y: And while most marketing documents acknowledge that closing below IPO price is a real possibility, a la Uber, for example, it is still true that most IPOs do tend to go up when trading opens. Paired with the fact that there is no limit to price changes in the US, unlike in China where prices are capped daily at movements of 10% in either direction, and you have eager Chinese investors who see the US IPO markets as one of the best bets for low risk and high reward trades.

R: Could this be what’s accounting for the sudden pops and subsequent drops in US-listed Chinese IPOs? It’s possible. Journalist Stella Xie wrote an interesting piece for the Wall Street Journal back in March where she talked about how China’s “night traders” are moving US stocks.

Y: They’re “night traders” because it is night time in China when they are executing trades during the US day time. Because they are Chinese, most of their trades revolve around the aforementioned US-listed Chinese companies, although there is also plenty of interest in firms like Tesla, which enjoy a very good reputation in China.

R: Because many Chinese companies often begin with relatively small floats, ie shares for trading, it may not take that many investors piling in to result in drastic price fluctuations. According to one Reuters article, Chinese companies float between 4 and 19% of their shares while non-Chinese companies range between 14 and 86%. Less shares, larger swings.

Y: And it’s entirely possible that’s what’s been happening with regards to these Chinese IPOs, because as we’ve already explained, most Chinese investors consider it a must-win bet and do not care at all about the underlying fundamentals of the company.

[27:03] R: Beyond IPOs though, there are many Chinese retail investors, especially those who work in tech, who believe that they understand the Chinese companies better than US analysts. When Pinduoduo was accused of discrepancies in its regulatory filings, it only spurred some young Chinese investors to buy more of the stock, believing it to be under unwarranted attack.

Y: According to the article, “Wang Haitian, a 30-year-old former journalist who now trades stocks full time, saw the short seller’s report as a buying signal. “Our judgment of Chinese internet companies is more grounded than foreign investors,” he said.”

R: Not all Chinese investors are so bullish, however. When the Blue Orca short selling report on Pinduoduo came out, it was actually analyzed in detail by numerous Chinese analysts and finance publications. Not all were so brash as Mr. Wang, and many took the allegations seriously. However, they also generally concluded that these accusations were weaker than those that had been leveled at Chinese companies in the past and thus did not constitute an existential threat to Pinduoduo.

Y: In fact, there is a good group of Chinese investors who blame the volatility on American newbie retail investors. In Chinese internet slang, newbie investors are called 韭菜, or chives, because they are cheap and easy to grow. Basically, they are not only stupid but helpless, easily manipulated, and there are wave after wave of them — endless chives to harvest, 割不完的韭菜。

R: Chives are used in all sorts of contexts, by the way, not just the stock market, although that’s where it originated. But cryptocurrency, p2p lending, all saw lots of innocent chives lose their hard-earned savings. It’s all quite tragic, despite the snarky meme.

Y: And actually, in the case of American retail investors, it’s possible that some of them are crypto investors who got re-directed to Chinese stocks after the crypto winter descended because, well, where else are you going to find this kind of volatility?

R: It’s hard to say how systematic this is though, as we only see some anecdotal evidence of people complaining that their crypto group on the free trading app Robinhood has been taken over by folks shilling Chinese stocks such as NIO and Qutoutiao.

Y: Either way, the enthusiasm some American 韭菜 have for Chinese stocks have the Chinese people confused. The American stock market has become just as irrational and opaque as the Chinese A-share market, they complain. No one knows anymore why a stock is moving up or down.

[29:43] R: Finally, there is one last thing I feel like we really must mention that will further help explain why Chinese investors love US equities. Yes, they are irrationally optimistic when it come to IPO shares. But also, they enjoy certain tax “benefits” on their investments.

Y: This is because according to IRS rules, as long as you declare that you are a non-resident alien, that is, you don’t live here and you don’t hold citizenship, then you do not have to pay capital gains tax to the US government.

R: What about dividends, you ask? Well, China has a treaty with the US where the tax rate is 10% instead of the usual 30%. Interest on bonds, as long as they are directly held, are also tax-free. All you have to do to enjoy these advantages of not being a US citizen is to fill out the W-8BEN form every two years.

Y: That doesn’t mean of course that Chinese people don’t pay any taxes whatsoever. Strictly speaking, they are still subject to Chinese taxes, although the Chinese tax code very kindly lets you deduct the amount you’ve already paid to the US IRS so you are not double taxed. Realistically though, most Chinese people seem to be getting away with not reporting their US gains.

R: So yeah, there’s that tax thing driving demand from China for US equities. The loophole will probably close soon, if not already, but meanwhile, it helps explain the market growth.

[31:14] Y: So that’s pretty much really all you need to know about Chinese overseas online brokerages. Shall we go ahead and summarize what we learned today, Rui?

R: Okay So in March of this year, two unicorn fintech companies, both catering to mainland Chinese investors who want to buy securities abroad, went public in the US. Futu was founded by an ex-Tencent employee and received investment from Tencent, while the other, Tiger Brokers, was founded by an ex-Netease employee and was funded by Xiaomi and Interactive Brokers.

Y: They both offer media, community and tools for users, and are neck-to-neck in trading volume. However, Futu has three times as much revenue as Tiger and is profitable, whereas Tiger is extremely unprofitable, because Futu has done a lot more with its margin financing business, which accounts for half of its sales.

R: Both companies though, are subject to a lot of regulatory risks, including foreign currency exchange and potentially needing to be licensed in China in the future.
And while Futu just received a clearing license this week, thus far both companies effectively act as introducing brokers, meaning that they don’t actually settle or clear any of their customers’ trades, but instead aggregate order flow to be executed by a licensed partner entity, someone like Interactive Brokers.

Y: Not knowing this, some Chinese investors have accused Tiger of fraud when they found that they didn’t get their promised allocation in a recent Chinese IPO.
They were all up in arms about it because not only was it a breach of contract, IPOs in China are pretty much considered failsafe investments — super low risk and super high reward.

R: This might explain why it’s suspected that Chinese investors are putting a lot of money into the new Chinese IPOs and pushing them to large pops that burst a few days later. Cough, NIO, Luckin, and pretty much every other Chinese IPO that has listed in the last year.

Y: No kidding. The seesawing stock price of some of these US-listed Chinese securities could give you whiplash. In fact, Reuters has called this, cheekily, “trading with Chinese characteristics.”

R: There are plenty of American traders who also have a gambler’s mentality though, so that’s not helping either. But whether the fluctuating prices be due to Chinese night traders or US newbie chives, a potential and serious consequence is that large institutional investors may take notice and put off investing in or avoid Chinese companies altogether, exacerbating the credibility problem that many Chinese listings already have.

Y: And the numbers aren’t helping. Last year, investors in US-listed Chinese IPOs lost an average of 16%. Whether investors decide to sit out will be the age old battle between greed and fear. What do you guys think? Which will win out? Are you putting in more money into the market these days or pulling out? Let us know by tweeting at us at @Techbuzzchina!

[34:40] Y: Alright, that’s all for this week folks! Thanks for listening. As a reminder, episodes will now be available every other Friday instead of Wednesdays. We really enjoyed putting this together, and we are always open to any comments or suggestions. You can find us on twitter at thepandaily, at techbuzzchina, and my personal Twitter account is @GINYGINY.

R: And my Twitter is spelled @RUIMA. TechBuzz China by Pandaily is powered by the Sinica Podcast Network. Pandaily.com is an English language site that tells you “everything about China’s innovation.” Our producers are Shaw Wan and Kaiser Kuo. Our interns are Wang Menglu and Mindy Xu! See you in two weeks!