The Middle and Back-Office Services Supporting
Rapid Growth in China's Mutual Fund Market
Eiichi Sekine

I.

Introduction

China's mutual fund market is growing rapidly1. China established rules regarding
mutual funds targeting securities investments in 19972, the year that the establishment
and sale of such funds really began. Rules for open-end mutual funds were set in 2000,
and the first such fund was established in 2001. Since then, the rapid growth inChina's market has been driven primarily by open-end mutual funds. China's mutualfund market at the end of 2007 totaled Rmb3.2831 trillion in net assets, of which
Rmb236.5 billion was in closed-end funds and Rmb3.0466 billion in open-end funds(including Rmb108.4 billion in QDII funds3).Year-on-year growth in assets to end2007 was 280%, versus only 80% to end-2006. Although a large reason for the growthin net assets was rising share prices, the SSE Composite Index only increased 97%
that year, and thus much of the growth was from the inflow of funds. Another obvious
factor is the growth in the number of mutual fund accounts, which went from 1.47
million accounts at end-2005 to 3.72 million at end-2006, and then increased by afactor of 7x to 26 million accounts during 2007. This is rapid growth, even whencompared against the annual 50% increase in the number of stock trading accounts in2007 (Figure 2)4.

1

2
3
4

For more on China's asset management industry, see Takeshi Inoue and Eiichi Sekine,
Chugoku no Nenkin Seido to Shisan Un'you Gyoukai (China's pension system and asset
management industry), Zaikai Kansoku, Fall 2006 (in Japanese). For more on China's
mutual fund industry, see Nomura Institute of Capital Markets Research, editors, Chugoku
Shouken Shijou Taizen (All about the Chinese securities market), Nihon Keizai Shimbun
Shuppansha, 2007 (in Japanese).
China established and distributed its first mutual fund in 1991.
QDII stands for Qualified Domestic Institutional Investors, and is normally pronounced"cue-dee."
The results of an investor survey on mutual funds, taken by the Securities Association ofChina, provide evidence that mutual funds are becoming more common among people intheir 30s and among low-income groups.

The Middle and Back-Office Services Supporting Rapid Growth in China's Mutual Fund Market 55

Figure 1: Mutual fund net assets(Rmb billions)
3,500
3,000

Closed-end

2,500

Open-end

2,000
1,500
1,000
500
0
1998

Note:
Source:

99

00

01

02

03

04

05

06

07
(Year)Net assets also include qualified domestic institutional investors (QDII)
Nomura Institute of Capital Markets Research, based on data from CSRC andWind Information

Figure 2: Number of securities accounts in recent years(Unites: 1000)

120,000
100,000
80,000

A shares60,000

B sharesMutual funds

40,00020,0000

Source:

2002

2003

2004

2005

2006

2007

Nomura Institute of Capital Markets Research, based on data from CSDCC

The infrastructure supporting this rapid growth in the mutual fund industry consistsof middle and back-office services and systems related to mutual fund establishment,
distribution, redemption, investing and reporting, the most important of which arefund accounting systems and their supporting transfer agent (TA) systems. Fund
accounting consists of ensuring that the daily reconciliation with NAV5, the creationof legally required ledgers, results processing, and the creation of documents forexternal reporting are all done accurately and error-free. These services result in an
exchange of information among the fund management firm, distributors (securities
5

NAV indicates the market price of mutual fund shares, and stands for net asset value,
which is net assets divided by the number of shares. NAV is the basis upon which mutualfund shares are bought and redeemed, and thus calculated and announced every
business day.

56

Nomura Capital Market Review Vol.11 No.2

houses and banks), stock exchanges, clearing and settlement institutions, andcustodian. Although the accurate and consistent performance of these services may betaken for granted, if a mistake does occur, it could cause market participants to lose
confidence in the market, and thus the importance of these services cannot be
overemphasized.
In this paper, we examine the overall framework and specifics of the middle andback-office services that support the rapid growth of China's mutual fund market6.

II. Middle and back-office services in China's mutual fundindustry
1. Workflow until NAV calculation and announcement
We start by looking at the workflow from the perspective of middle and backoffice services at the fund management firm, specifically those fund accounting tasks
related to NAV calculations. NAV calculation is performed at the end of every trading
day, and requires regular communication, coordination, and reconciliation with certain
internal divisions as well as with the custodian and other outside institutions. It also
requires the delivery of news releases and other dispatches to the newspapers andother media. For mutual funds that invest in stocks and bonds listed on China's stock
exchanges, the NAV calculations and reconciliations that form the basis of fundaccounting are as follows (Figure 3)7.
Figure 3: Work flow for NAV calculations by fund management firms
NAV calculation
Advertising(3 major newspapers,
Internet) (6)(T+1 09:00)

