PNC SRO QUARTERLY UPDATE 3RD QUARTER 2018 EDITION

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1 TREASURY MANAGEMENT PNC SRO QUARTERLY UPDATE 3RD QUARTER 2018 EDITION CHINA GDP GROWTH FY2015 FY2016 FY2017 1Q2018 2Q % 6.7% 6.9% 6.8% 6.7% RMB EXCHANGE RATE (USD/CNY) 1 End of 2015 End of 2016 End of Q2018 2Q FIGURE 1: MOBILE Figure 1: Mobile PAYMENT Payment Transaction TRANSACTION Amount AMOUNT China s China's Third-Party 3rd Mobile Payment Transaction Amount in Trillion RMB 100 HOT TOPICS FOREIGN EXCHANGE RESERVES (BILLIONS USD) Q2018 2Q2018 $3, $3, $3, $3, $3, WHAT RECENT CHANGES TO THIRD-PARTY MOBILE PAYMENTS IN CHINA MEAN FOR BUSINESS China s third-party mobile payments market has seen vibrant growth in the last few years and has transformed the way payments are made. Within the industry, Alipay and WeChat Pay have dominated the market, claiming 92% market share. 3 As Chinese consumers grow accustomed to these payment methods, there are growing implications for foreign companies looking to sell to them. For many, the payment methods are unfamiliar in their home countries. WeChat and Alipay have become indispensable in the consumer-tobusiness (C2B) and peer-to-peer (P2P) payments ecosystem in China, especially in urban areas e 2018e 2019e China's 3rd Party Mobile Payment China s Third-Party Mobile Payment... Source: iresearch, 2017 China 3rd Party Mobile Payment Report Source: iresearch, 2017 China s Third-Party Mobile Payment Report WeChat and Alipay have become indispensable in the consumer-to-business (C2B) and peer-to-peer (P2P) payments ecosystem in China, especially in urban areas. Their dominance in the mobile payments space can be attributed to their ease of use and integration into other aspects of consumers daily lives. In the case of Alipay, owned by the Alibaba Group, its integration with T-Mall, China s largest e-commerce platform, also owned by Alibaba, helps propels its usage. For WeChat Pay, owned by Tencent, its integration with WeChat, which is China s largest instant messaging and social network mobile application, helps increase its customer reach. While debit and credit cards are available in China, they are not as widely adopted as in other regions, such as the United States, Europe and even other parts of Asia. The reward programs that credit card issuers in China offer also are not significant enough for consumers to prefer using cards for their purchases. 1 China Foreign Exchange Trade System (CFETS); central parity exchange rate set by the PBOC 2 State Administration of Foreign Exchange: The time-series data of China s Foreign Exchange Reserves 3 iresearch, 2017 China s Third-Party Mobile Payment Report

2 PNC SRO QUARTERLY UPDATE 3RD QUARTER 2018 EDITION 2 For foreign companies selling to consumers in China, familiarity with the mobile payment channels is critical as urban consumers overwhelmingly prefer these methods. Therefore, building an effective local payments strategy that is well-integrated with the customer s sales experience is not only prudent, it is expected. While WeChat and Alipay are largely used for domestic transactions in China, they are also gaining ground outside of China, supporting cross-border transactions for Chinese tourists travelling abroad. In fact, despite the recent trade tension between the U.S. and China, Tencent is looking for opportunities in the U.S. market later this year. 4 Payment being made by scanning static QR code With the ability to make payments instantly through scanning Quick Response (QR) codes or through chat messages, WeChat Pay and Alipay have gained wide adoption and have quickly become the preferred method of payment for many. The ability to pay another individual instantly and make purchases at e-commerce sites, supermarkets, malls, taxi cabs, roadside stalls, restaurants, etc., are some examples of day-to-day usage. Embracing the digital wallet nature of Alipay/WeChat, many consumers have even ditched their wallets and carry little to no cash or card, and merchants at the point of sale ask customers if they would like to pay via WeChat or Alipay while they usually do not mention cash or card. Regulations have had to play catch-up with the rapid growth of the industry. Some early growing pains have included the lack of real-name verification on the mobile payment accounts, and lack of security on the static QR codes for C2B payments. Most recently, a new payment system was implemented to regulate the payments clearing for these transactions. REAL NAME VERIFICATION: During the initial rollout of WeChat Pay and Alipay, the user authentication requirement was not in place, leaving open the risk of money laundering and scams through these channels. The People s Bank of China (PBOC), in response, created stricter rules and regulations on user authentication. The regulations went into effect on July 1, Now that the rules are implemented, user authentication is required in order for WeChat and Alipay users to leverage the payments feature, and the users transaction limits are adjusted based on the level of information provided for authentication: Type I: One authentication method is used (typically linking to a bank card), and the payment limit is RMB 1,000 total. Type II: In-person ID verification or three external authentication methods, such as ID, bank card, water and electric bills, etc., are required and RMB 100,000 in transactions are allowed per year. Only purchases and P2P transfers are allowed, while wealth management products are not. Transfers to the user s own bank accounts do not apply towards the limit. Mobile payment being made at the point of sale 4 CNBC: Chinese tech giant Tencent plans to expand its US payments footprint despite ongoing trade war

