Capital Markets Welcome Major Reform: What's Behind the Launch of the STAR Market? | Source Code Capital Policy Research

Source Code Capital Policy Research

By: Source Code Capital Policy Research Team

The announcement that the Shanghai Stock Exchange will establish the STAR Market and pilot a registration-based IPO system quickly became the focal point of capital market attention.

On November 5, China's top leadership announced at the inaugural China International Import Expo that the STAR Market would be established at the Shanghai Stock Exchange (hereinafter referred to as "SSE") with a pilot registration-based system, supporting Shanghai's construction as an international financial center and a hub for scientific and technological innovation, while continuously improving the fundamental institutions of the capital market. Just four hours later, the China Securities Regulatory Commission (CSRC), the Ministry of Finance, and the SSE issued official statements in succession, proposing a series of measures.

The fact that the STAR Market was proposed by the central leadership obviously signals that it is being positioned at the highest level of capital market top-level design. The timing of this announcement — following the recent sharp decline in A-shares, Donald Trump's announcement of willingness to expand exports to China, and the conclusion of the private enterprise symposium — carries considerable significance. Its symbolic meaning outweighs the establishment of the STAR Market itself, with deeper political implications. It provides important support for strengthening market functions and boosting market confidence, and helps improve the international perception of China.

It should be noted that the STAR Market will be the first to pilot the registration-based system. This means that fundamental systems related to the registration-based system, including issuance and underwriting, will also be revised. The registration-based system accompanying the STAR Market carries market expectations of greater support for "four new" (new technology, new products, new business models, new models) companies to go public. However, the pilot of the registration-based system does not mean lowering thresholds, nor does it mean a massive concentration of companies going public. Regulatory authorities will control the pace and intensity of the pilot based on market conditions and capacity.

In its response to media questions, the CSRC emphasized that the pilot of the registration-based system has strict standards and procedures, with greater emphasis on the truthfulness and comprehensiveness of information disclosure, on the quality of listed companies, on stimulating market vitality, and on protecting investor rights and interests at every stage from acceptance, review, registration, issuance to trading.

The STAR Market is part of a package of reforms to China's multi-tiered capital market. Although many policy details have not yet been finalized, and specific market positioning and listing standards have not been further announced, we attempt a preliminary analysis and inference of STAR Market-related issues based on the background of its establishment, regulatory statements, and the historical development patterns and regulatory philosophy of China's capital market, to explore the underlying messages.

1 What is the STAR Market?

The term "STAR Market" is not unfamiliar to the market.

In December 2015, the Shanghai Equity托管 and Exchange Center launched a "Technology Innovation Board," officially called the "Technology Innovation Enterprise Share Transfer System." Its original purpose was to support the development of "four new" enterprises, and it was a relatively small OTC market with limited liquidity. Currently, about 200 companies are listed there.

This new STAR Market differs from the previous concept. This time, it refers to opening a STAR Market at the SSE, which was proposed for the first time. On November 5, the SSE stated that the STAR Market is a new board independent of the existing main board market, and that the registration-based system will be piloted on this board.

The key phrase here is "new board," not "new market" or "new product."

This means the STAR Market should fall within the broad category of the stock market, implementing basic systems such as public issuance and continuous trading, fundamentally different from the National Equities Exchange and Quotations (commonly known as "NEEQ" or "New Third Board") and various regional equity exchange centers (commonly known as "Fourth Board").

Market expectations for an innovation enterprise listing venue have existed for some time. On December 23, 2015, the State Council Executive Meeting determined to establish the Strategic Emerging Industries Board at the SSE to improve the efficiency of financial services for the real economy. On March 30, 2018, the General Office of the State Council forwarded the CSRC's "Notice on Several Opinions on Carrying Out the Pilot of Domestic Issuance of Shares or Depositary Receipts by Innovative Enterprises" (hereinafter referred to as the "Notice"), which already mentioned "supporting innovative enterprises to issue securities and list in domestic capital markets, assisting in the development and upgrading of China's high-tech industries and strategic emerging industries, and promoting quality transformation of economic development."

