China has for years encouraged long-term investors such as foreign insurers and pension funds to invest directly in the country's stocks and bonds, as part of its broader reforms of the country's financial sector.

But hedge funds, criticized by some investors and regulators around the world for stoking volatility in markets, have not found favor with the mainland regulators and have so far not been allowed direct access to China's markets.

That could be changing.

The China Securities Regulatory Commission (CSRC) is considering a proposal to lower the bar for obtaining a license that allows foreigners to buy securities in the country, said two industry sources with knowledge of the regulatory agency's thinking on the issue.

It is also looking at expanding the types of investors that may be allowed to obtain the license, called a Qualified Foreign Institutional Investor (QFII), as part of efforts to broaden the program, Wang Lin, a senior CSRC official, was quoted by the official Shanghai Securities News on Wednesday as saying.

The move could pave the way for hedge funds to gain direct access to one of Asia's biggest stock markets, where a growing number of companies are seeking a listing. Some 2,400 China stocks tracked by Starmine have a combined market value of $4.1 trillion compared to $3.6 trillion of 2,500 Japan stocks.

Investors seeking exposure to alternative investments in China would be drawn to hedge funds after the move, some analysts said.

"The more sophisticated investors in China have probably gained some experience getting exposure to alternative vehicles," said Ken Yap, a director at research and consultancy firm Cerulli.

"The time might be just right for them to consider some of the more established hedge funds to also get access to China, through the QFII licenses."

A source at one of the biggest prime brokers for QFIIs said that until now, China had been reluctant to issue QFII licenses to hedge funds, even if they met the CSRC's criteria.

New York-based hedge fund Och-Ziff Capital Management applied for QFII status a few years ago, according to two sources familiar with the matter, but the asset manager has not yet been granted a license.

The new initiative to ease the qualification requirements appeared to reflect a softening attitude towards hedge funds, the prime broking source said.

Currently, many hedge funds are accessing the Chinese market via their prime brokers, who use their own QFII quotas to purchase stocks or bonds on behalf of their clients.

The CSRC and a spokesman for Och-Ziff declined to comment. The sources mentioned in this story did not wish to be identified because of the sensitivity of the matter.

LOWER THRESHOLD

For all institutions other than securities brokerages and banks, current rules require that a potential QFII must have at least $5 billion in assets under management and must have been in business for at least five years to qualify for a license. The thresholds for banks and brokerages are higher.

If the minimum requirement for assets under management were to be lowered, it would mean that many smaller funds, including certain hedge funds that currently do not qualify for the program, could be able to obtain QFII licenses.

Some of the tools hedge funds normally use are already in place. China already allows QFII funds to trade stock index futures, a product it launched in 2010.

Cindy Qu, an analyst at fund consultancy Z-Ben Advisors, said that many hedge funds, which can access Chinese stocks via indirect channels, may not be keen to apply for QFII licenses, which would expose them to greater regulatory scrutiny.

SWEEPING REFORMS

A broadening of the base of QFII investors from around 160 now would fit in with the securities regulator's overall push to clean up and professionalize the country's markets and gradually liberalize the flow of capital into and out of the country.

Last week, a U.S. official said China had agreed to raise the ownership cap for foreign investors in domestic brokerage joint ventures to 49 percent from the current 33 percent and to allow them to trade commodities and financial futures.

Beijing has already started to expand the QFII program in other ways, announcing in April that it would increase the overall cap on QFII quotas by $50 billon to a total of $80 billion.

CSRC's Lin also said the regulator was looking at letting QFIIs invest in a greater variety of financial instruments and making it easier for them move money in and out of the country, according to the Shanghai Securities News.

The CSRC has granted QFII licenses to 158 foreign investors since the first ones were handed out in 2003, including to institutions such as American International Assurance Co Ltd, Korea Investment Corp and the Kuwait Investment Authority.

And 129 of them have obtained a combined investment quota of $25.19 billion from the country's foreign exchange regulator, with a pickup in recent months.

Sources told Reuters last month that China could also expand the Qualified Domestic Institutional Investor (QDII) scheme, which mirrors QFII in allowing domestic institutions to invest overseas, as part of efforts to free up capital flows.

(Additional reporting by David Lin in SHANGHAI; Writing by Jason Subler; Editing by Muralikumar Anantharaman)

• A Permanent Economic Emergency