3 PNC SRO QUARTERLY UPDATE 3RD QUARTER 2018 EDITION 3 Type III: In-person ID verification or five external authentication methods are required from the types listed above, allowing for an RMB 10,000 daily limit and RMB 200,000 in transactions per year. This type accommodates purchases and P2P transfers, as well as the purchase of wealth management products offered on a third-party platform. Transfers to the user s own bank accounts do not apply towards the limit. QR CODE SECURITY: QR code security at the point of sale was scrutinized recently by the PBOC due to the inherent lack of security of static QR codes. Many QR codes that merchants present to customers for payment would be home-printed on a piece of paper and displayed on a desk in public areas. Perpetrators would exploit them by replacing the QR code with their own and, instead of pulling up the merchant s payment account, the compromised QR code would point to a webpage with harmful content, such as a virus or Trojan horse, or pull up the perpetrator s account, causing payments to be routed to the perpetrator instead of the merchant. The risk mitigation levels are separated from A to D. Active QR codes are classified from Level A to Level C depending on the level of customer authentication available, and static QR codes are Level D regardless of authentication. The implication is that the less authentication required or if a static QR code is used for payment the more restrictions are placed on the amount that consumers can transact. For example, for Level A, defined as using at least two types of authentication methods with digital certificates or electronic signatures, there s no set limitation on transaction amounts. On the other end, for Level D, the daily transaction limit is RMB 500 for the consumer. Merchants that had relied on a static QR code at the point of sale may need to upgrade to dynamic QR codes through a payment terminal, especially for higher transaction amounts. CLEARING MODEL AND RESERVE FUND The most recent regulatory changes have a significant impact on how mobile payments are cleared, as well as on the profitability model for third-party payment companies such as Alipay and WeChat Pay. As of July 1, 2018, third-party payments that ultimately involve bank accounts, such as mobile payments, are required to be processed through the non-bank payment institution payments and clearing platform system called Nets Union Clearing Corporation (NUCC). NUCC is owned and operated by a consortium of companies, including entities backed by the Chinese central bank and third-party payment companies, including Alibaba and Tencent. Example of home-printed static QR code The PBOC released regulation on QR codes at the end of 2017, which was implemented in April The regulation limits the transaction amount depending on whether the payment is made using a static QR code that customers scan to make payments or an active QR code that changes periodically on the phone or payment terminal. One of the reasons for this change is anti-money laundering (AML) concerns. Prior to this change, the payments were cleared through a closed network within the third-party payment company s own network and ecosystem, into which the central bank did not have visibility. Centralizing the routing through a clearinghouse provides the visibility the central bank needs to monitor the transactions, including for AML purposes. This is a significant departure from the prior operating model, whereby each payment company set up their own banking relationships to facilitate the settlement of the funds ultimately due to the account holders banks. The new requirements essentially sever the ties between the payment companies and banks, moving the payments traffic onto the NUCC platform.

4 PNC SRO QUARTERLY UPDATE 3RD QUARTER 2018 EDITION 4 In addition to introducing the payment system, the PBOC requires that these payment companies deposit 100% of their prepayment reserve funds with a centralized custodian by January Prepayment reserve funds are payments from online shoppers held temporarily by payment companies prior to being paid to the merchants. The payment companies earn interest or investment income on the withheld funds. The reserve ratio was 20% when the policy was initially announced. It was raised to 50% as of April 2018, and it is being incrementally increased to the 100% target as January 2019 approaches. While it doesn t appear as a major change, investment income from prepayment reserve funds has been a significant revenue source for some third-party payment processors. Alipay and WeChat Pay are estimated to hold nearly 1 trillion yuan ($151 billion) of customers funds combined, about 90% of the total reserve funds, according to Caixin. 5 As a result, Financial Times 6 estimates that Alibaba and Tencent could stand to lose around $1 billion in revenue due to the new payment rules. What this means for companies While the recent changes will be mostly invisible for companies from an operational standpoint, they could lead to higher costs down the road for the following reasons: 1 While the payments clearing changes to the NUCC platform should have minimal impact to the end users experience, the clearing costs for transactions for payment companies may increase as the payment processors now have to connect to the centralized platform, increasing operational costs. Additionally, payment processors previously negotiated fee schedule with each bank for settling the funds from the payment processors to the customers actual bank account may no longer apply, creating a different cost structure for the payment companies that may eventually affect the cost of these services for merchants. In addition to introducing the payment system, the PBOC requires that these payment companies deposit 100% of their prepayment reserve funds with a centralized custodian by January The prepayment reserve fund requirement would impact the payment processors profitability model as it is one of the ways that these payment companies generate revenue. Without this source of income, they would need to look for other ways to make up the lost revenue, such as raising the service costs for merchants or introducing higher fees when settling the funds from within the digital wallet to the actual bank accounts. CONCLUSION For foreign companies looking to sell to consumers in China, understanding the market s payment practices and payment market changes is important when developing a company s payment strategy, especially when the payments experience is an integral part of the sales process. As the mobile payment industry as a whole continues to evolve and mature, you can expect more regulations that address certain gaps and issues in the future. CHINA S RECENT IMPORT POLICY CHANGES AND WHAT THEY MEAN With the trade imbalance being one of the contentious points between the U.S. administration and the Chinese government, China has been introducing policies to encourage imports, including from the United States. The reduction of import taxes on certain goods as well as plans for the first International Import Expo can be perceived as a way for China to address the trade imbalance. It can be argued that these policies go beyond solely addressing trade imbalances. Chinese consumers have shown interest in purchasing foreign goods, especially as the Chinese middle class gains wealth and sophistication in discerning their purchases. There is also the perception that foreign products in certain areas, such as infant, health supplements, cosmetics, etc., are of a higher quality than similar domestic products. However, many of these foreign products have had import duties assessed, a complaint shared by many foreign companies as the import duty makes their products comparatively more expensive and reduces sales. Not deterred, many Chinese consumers take overseas shopping trips to countries and regions where the cost of these foreign goods is comparatively cheaper than purchasing them within China. 5 Caixin: PBOC to Raise Reserve-Funds Ratio for Third-Party Payment Firms to 100% 6 FT: Tencent and Alipay set to lose $1bn in revenue from payment rules

