I don’t think many people know what a Variable Interest Entity is. But today, in the middle of a Trade War, it might be the most important thing to understand.
In China, it is illegal for a foreigner not living in China to have an ownership stake in a domestic Chinese company. But there are ways around it. Let’s take Alibaba for example –
“the Amazon of China.” Today, it trades on the New York Stock exchange under the Ticker BABA. Anyone in the US can buy it. Heck, anyone with access to US markets can buy it.
But how is that possible if China does not allow foreigners outside of China to own a stake in their public companies?
It’s possible because you aren’t buying Alibaba. What I mean is, you aren’t buying THE Alibaba, the one in China that is actually doing the business. You are instead buying a shell company based in the Cayman Islands that’s kind of pretending to be Alibaba. The only reason why that shell company is worth what it is in US markets (Alibaba’s market cap on the US exchange is $436 billion right now) is because it claims to have a contract with the REAL Alibaba in China. This contract basically says the Cayman Island Alibaba is entitled to get economic profits from the real Chinese Alibaba and that’s all US investors are buying. A piece of a contract.
This is what it’s called: a Variable Interest Entity or VIE for short. When Alibaba was getting ready to IPO in 2014, it was the biggest IPO in US history. The ownership structure was talked about quite a bit from major media to social media. But, our financial system is very good at selling the shiniest of things and perhaps no one wanted to really consider what was going on. Or maybe most people did look into it and because times were different in 2014 said, “You know, this is okay because US and Chinese Variable Interest Entities have been working for years and country relationships are good.”
That was 2014.
The current political landscape throws the ownership of these variable interest entities and the huge sums of money indexed to them and passively invested into them on center stage. As of this writing, when calculated by sheer market cap, the value of all Chinese Variable Interest Entities being traded on US markets is way in excess of $1 trillion. Yes, more than $1 trillion. So somehow, clearly without much regulation at all, we’ve managed to package quite a few of these Chinese VIEs and sell them across the country and across the world to anyone who has access to American markets.
The investment management company Blackrock collectively holds $12 billion worth of the Alibaba VIE.
Vanguard, Fidelity, Morgan Stanley, and the list goes on all own quite a bit themselves. It’s also a lot more than just Alibaba. Think Baidu, China Mobil, Weibo, and the list goes on and on.
This is how a single loophole potentially becomes the most important weapon in the Trade War. Are either President Trump or Xi crazy enough to threaten the existence of the Variable Interest Entity? What I mean is, what if one of them decided to say, “you know what, Variable Interest Entities are not allowed any more in our country.” Does a Trump tweet about Variable Interest Entities sound that unreasonable?
Would Xi be so crazy to tell Trump he can wipe out millions of American savers who have been peddled into these VIEs overnight?
Essentially, every Chinese Variable Interest Entity you can think could theoretically go to $0. Just like that. Because the ability to invest in something like Alibaba on US exchanges in the first place only exists because of the Variable Interest Entity loophole. The key word here is loophole. And usually loopholes get exposed, closed, or debated.
This loophole connects the shares you bought in the US to the Cayman Islands, which are then connected by a contract that has no legal authority or oversight to the actual company in China. But hey, it’s a promise. If the loophole is ever closed, it would essentially mean all US holders would be left holding a PO Box in the beautiful Caymans and nothing else.
Now what’s really fascinating about this conundrum is that there is no legal authority. If any of this were to happen, no one can sue anyone. There is no oversight for any US shareholders of Variable Interest Entities. Nothing. Unless maybe you want the US military to march overseas and get your money back.
Now, I should be clear that I do not like fear mongering. I tend to champion buying dips and exposing the top callers. This isn’t supposed to be either of those two things. Instead, if anything, it’s meant to expose the packaging and selling of these VIEs.
Wall Street, at its core, is really good at building perfect looking presents. These presents have the best wrapping, the perfect bow, and the most ideal color. They shine and you just want it. You have to buy it. But rarely does the financial machine show you what’s behind the beautiful wrapping. I think of all the Alibaba IPO fees our fantastic investment banks collected along way with their marketing messages. “Dude you’re buying Alibaba, the Amazon of China!”
More recently, we watched the inverse VIX ETN that traded under the ticker XIV. The one that went bust over night. It was marketed as a way to short the VIX with a few clicks from your retail brokerage account. That did not go well.
Now, let’s pretend for a second none of this matters. Fast forward the next 10 years. This blog post sucks and meant nothing. Say Alibaba (the US one) goes 10x from here. Well, that is totally fine. But at the very least, now more people are aware of the ownership structure and risks that are being peddled daily across financial markets, especially VIEs today in the middle of serious political turmoil. For that reason alone, some good has been done.
To read more about this, I wrote a post back in the day called, Here’s Why You Need To Be Careful of ETFs and ETNs. It talks more about this subject and why you need to start reading more prospectuses.