The listing of innovative enterprises was already proceeding according to schedule, but was halted due to significant changes in securities market conditions and other factors. This proposal, elevated to opening a new board at the SSE, also represents the high-level leadership's significant concern for the listing of high-quality innovative enterprises, and is essentially an "institutional welcome back" for new economy enterprises to the domestic capital market.

2 Why launch the STAR Market?

In recent years, exploration of how to improve the capital market's ability to serve innovative enterprises has never stopped. From the 2015 proposal of the Strategic Emerging Industries Board concept, which aimed to establish a specialized board to support startup financing, to the trial of Chinese Depositary Receipts (CDRs) to support innovative enterprises that meet national strategic needs, possess core technologies, and enjoy high market recognition to list domestically, regulatory authorities have attempted to increase A-shares' support for technology innovation enterprises through multiple institutional reforms. However, due to market performance and economic restructuring factors, the progress has been less than satisfactory.

On one hand, capital market institutional reforms have been unable to meet the actual needs of innovation-driven and high-quality development. On the other hand, technology innovation enterprises have frequently chosen to list in Hong Kong, the United States, and elsewhere. The urgency of reform is obvious: to retain good enterprises and innovative enterprises, and to enhance the capital market's financing capacity, bold reforms must be advanced on the basis of ensuring stable market operation. Thus, the STAR Market emerged.

The CSRC stated that the CSRC Party Committee deeply recognizes that establishing the STAR Market at the SSE is a major reform measure to implement the innovation-driven and science and technology powerhouse strategies, promote high-quality development, and support Shanghai's construction as an international financial center and a hub for scientific and technological innovation. It is also an important arrangement to improve fundamental capital market institutions, stimulate market vitality, and protect the legitimate rights and interests of investors.

The SSE stated that establishing the STAR Market and piloting the registration-based system is a major capital market reform measure to enhance the ability to serve technology innovation enterprises, increase market inclusiveness, and strengthen market functions. Through new systems for issuance, trading, delisting, investor suitability, and securities company capital constraints, as well as supporting measures such as introducing medium- and long-term funds, incremental pilots will proceed gradually, with new capital matching the progress of the pilot. The goal is to achieve a balance between investment and financing, between primary and secondary markets, and between the interests of new and existing shareholders in the STAR Market, while promoting positive expectations in the existing market.

The SSE has been preparing the idea of establishing a STAR Market for several years, from attempting unicorn CDRs, the Strategic Emerging Industries Board, and the International Board to the current STAR Market, mainly to support the listing of some technology innovation enterprises. Some voices suggest that the "STAR Market" concept proposed today is basically consistent with the Strategic Emerging Industries Board and represents a revival of previously shelved proposals. Some industry insiders point out that the STAR Market may be "Strategic Emerging Industries Board 2.0," possibly representing an upgraded version of the "Strategic Emerging Industries Board" proposed by the State Council in 2015.

It can be expected that the SSE's establishment of the STAR Market and pilot of the registration-based system serves two purposes: first, to support the development of emerging industries; second, to make the pace and pricing of new share issuance more market-oriented, adapting to the needs of economic development.

3 When will it be officially launched?

The STAR Market was announced at the China International Import Expo, which to some extent conveys confidence and determination in this reform to the outside world. Therefore, establishing the system, selecting enterprises, and achieving a smooth launch are the top priorities.

However, the launch of the STAR Market will take time. Under normal circumstances, the following procedures are still needed for the STAR Market's launch:

(1) Formulating complete rules and supporting systems and soliciting opinions;

(2) Developing relevant review, issuance, and trading systems;

(3) Completing relevant review procedures for prospective listed companies.

According to our understanding, the CSRC currently does not have complete institutional rules and detailed regulations. This was confirmed in the SSE's response to media questions, where the SSE stated that under the guidance of the CSRC, it will actively research and formulate the STAR Market and registration-based system pilot plan, solicit market opinions, and implement it after completing approval procedures. Next, under the unified deployment of the CSRC, the SSE will formulate work plans, various rules, and supporting systems in accordance with relevant national laws, regulations, and policies, and complete the development of relevant technical systems.