5 PNC SRO QUARTERLY UPDATE 3RD QUARTER 2018 EDITION 5 China s first international import fair will be held in Shanghai To boost options for consumers, the Chinese government published a list in June 2018 containing a list of nearly 1,500 consumer products that would have their import tariffs reduced or removed to spur demand. 7 Some of the goods include apparel, cosmetics, home appliances and drugs. This is also in line with the pledge of opening up the economy. To further encourage imports, China s Commerce Minister Zhong Shan announced in November 2017 that the inaugural China International Import Exposition (CIIE) will take place in Shanghai between November 5 and 10 this year. As the first-ever import fair in China, it provides a platform for foreign companies looking to sell into the burgeoning and increasingly sophisticated Chinese consumer market. The reception for the CIIE appears to be positive thus far. The exhibition has already been overbooked by 20%. 120 countries are planning to participate as of March 2018, 8 and about 150,000 buyers are expected to visit the fair. 9 The CIIE therefore provides an opportunity for foreign companies to showcase their products and services for the Chinese market. 7 SCMP: China to halve import tariffs on 1,500 consumer products from July 1 8 SCMP: Why China is betting on Shanghai trade expo for global goodwill 9 SCMP: China s first global import fair signals shift to consumer-based growth China s push for imports comes during a critical time as trade tension creates uncertainty for companies doing businesses with both the United States and China. Some tariffs were already in place between the two countries as of July 6. While China has demonstrated willingness to encourage imports into the market to offset some of the concerns about trade imbalance, uncertainty will continue for some time. SROs CONTACT INFORMATION Grace Zhu Chief Representative grace.zhu@pnc.com Chris Chen Representative CertICM chris.chen@pnc.com Jenny Xu Deputy Representative jenny.xu@pnc.com READY TO HELP At PNC, we combine a wider range of financial resources with a deeper understanding of your business to help you achieve your goals. To learn more about how we can bring ideas, insight and solutions to you, please contact your Treasury Management Officer or visit. The information contained herein ( Information ) was produced by an employee of PNC Bank, National Association s ( PNC Bank ) foreign exchange and derivative products group. Such Information is not a research report nor is it intended to constitute a research report (as defined by applicable regulations). The Information is of general market, economic, and political conditions or statistical summaries of financial data and is not an analysis of the price or market for any product or transaction. This document and the Information it contains is intended for informational purposes only, and should not be construed as legal, accounting, tax, trading or other professional advice. You should consult with your own independent advisors before taking any action based on the Information. Under no circumstances should the Information be considered trading advice or a recommendation or solicitation to buy or sell any products or services or a commitment to enter into any transaction. The Information is gathered from sources PNC Bank believes to be reliable and accurate at the time of publication and are subject to change without notice. PNC Bank makes no representations or warranties regarding the Information s accuracy, timeliness, or completeness. All performance, returns, prices or rates are for illustrative purposes only. Markets do and will change. Actual results will vary, and may be adversely affected by exchange rates, interest rates, or other factors. PNC is a registered service mark of The PNC Financial Services Group, Inc. ( PNC ). Bank deposit and treasury management products and services are provided by PNC Bank, National Association ( PNC Bank ), a wholly-owned subsidiary of PNC and Member FDIC. PNC Bank s Shanghai Representative Office was approved by the China Banking Regulatory Commission on April 16, PNC s Shanghai office is prohibited from engaging in any form of operational business activities in compliance with the People s Republic of China on Administration of Foreign-funded Banks released by the State Council. Accordingly, PNC s Shanghai Representative Office does not accept deposits, underwrite loans or issue credit of any kind, or sell wealth management products in China. Any activities of these types in China using the PNC name or trademarks are not authorized by PNC The PNC Financial Services Group, Inc. All rights reserved. CIB TM PDF