(1)
Order

(2)
Order

Fund
management
firm
Reconcile (5)Stockexchange

BrokerConfirmation(3)

Confirmation(3)

Confirmation(3)(T+0 after 15:00)
Confirmation (3)Custodian
NAV calculation

Source:6

7

CSDCC
Settlement data(4) (T+0 15:00)

Nomura Institute of Capital Markets Research, based on interviews in China

Based on interviews of fund management firms, custodians, and system providers taken
in Shanghai in May 2007 by Masahiko Igata (Managing Director, Research), Takeshi
Inoue (now Senior Analyst, London), and Eiichi Sekine.
The middle and back-office organizations are different for each fund management firm.
One firm interviewed, which has established and distributed 11 mutual funds with net
assets totaling Rmb40 billion, had assigned 45 (one third) of its 160 employees to middle
and back-office services. This included six to seven employees assigned to calculating
NAV, with each employee responsible for two to three funds. The nearly 40 other middle
and back-office employees were responsible for fund registration (purchases and sales),auditing, risk management, IT, and human resources.

The Middle and Back-Office Services Supporting Rapid Growth in China's Mutual Fund Market 57

1) Day of trade (T+0)
On the day that the mutual fund shares are traded (T+0), the fund management firm
submits a trading order to the broker (1).
The broker submits said order to the stock exchange (2), and the stock exchange
sends a trade confirmation to the broker, custodian, and CSDCC8 (3).
CSDCC sends settlement data to the custodian at 15:00, when the market closes (4).
After all trading has ended, the fund management firm and custodian eachcalculate NAV and then compare numbers (5)9. They also exchange and compare dataon fund purchases and redemptions.

2) Trading day plus one (T+1)
All fund management firms report NAV by the start of trading at 09:00 (6) through
China's big three securities dailies (China Securities Journal, Shanghai Securities
News, and Securities Times) as well as on their own Websites.

3) Supplementary tasks to main work flow
One fund management firm we interviewed said that reconciliation tasks on the
day of trade were completed on average around 19:00. Another fund management
firm said in an interview that, assuming no problems in the systems (explained later)used by the fund management firm and custodian, both the fund management firm andcustodian receive the same final data from the stock exchange, and assuming that datacontains no errors, their NAV calculations should match up, as a rule. If there aredifferences or errors in the NAV between the fund management firm and the custodian,
the only option is to review each trade, one by one, and fix the error on the day of
trade.
Notices for T+1 can practically speaking be confirmed on the fund management
firm's website as early as the day of trade. The newspapers also publish theinformation on their websites in addition to their print editions, and because even theprint editions are delivered early in the morning, investors can confirm thisinformation before trading begins on T+1.

8
9

China Securities Depository and Clearing Corporation Ltd., an integrated provider ofregistration, safekeeping, and settlement of securities transactions.
This reconciliation is usually done by phone or fax, rather than electronically, owing toincompatibilities at the system level.

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Nomura Capital Market Review Vol.11 No.2

2. No room to outsource the calculation and reporting tasks
1) Calculation and performance reporting
The calculation of NAV, notices to the major newspapers, and periodic reports to
the China Securities Regulatory Commission (CSRC) are all tasks handled in-houseby the fund management firm, because there is no room to outsource even a portion ofthese tasks, nor is there any leeway for pre-coordination with the custodian.

2) Compliance reporting
Both the fund management firm and custodian must submit periodic compliancereports to the CSRC. This is done without outsourcing; both compile their own reports
and submit them independently to the CSRC.
The chief compliance officer named by the fund management firm must report to
the CSRC the investment status of each of its funds as well such company-wide issues
as changes in shareholder composition, changes in the management team, and whether
investors are given any profit guarantees. Practically, this is handled by an auditing
department that reports to the compliance officer and is independent from the rest of
the company. The custodian, meanwhile, checks on whether each fund is being
invested according to its prospectus, and must report this to the CRSC10.

III. Systems for middle and back-office tasks
1. System for calculating NAV a near monopoly
1) Handling NAV calculations with a standardized system
The presence of outside vendors that can provide advanced systems, whether for
NAV calculations or TA, is an important factor behind the rapid growth of China's
mutual fund market. The systems used in China's mutual fund industry must be
inspected by the CSRC ahead of time. This is true not only of systems developed inhouse, but also of systems developed by outside vendors and sold to fundmanagement firms. These prior CSRC inspections ensure that the specifications ofsaid systems reflect the thinking and rules established by the authorities. Use of astandardized system makes it possible for a newly established fund management firm
to enter the mutual fund business without having to develop its own system fromscratch.
The middle and back-office systems handling NAV calculations are usuallypurchased from outside vendors, and are typically standardized systems that havealready been inspected by the CSRC. Ysstech 11 is a designer and seller of NAV
10

11

Based on on-site interviews, we learned that compliance reports from custodians haveuncovered cases in which mutual fund distributors have offered discounted commissions
to important customers.
For an overview of the company, see its website (http://www.ysstech.com).