The CSRC pointed out that the Standing Committee of the National People's Congress already authorized the implementation of a stock issuance registration-based system in December 2015. At the beginning of this year, corresponding systems were prepared for innovative enterprises including CDRs, and three years ago the SSE also conducted special research on the registration-based system and the Strategic Emerging Industries Board. The SSE has even completed the development of the issuance review system.

Therefore, it is expected that the CSRC and SSE will soon be able to release draft supporting regulations for public comment, which conventionally requires one month. According to communication with relevant personnel, all parties are currently making intensive preparations, and there is no clear timeline for the STAR Market's implementation.

China Securities Journal also reported that regulatory authorities are currently formulating pilot plans for the STAR Market and the registration-based system, which requires balancing multiple relationships. For example, new capital must match the progress of the pilot, investment and financing must adapt to each other, primary and secondary markets must respond to each other, and the interests of new and existing shareholders of companies must be balanced — all of which must be considered in institutional design. Additionally, technology innovation enterprises and new economy enterprises with new models exhibit obvious performance differentiation, posing significant risks for ordinary investors. Thresholds need to be set at the institutional level regarding assets, investment experience, and risk tolerance capacity, strengthening investor suitability management for the STAR Market.

Of course, the pilot launch of the registration-based system also requires a sound institutional foundation, investor education, supporting amendments to the Securities Law, delisting mechanisms, and implementation of regulatory rules. On November 6, the CSRC issued the "Guiding Opinions on Improving the Stock Suspension and Resumption System for Listed Companies," indicating that various supporting policies are already underway.

4 Which enterprises can list on the "STAR Market" during the pilot phase?

Synthesizing various sources, the STAR Market is horizontally analogous to the ChiNext board of the Shenzhen Stock Exchange, but unlike ChiNext's approval-based system, the STAR Market adopts a registration-based system. Preliminary judgment suggests it may be similar to the "Strategic Emerging Industries Board" prepared in 2015, with possible upgrades based on that board, providing some experience for reference.

Currently, the detailed rules and thresholds for the STAR Market's establishment are still in their infancy. According to the CSRC's "Notice," "pilot enterprises should be innovative enterprises that meet national strategic needs, possess core technologies, enjoy high market recognition, belong to high-tech industries and strategic emerging industries such as internet, big data, cloud computing, artificial intelligence, software and integrated circuits, high-end equipment manufacturing, and biomedicine, and have reached considerable scale."

According to informed sources, the first batch of STAR Market companies should mainly consist of already mature innovative enterprises that were originally planned for listing, and the number will not be too large. By analyzing the detailed rules of the "Strategic Emerging Industries Board" and CDR issuance standards, we can attempt to infer the conditions for listing on the STAR Market.

According to the design at that time, China's strategic emerging industries were identified as seven major areas:

(1) New energy and energy conservation and environmental protection;

(2) New information industry;

(3) Bio-industry;

(4) New energy;

(5) New energy vehicles;

(6) High-end equipment manufacturing;

(7) New materials.

The Strategic Emerging Industries Board would mainly serve relatively large, mature enterprises that have passed the growth stage in vibrant emerging industries such as internet, energy conservation and environmental protection, bio-industry, new energy, high-end equipment manufacturing, culture, and new-generation information technology.

Combined with the issuance standards then determined for the stalled unicorn CDRs, and information from CSRC and SSE responses to media questions, the keywords are addressing weaknesses and incremental reform. From this, we can infer the general direction:

First, de-emphasizing profit requirements while mainly focusing on enterprises' sustained profitability capability.

The CSRC's "Measures for the Administration of Initial Public Offerings and Listings" and "Measures for the Administration of Initial Public Offerings and Listings on the Growth Enterprise Market" have already made clear provisions on enterprise profitability. However, the current "Securities Law" states "has profitability capability," not profitability itself — "there is still room for interpretation here."

Second, allowing companies with special equity structures such as VIEs to list. This is equivalent to giving a green light for many internet companies that have not yet achieved profitability to go public, and also establishes a channel for Chinese stocks listed overseas to return to domestic listing.

