A recent report on Chinese Banking by UBS analysts Irene Huang, Michelle Li and Stephen Andrews highlights the emergence of Money Market Funds (MMFs) in China and says these funds could usher in a wave of disintermediation in the Chinese banking industry within the next two years.

Money market funds: The digital challenge

In June this year, China’s biggest e-commerce company, Alibaba Group Ltd, announced that its third-party payment platform, Alipay, also the biggest in the country, would launch Yu E Bao, a dedicated fund management platform. Alipay provides payment solutions to 460,000 merchants and boasts 800 million registered accounts, which can now divert cash from their Alipay accounts into a Money Market Fund managed by Tianhong Asset Management Co.

According to the UBS analysts,  Tianhong Asset Management, which counts Alibaba Group, Tianjin Trust, and North Industries Group Finance amongst its stakeholders, has issued Rmb100B of Yu’E Bao Money Market Funds within five months.

Full disintermediation

This is a development that is similar to what happened in the US in the 1970s, the era of interest liberalization, but with a qualitative difference – online sales. Electronic transfer of funds to and from Money Market Funds in China would lead to a rapid transformation in the Chinese money market towards full disintermediation, in contrast to Wealth Market Products, that have achieved only partial disintermediation.

Money market funds could fuel rapid growth

As a result of their quality of being the investment vehicle of choice for short-term cash management for corporates, pension funds and individual funds, Money Market Funds will directly compete with banks for short-term flows and deposits. Investment and redemption is simple, NAV-based, and highly liquid compared to bank deposits. MMFs have grown rapidly during the last two years to about Rmb600B as of November 2013, but offer immense market growth.

1-mm-size Money Market Funds

1a-mmf-growth Money Market Funds

New competition will shave margins for banks

Banks will face erosion of margins because of the shift away from lucrative low-cost deposits to Money Market Funds.

“We expect fast growth in Money Market Funds to divert more customer deposits away from banks. As Table 1 shows, every 5% of total deposits diverted to MMFs leads to a 5bp NIM contraction,” say the UBS analysts.

2-nim-impact Money Market Funds

Drivers for rapid growth of MMFs

Regulatory relaxations, innovative product design, online transaction facility and the global trend towards disintermediation are the key long-term factors that would drive the rapid adoption and growth of Money Market Funds in China.

What should banks do?

“We believe interest rate liberalization will accelerate due to market forces. The solution for banks to compete with alternative investments includes enhancing risk-pricing, and further developing integrated platforms to drive distribution and cross-selling opportunities,” recommend UBS AG (NYSE:UBS).