The Middle and Back-Office Services Supporting Rapid Growth in China's Mutual Fund Market 59

calculation systems with over a 90% share of both the fund management firm andcustodian markets.

2) NAV calculation systems from Ysstech
Ysstech is a China-based vendor established in Shenzhen in 1998 and comprised
primarily of systems engineers with experience writing financial accounting software.
When we interviewed the company at its offices in May 2007, it had 100 employees,
approximately 80 of which were systems engineers involved in development.
The Golden Finger financial asset management system developed and sold byYsstech comprises two modules: (1) a financial accounting module (for accounting
reports and data consolidation) and (2) an asset calculation module (NAV calculation).
The financial accounting module handles voucher management, accounting registers,
classification registers, accounting reports (financial reporting), and balance sheets.12
The asset calculation module handles the setup of specific names bought by themutual fund, as well as data import, automated entries, and manual input13.
The two modules are developed specifically for each fund, including closed-end
funds, open-end funds (stocks, bonds, and indices), hybrid funds, and money market
funds. The system is also developed to work with trust investments through the basic
pension system and corporate pensions14.
The fee schedule differs depending on the model and the product. Implementing asystem for a non-ETF, regular mutual fund (with 3 to 4 names) costs roughly several
million yen, and the system can be in operation within a week. Ysstech also provides
training for financial institutions that implement its systems.

2. Compatible TA systems
1) Hundsun Technologies' TA System
The transfer agent (TA) system that fund management firms use to manage
accounts is either (1) purchased from an outside vendor, (2) developed by outside
vendors under contract, or (3) developed in-house.
The TA system most commonly purchased from an outside vendor is that fromHundsun Technologies15. Of the fund management firms with open-end mutual funds,
over 70% (42 firms) use Hundsun's TA system. Established as a domestic vendor in
12

13
14
15

60

The underlying ledgers for accounting reports can now be prepared to enable electronic
reporting, pursuant to the Ministry of Finance's Measures Governing Financial Accounting
at Securities Investment Trust Funds. The ledgers can also be freely customized andsubject to data searches, and because they are based on Excel spreadsheets, caninclude functions.
Data from the stock exchanges can now be received automatically. Some bondtransactions on the interbank bond market must be entered manually.
Private placements are not included among the products being developed. Version 4 of its
QDII asset management software was released in October 2007.
For an overview of the company, see its website (http://www.hundsun.com).

Nomura Capital Market Review Vol.11 No.2

1995, Hundsun began developing software for fund management firms in October
1998, the same year it listed its shares on the Shanghai Securities Exchange. Of its
1000 employees, 135 are systems engineers working on the development of software
for fund management firms 16 . Hundsun began R&D on TA systems in 2001,
established offices in both China and the US, and has been gaining market share since2004. It has also lent its employees to work with foreign-capitalized fund management
firms starting operations in China, gaining expertise in the process.
Although Hundsun also sells NAV calculation systems, Ysstech entered thatsegment earlier and captured the bulk of the market. Consequently, in the market for
middle and back-office services offered to fund management firms, Hundsun is thedominant player for TA systems used until trading ends at 15:00, while Ysstech's
systems dominate the market for the NAV calculation that commences at 15:00. The
cost for installing Hundsun's TA system is approximately ¥20 million, andimplementation has been completed in as short a time as one month.

2) CSDCC's TA system currently offers few advantages
Some fund management firms that choose to purchase from an outside vendor have
opted for CSDCC's TA system. CSDCC, a 50/50 joint venture between the Shanghai
and Shenzhen stock exchanges, was established in March 2001 to increase theefficiency of clearance and settlement. It has built an integrated securities settlement
system that provides for the registration of China's listed stocks and the clearance andsettlement of trades. The advantages of using CSDCC's TA system are its standardized
specifications, the ability of mutual fund distributors (banks and securities firms) towork directly with data without going through the fund management firm, and adecreased work load on the fund management firm. The Shanghai Stock Exchange
implemented a sales platform using CSDCC's TA system in 2006, and has beenencouraging others to use that system.
Disadvantages of the CSDCC's TA system include (1) an increase in costs as thenumber of funds increases, because fees combine a fixed fee with a variable fee basedon the number of funds and (2) the development and adaptation of the system to newfunds is slow. After weighing these positives and negatives, fund management firms
are apparently concluding that it is better, from the perspectives of both cost andflexibility, to use TA systems offered by an outside vendor. Foreign-capitalized fundmanagement firms initially followed the government's recommendation andimplemented the CSDCC's TA system, but it appears that they have begun to use otherTA systems, owing to the inflexibility of the CSDCC system once the number offunds reaches three to four.

