Internet finance in China is taking off and deposits in online funds such as Alibaba’s Yu’e Bao are swelling. What are the risks that investors should watch out for?

Current and would-be investors in China’s tech sector titans are advised to take a closer look at the mechanics propelling the stellar growth of their online fund offerings.

Online funds like Yu’e Bao (Chinese for leftover treasure), launched by e-commerce giant Alibaba, have been hailed as pioneers of financial innovation. They have ushered in a form of backdoor interest-rate liberalization that offers casual investors access to the kind of returns previously only available via investments in trust products and other forms of loan financing offered by traditional banks.

However, as Alibaba gears up for its landmark initial public offering (IPO) in New York, regulatory clouds are gathering on the horizon, amid concerns regarding the impact funds like Yu’e Bao are having on the wider banking system.

In the nine months since its launch last summer, Yu’e Bao has swelled to more than RMB 500 billion ($81 billion) across some 81 million account holders, effectively outstripping the number of active equity trading accounts in the whole country, and elevating Yu’e Bao to the position of the fourth-largest money market fund worldwide, according to a recent Financial Times report.

Hong Kong-listed Tencent, Alibaba’s rival in everything from third-party payments to mobile apps, has its own offering in Li Cai Tong, which while significantly smaller than Yu’e Bao, still pulled in RMB 10 billion in less than a week of its January launch, and has been growing strongly ever since. Baidu has also launched its own offering known as Baifa.

Depositors have been attracted to Yu’e Bao because of the ease with which they can transfer money from their Alipay accounts, often linked to their activities on the online sales platform Taobao, and to Li Cai Tong via swift transfers made through the WeChat social messaging service’s Tenpay facilities. Both enable fund transfers with the click of a smartphone button, and holdings can be redeemed daily.

Moreover, with the interest on demand deposits in traditional banks capped at 0.35%, Yu’e Bao’s annual return of 5.59% is markedly more appealing, especially when it is assumed to be risk-free.

The lack of a minimum balance requirement and the ease of access of online funds like Yu’e Bao are attracting non-typical Chinese investors, who often have less cash to spare than those who would traditionally invest in the kind of wealth management products (WMP) offered by traditional banks. “Yu’e Bao is easy and simple, and people have trust in Ma Yun [Jack Ma, CEO, Alibaba] and Alibaba,” says Zhang Ziting, a business manager at the European Chamber of Commerce in Beijing. “People just aren’t thinking too much about the risk yet.”

“I would say that most investors in Yu’e Bao are not blue collar workers but are people like me and my mum,” she adds. “We use Taobao frequently and have knowledge of online banking. Investment opportunities in China are either too few or too expensive, and they are always complicated, but this is simple.”

The funds in Yu’e Bao are overseen by Tianhong Asset Management and invested in a fund known as the Zenglibao Money Market Fund, the custodian of which is CITIC Bank. In a recent interview with Caixin magazine, the fund’s manager, Wang Dengfeng, explained that the funds are invested primarily in the interbank market, across a suite of 29 banks, as well as a “safe” selection of state and corporate bonds.

“Most WMP sold by banks these days are non-guaranteed, while the Yu’e Bao product is guaranteed,” says Sara Hsu, an expert on China’s shadow banking sector and an Assistant Professor of Economics at the State University of New York at New Paltz. “The instruments are far safer than some that are sold through banks, which may have a stake in non-standard credit assets like trust loans. The risk of investing in Yu’e Bao is lower therefore than that attached to standard WMPs.”

Logically, the ultimate guarantor of the funds is Alibaba Group, via the controlling stake it holds in Tianhong Asset Management, but the lack of regulation in the sector has allowed the fund to operate in a regulatory grey area without a formal guarantee.

“Alibaba hasn’t put a formal guarantee—there’s no official guarantee—but there is an implicit guarantee,” says Jason Bedford, independent China shadow banking expert and a former senior manager with KPMG. “The funds that Alibaba has raised are pretty close to its value [$81 billion versus estimated market valuation of about $128 billion]—you can pretty much guarantee that if they had to pay out, they couldn’t do it.

“Of course, that’s not going to happen but at the rate that they are growing eventually you don’t need a lot to go wrong for this company to go bad. There is a regulatory risk—all you have to have is a poorly worded statement by the China Securities Regulatory Commission or the China Banking Regulatory Commission to spook investors.”

Mark Williams, Chief Asia Economist at Capital Economics, agrees that there is no guarantee on the funds, but adds that as there is no deposit insurance scheme in China, they effectively face the same risk of default as regular bank deposits.

“There is an issue over liquidity—what if falling interbank rates caused a large number of depositors to run for the door? But I think this risk is easily overdone,” he says. “Most funds are invested in one-month products, so redemption pressures should be manageable in all but extreme circumstances.”

It’s a possibility that Zhang has considered as well. “I reckon that if the interest rate drops to around 4%, a lot of people will take [their] money out. What will happen then? I have no idea,” she says.

However, while the scenario of a race to exits amid falling rates may be unlikely, the wider issue of how the online funds impact the banking system should be of immediate concern.

“Clearly this is already a form of interest rate liberalization, and what’s happening is that it is contributing towards the cost of funding for financial institutions,” says Jonathan Cornish, Fitch Rating’s Managing Director in Hong Kong. “Whether that be their deposit taking activities, interbank funding–across the whole spectrum we see an increase in funding costs as a result of a squeeze in margins and lower profitability overall, at a time when the banks if anything should be increasing their return on capital generation because of the very high leverage in the banking system.”

