As many as 58 of China's 95 brokerages have been downgraded by the China Securities Regulatory Commission in its annual classification.
The main reasons for the downgrades are brokerages' non-compliance with regulations, flouting of rules and below-par risk management capacity, according to Dong Dengxin, a researcher at the Wuhan University of Science and Technology and a financial analyst.
Researchers said the downgrades will help make the market more transparent and cleaner.
But, the downgrades are also expected to further squeeze brokerages' already shrinking net profit due to market fluctuations.
The previous annual review led to XX downgrades last year.
The CSRC classification system accords ranks or ratings to brokerages based on their record or performance. A set of criteria determines a brokerage's rank. Key factors are risk management capacity, profitability and compliance.
Eleven ranks are distributed over five classes. The top-rated A Class has three ranks: AAA, AA and A. Ditto for the B class (BBB, BB, B) and the C class (CCC, CC, C), followed by the D class (D) and the bottom-of-the-pile E class (E).
Currently, no brokerage has the highest AAA rating. Only eight brokerages are rated AA.
According to the CSRC regulations, a downgraded brokerage is required to increase its allocation to its investor-protection fund.
Else, it would attract fresh restrictions that would stop it from starting a new line of business as well as expanding current businesses, said analysts.
Founder Securities Ltd, which was classified as A last year, was downgraded to C this year for several instances of flouting the CSRC rules.
According to Founder Securities, it has been probed and punished for breaking disclosure rules and for not meeting the 'know your customer' or KYC norms in some transactions.
Following the downgrade, Founder Securities now needs to augment its investor protection fund from 1 percent of revenue to 3 percent.
Shenwan Hongyuan Securities said in a note that brokerages can compete fairly only when they all operate based on the rules and law. The downgrades, it said, suggest the market regulator is strengthening compliance and risk management - and cracking down on misbehavior, dishonest and illegal practices.
A downgrade may affect a brokerage's business actitivities such as investment banking. Bond issuers generally do not prefer to hire low-ranked brokerages as underwriters, particularly when other higher-rated ones bid for the same role, said Yin Jianjun, a researcher with Shanghai-based Shenda Asset Management.
Stricter compliance requirements and fluctuating market conditions will likely hurt the profitability of brokerages in the second half of 2016, according to a research note from China Merchant Securities.
"Equity market is going to be more active in the second half of 2016 with more channels anticipated to open to investors, such as Shenzhen-Hong Kong stock connection, and more initial public offerings to be seen. New issuance of stocks and bond issuance will certainly benefit larger players in the sector," China Merchant said in the note.