Third, differentiated and innovative institutional arrangements. Regarding issuance procedures, implementing a registration-based issuance system and appropriately considering simplified issuance procedures; regarding equity incentives, establishing flexible equity incentive systems.

If the STAR Market's institutions draw on the experience of mature international capital markets, then allowing companies with dual-class share structures to list and allowing technology companies that have not yet achieved profitability to list will become highly probable events.

5 Differences and relationships between the STAR Market, NEEQ, and ChiNext

The signals of supporting innovation and entrepreneurship, supporting private enterprises, and supporting small and medium enterprises demonstrate that different boards of China's capital market can achieve differentiated development.

The NEEQ mainly serves the development of innovative, entrepreneurial, and growth-oriented small and medium enterprises, characterized by large quantity and wide coverage, with relatively loose listing conditions. ChiNext is positioned for entrepreneurial enterprises, small and medium enterprises, and high-tech industry enterprises that temporarily cannot list on the main board; listed companies are mostly engaged in high-tech businesses, at the entrepreneurial stage, relatively small in scale, with not particularly outstanding performance. The STAR Market serves the construction of Shanghai's science and technology innovation center and technological innovation, positioned as a pilot practice of the registration-based system at an exchange, which will bring securities issuance of a large number of new economy and biomedicine enterprises. It is not aimed at expanding enterprise coverage or serving the development of small and medium enterprises.

ChiNext, NEEQ, and future emerging boards and the STAR Market have listed or to-be-listed enterprises at different stages with different industry characteristics, but without clear boundaries. Although issuance mechanisms differ, with emerging boards and the STAR Market possibly implementing the registration-based system from "birth," after the completion of new share issuance registration-based system reform, several markets will both complement and compete with each other.

It cannot be denied that the establishment of the STAR Market will certainly have an impact on ChiNext or NEEQ in the long term, but we believe regulatory authorities will formulate relevant detailed rules to mitigate the impact on ChiNext or NEEQ. The threshold for transferring from NEEQ to the STAR Market is an important indicator to watch.

6 Impact of the STAR Market's establishment on regulatory methods and market structure

The registration-based system has been proposed for quite some time, and regulatory authorities have been relatively cautious in its specific implementation. The establishment of the STAR Market and the pilot of the registration-based system will inevitably impact existing regulatory methods and the market participant structure:

First, the registration-based system makes during-process and ex-post supervision the focus of regulatory authorities. Shifting from strict listing review to strict information disclosure review, regulation accordingly turns to during-process and ex-post supervision. There will still be strict standards and procedures, with stages including acceptance, review, registration, issuance, and trading, with greater emphasis on the truthfulness, accuracy, and completeness of information disclosure, and on the quality of listed companies. At the same time, this also indicates that regulatory penalties for market violations will gradually increase.

Second, the market participant structure will change, with the era of institutional investors arriving. In its response to media questions, the CSRC mentioned that it will guide the SSE to strengthen investor suitability management for the STAR Market in terms of assets, investment experience, and risk tolerance capacity, and encourage small and medium investors to participate in STAR Market investment through public funds and other means. This means that during the pilot period, the STAR Market may set relatively high准入 thresholds for small and medium investors; the greatest change may be ushering in the era of institutional investors, with professional investors driving valuation systems back to rationality.

Conclusion

China's capital market has always had a Nasdaq dream. Whether the SME Board evolved from the Shenzhen Stock Exchange's main board mechanism, the ChiNext board that emerged in 2009, or the expanded NEEQ in 2014, all were regarded as institutional attempts at a Chinese version of "Nasdaq," but ultimately these boards failed to live up to their names due to various problems.

For the A-share market, the STAR Market's pilot of the registration-based system does not mean that conditions for fully implementing the registration-based system in the A-share market are already sufficiently mature. The realization of the registration-based system requires corresponding improvements in legal systems, delisting systems, investor protection, penalties for illegal activities, and regulation. Hasty launch would be counterproductive.

Note: This article analyzes based on existing information; specifics shall be subject to the STAR Market's formal supporting systems and detailed rules.

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