The kind of yields on offer from the online funds, with Li Cai Tong at last count offering an indicative return of 8.3%, suggests that the four companies overseeing the fund, which include China Asset Management Co. and GF Fund Management Co., are lending to the kind of smaller financial institutions that pay higher rates on interbank exposures.

“With regard to traditional deposits that’s not so much the case because the deposit rates are regulated but for interbank funding which is more market orientated it is the smaller banks [that] have been paying more–and it’s them who are more exposed to the use of interbank funding and to the issue of WMP in order to secure funding, which therefore makes them more vulnerable to dislocation in those markets,” Cornish says.

Cornish contends that while there is virtually no risk of these loans not being repaid eventually, there is a higher likelihood of instances where they may not be paid on time. “Clearly it’s instances like that that have the ability then to affect liquidity at one or multiple institutions,” he says.

“That’s where we get down to WMP, which are often transacted within a month, outside normal reporting rates where loan deposit ratios are disclosed, and it comes down to common cash flow, and if you have sufficient funds to meet your obligations. In the past we’ve seen that some banks haven’t had those funds with which to repay their obligations and there have been delays, but not necessarily payment not being made entirely.”

Bedford also cautions that by effectively drying out demand for longer tenure term deposits and then relending these back to banks at higher rates, the online funds risk coming into conflict with the banks. “That increases the loan deposit ratio pressure [on banks] as they are effectively losing deposits and having to rely on what are potentially much shorter term, very fungible interbank deposits,” he said.

Major banks have already reacted to the intrusion by raising one-year deposit rates to the maximum allowable level of 3.3%, but these still significantly lag those offered by the most popular online products.

There are also indications that this discontent and consequent behind-the-scenes lobbying of banks, as well as the payments company China UnionPay, now pose a significant regulatory risk to the rise of the online funds, and of the wider third-party payments market.

On March 14, People’s Bank of China (PBOC), the central bank, suspended virtual credit cards issued by both Alibaba and Tencent, as well as payments made by swiping QR codes with smartphones, citing the potential security risks to users’ financial and personal information. The credit cards were to have allowed users to buy goods online via Alipay and Tenpay, while QR codes are widely used to redeem discounts and promotions, as well as make direct payments.

The PBOC move caused a sharp fall in Tencent’s stock price as investors digested the implications of such regulatory intervention, which few had expected given previous statements that indicated the central bank largely endorsed the kind of financial innovations being pushed by the online firms.

“I think [the PBOC decision] was a wise move for a government that wants to control its financial sector,” says Sara Hsu. “Allowing the issuance of virtual credit cards would essentially extend the lending base, possibly by a very large amount. Granted Alibaba and Tencent have some Big Data to use as a foundation for judging customer creditworthiness, but it is still incomplete… and without person-to-person payment verification there is great deal of room for fraud. You put the two together—potentially large credit expansion, some of which may be fraudulent, and you have a recipe for disaster unless measures are taken to strictly regulate this business.”

The central bank is also reported to be considering strict restrictions on third-party payment transaction volumes, which would have a devastating impact across online funds, as well as online shopping and payments.

A draft circulated to various Chinese media outlets indicates the PBOC has asked for feedback on suggestions for a limit of RMB 1,000 per transfer, caps on monthly payments of as low as RMB 5,000, and RMB 10,000 for annual aggregate cash transfers.

If enacted, the draconian draft measures will effectively stymie growth of Yu’e Bao, Li Cai Tong and their ilk. However, investors might want to ask if PBOC regulation would actually be a necessary and welcome block on the growth of the online funds specifically, even as the consequences for wider third-party payment transactions are obviously serious given how integral they are to Alibaba’s business model in particular. Third-party mobile payments in 2013 increased 707% on the year to RMB 1.22 trillion, with Alipay handling the bulk of those transactions, according to data from consultancy iResearch.

Whichever way the axe falls as regards regulation, and there is still wiggle room for the tech firms to push back against the PBOC, the situation highlights the desperate need for some form of deposit insurance scheme in China. During the National People’s Congress in Beijing earlier this month, Premier Li Keqiang pledged that the introduction of bank deposit insurance would be one of the major financial reform tasks of 2014, but this has been on the agenda for at least a decade, and so far there has been little in the way of concrete policy.

“The system desperately needs deposit insurance so those who are not insured will not be perceived as being risk-free,” says Anne Stevenson-Yang, Co-Founder and Research Director of J Capital Research in Beijing. “What the government has to do is figure out what’s guaranteed and what’s not guaranteed, and deposit insurance is the critical move in making that assessment. You can’t really have a special set of rules for online platforms [and these also include riskier peer-to-peer lending platforms], otherwise the money will just migrate to small loans, private equity, venture capital or something else. You need to say clearly—this type of institution has guarantees and this type does not, so if you want to make loans through this type go right ahead but you might lose your money.”

Also at play is the speed with which the authorities pursue interest rate liberalization, something that central bank governor Zhou Xiaochuan said at a recent press conference would happen within “one or two years”.

“I think it will happen faster than that,” says Bedford. “The whole fact that you can have a disintermediation of deposits from the banks so rapidly to Alibaba and Tencent is a sign of the market demanding better uses of their money. The banks are pushing back against it for obvious reasons, but the economic pull on China is tremendous–and banks continue to lend to state sectors because they have no pressure whatsoever to come out with a risk-efficient outcome.”

How the government negotiates its way around tasks that it has shied away from addressing for so long is now crucial to the viability of the business models created by Yu’e Bao, Li Cai Tong and their rivals, and should be high on the list of existing and potential investors in both their parent firms.