16

As of April 2007. Hundsun Technologies develops systems not only for fund management
firms but also for banks, insurance companies, and securities houses. It also appears thatHundsun has partnered with Nomura Research Institute and signed deals to develop
systems for Japanese securities firms.

The Middle and Back-Office Services Supporting Rapid Growth in China's Mutual Fund Market 61

The CSDCC apparently has set a goal of integrating TA systems over the next fiveto ten years17. Nevertheless, for CSDCC's TA system to become the de facto standard
in the mutual fund market, it will have to compete against Hundsun and other privatesector vendors, and must also address the issues identified by the fund management
firms, including adapting more quickly to new funds.

IV. Future challenges
1. A shortage of skilled personnel in middle and back-office services
China's mutual fund industry has standardized the work flow of middle and backoffice services and implemented systems to support those services. We expect this tofacilitate rapid market growth over the near term and the entry of foreign capitalized
firms into the market. Although the systems continue to progress, it appears that the
supply of people capable of performing these middle and back-office services has notbeen keeping up with growth in the market.
As noted earlier, China's first mutual fund was formally introduced in 1997, andmost of the funds launched during this initial period were closed-end funds, for which
the NAV was nothing more than a reference value, and thus calculated only once a
week. Because of this, the need for middle and back-office capabilities was not that
great.
In 2000, the CSRC established rules governing open-end mutual funds, and the
middle and back-office service environment changed once the establishment and saleof those funds started to take off in 2001. Specifically, errors in NAV calculations
could no longer be tolerated, and if there were any errors, it created liability fordamages, while also harming the brand of the company responsible. This explains
why middle and back-office service capabilities are now required to be much higher
than they used to be. In addition, China's capital markets have undergone
unprecedented changes recently, including the reform of nontradable shares 18 andmergers & acquisitions, both purely domestic as well as between domestic and foreign
firms. This has further raised the bar for mutual fund middle and back-office services.
Middle and back-office services do not consist simply of automated calculations of
NAV. They require experienced, senior employees with a strong understanding of, andinterest in, accounting standards, as well as a sharp eye for details, who can quietly
get the job done. We confirmed in our interviews, however, that finding such

17
18

62

CSDCC's TA system must be used for ETFs and LOFs listed on stock exchanges.
This is aimed at reforming the bifurcation of China's stock market into tradable andnontradable shares. Apparently there sometimes exist differences in opinion between
fund management firms and custodians in regards to NAV calculations that include theshares of companies that have reformed their nontradable shares.

Nomura Capital Market Review Vol.11 No.2

individuals was very difficult, and that headhunting from other firms was quite
common19.

2. Accommodating the opening of China's capital markets
Currently, the work flow is fairly simple because China's mutual funds only invest
in the domestic market, but as they increasingly invest overseas as a result of the
Qualified Domestic Institutional Investors (QDII) program and other factors, we
expect back office services to become more complex. This growth in overseas
investments will also necessitate greater interaction with overseas brokers, stock
exchanges, and settlement institutions, and we expect this to put further stress on
systems in terms of compatibility. Because of differences in the settlement cycle 20
between China and overseas markets, and owing also to the difficulty of directly
linking systems, overseas investments may require manual input for settlement.
People with experience in overseas markets will become important to China's
mutual fund industry, but because of the many years that overseas capital markets
have been closed to China's investors, finding such people will probably be achallenge.21

19

20
21

A common theme that has come up in our interviews in China is that the cost of middle
and back-office services has increased substantially as a result of the need to keep up
with the rapid growth, and relentless introduction of new products, in China's still-young
mutual fund industry. One fund management firm that we interviewed also noted that itwas constantly reassigning its personnel that although the total number of employees was
declining it was working to increase the number of front-office employees, and that
although it was difficult to rank its positions in terms of priority, if it were pressed to do so
the priority would first be on fund managers, researchers, and sales personnel, after
which would come personnel for middle and back-office services.
The settlement cycle in China is T+1 for A shares, mutual funds, government bonds, andcorporate bonds, which is faster than in the leading economies.
For more on QDII, see Eiichi Sekine, China's Offshore Investment Boom -- QDII for fundmanagement firms, Capital Market Review, Spring 2008.

The Middle and Back-Office Services Supporting Rapid Growth in China's Mutual Fund Market 63