China's latest proposal to regulate algorithm use is likely to hit Tencent Holdings Ltd.'s and Beijing Byte Dance Telecommunications Co. Ltd.'s ability to monetize user behavior.
The new rules on algorithm use are part of a broader move to strengthen China's legal framework for governing data security. If technology companies like Tencent and ByteDance are unable to use data from their various algorithms, their ability to generate revenue from advertising and attract users will be affected, analysts said.
Internet companies rely heavily on tracking data to figure out what products to sell to users. Tencent's user-targeted advertising and marketing services, for example, are among its major revenue sources. Similarly, ByteDance's trending short-video app TikTok, its Chinese version Douyin and news app Toutiao also rely on algorithms to recommend content to users.
"Return on investments for advertising will be less and the efficiency of distributing ads for merchants will be lower, which will mean less money is going to internet platforms [like Tencent] if algorithm use is restricted," said Tam Tsz Wang, China internet equity analyst at DBS Vickers Securities. Tam added that Tencent's advertising platform is a major distribution channel for its gaming business.
On Sept. 29, the Cyberspace Administration of China, or CAC, China's internet regulator, said it will set up governance rules for companies that use algorithm technologies within the next three years.
This followed a 30-point draft guideline issued Aug. 27 which proposed to stop companies from using algorithms that "encourage addiction or high consumption" in order to "safeguard national security and public interests." The draft requests service providers to ask for user permission before sharing their data and to present the logic behind the algorithms before deploying it in their services.
The combination of new and upcoming data security rules is likely to impact Chinese internet companies' ability to raise capital, lawyers and analysts said.
Tencent and ByteDance declined to comment on how the new rules might affect their businesses.
As of the second quarter of 2021, Tencent's online advertising, which accounted for 16.3% of Tencent's total second quarter revenue, increased 23% year over year to 22.8 billion Chinese yuan. Social and other ad revenue grew by 28% year over year to 19.5 billion yuan, and media advertising revenue was stable at 3.3 billion yuan. Tencent's online advertising revenue, as a percentage of overall revenue, has been in the high teens since 2017. At the end of 2020, Tencent's online advertising revenue was 82.27 billion yuan, making up 17.1% of the company's total revenue.
ByteDance pulls in nearly 60% of its ad revenue from its domestic version of TikTok, Douyin, according to a Reuters report.
"If advertisers see their monetization go down on Tencent and ByteDance's platforms and choose to pay a lower advertising rate, the tech companies could raise ad load to offset a decline in unit price," said Charlie Chai, vice head of research at 86Research, adding that this strategy is dependent on the economic conditions in China.
By inserting more ad loads, which allows for the control of the number of ads shown on a page in the same reserved space, Tencent and ByteDance can shore up revenue, Chai said.
The new algorithm rules may affect ByteDance's ability to retain customers if customers opt out, as its video recommendation algorithm becomes less powerful, Ke Yan, head of research at DZT Research, said. "However, there are ways for ByteDance to boost their user retention and user usage time. For example, ByteDance can invest in more content so there is more choice," Ke added.
The proposed regulation on algorithm use will also affect food delivery app Meituan and online traveling agency Trip.com Group Ltd., as the apps rely on algorithms to allocate food delivery orders and recommend traveling plans to users, Tam said.
"Trip.com Group has noticed the draft released by CAC and will take ... initiative to learn and follow the rules set by the regulators," said a Trip.com spokesperson.
"Trip.com has never manipulated the offering prices based on users' behavior data, and Trip.com only earns revenues from commission fees paid by third-party service providers instead of from users," the spokesperson added.
Meituan did not respond to S&P Global Market Intelligence by the time of publication.
In recent months, China has introduced several initiatives aimed at bolstering cybersecurity.
The Private Information Protection Law, or PIPL, was passed in August and is set to take effect Nov. 1. The law seeks to regulate the way companies process personal information, which includes any information that is recorded by electronic means, of individuals in China. It also applies to companies outside of China handling personal information of individuals in China.
China's Data Security Law, or DSL, was enforced Sept. 1 and has a broader remit as it looks at how companies use, collect, develop and protect all kinds of data in China. The overhaul deals with data security systems, governmental data, cross border data transfers and penalties for companies operating in China that do not comply with the law.
The two laws complement China's Cybersecurity Law, which came into effect June 2017 and acts as the baseline for China's cybersecurity guidelines. It requires network operators to allow for government-conducted security checks and requires that data is stored within China.
The series of cybersecurity guidelines bring some clarity, particularly when comparing them with other countries' data protection laws, Carolyn Bigg, a partner at DLA Piper who specializes in China data privacy law, said.
"The position around overseas data transfer is a lot clearer. It is now much more straightforward to access or transfer personal data outside of China," Bigg said, adding that the main aim of the DSL and PIPL is to encourage free flow of data within a confined framework.
Raising foreign funds
Meanwhile, internet companies like Tencent, ByteDance and Meituan, as well as foreign-based companies, will find it tough to keep up with the new data security rules because of their large-scale or sensitive data-processing activities in China, and therefore may not be able to attract investor interest as easily, Gabriela Kennedy, partner and head of the Asia IP and technology, media and telecom group at Mayer Brown, said.
"One of the factors that investors tend to look at when assessing an investment target is the company's ability to respond to and comply with regulatory requirements," Kennedy said.
Investors are less likely to invest in China's internet companies after seeing big Chinese technology companies investigated for various cybersecurity violations, Michael Sung, founder of venture capital company CarbonBlue Innovations, said.
In July, the CAC ordered Chinese app stores to remove DiDi Global Inc., followed by a cybersecurity review during which Didi was required to suspend new user registration in China. Didi Global said it will look at its cybersecurity risks and how it can improve its cybersecurity systems.
"There have been a couple of high profile moves by regulators such as Didi Global, and this shows a clear trend that Beijing is trying to rein in the unfettered tech giants in China," Sung said.
As of Oct. 25, US$1 was equivalent to 6.39 Chinese yuan.