By Andrew Freyre-Sanders, Managing Director, Brina Tan, Director and Vernon Willis, Executive Director – Execution Services, Haitong International Securities
Foreign investors raising allocations to China following MSCI partial inclusion will encounter a radically evolving market and will require expert guidance.
The most important recent development in China’s equities markets is the establishment of a domestic institutional investor infrastructure. Pension reform and new asset management rules, culminating in the creation of the Financial Stability and Development Committee in November 2017 to formalise, regulate and develop China’s financial system, have set in motion a fundamental shift towards institutionalising the markets.
Total domestic assets under management (AUM) held by insurance companies and mutual funds should rise by 30% a year as a result, according to Z-Ben forecasts, and will help erode the dominance of retail investors who currently make up around 80% of market activity.
The transfer of 10% of state-owned enterprises’ equity holdings to the existing Rmb2 trillion ($292 billion) National Social Security Fund (NSSF) is one of the largest asset transfers in China’s history. In addition, seven of the Rmb6 trillion local social security funds are moving to the NSSF to manage and invest in broader asset classes than just government bonds and cash, and 21 external fund managers have also been appointed to manage local social security funds. The introduction of tax-deferred pensions will further boost the savings industry.
The domestic asset management sector has also been fortified by new regulations, including limits to off-balance sheet offerings, a ban on guaranteed return products and the setting of a 10% provision target for fund managers. Meanwhile, the insurance, banking and fund management sectors have been opened up to foreign investors, allowing majority shareholdings which will rise to 100% ownership over the long term.
In combination, this means that China is not only going to see a rapid expansion in institutional pensions and other assets under management during the next five years, but also a major change in the fund management landscape, with greater openings for foreign asset managers and advisors balanced by the rising sophistication and development of China’s new breed of institutional investors.
The recent history of the Indian equities market provides a template. It rapidly evolved into an institutional investor-driven market as micro changes to its infrastructure were introduced, and global funds rushed to correct underweight allocations.
Foreign investor access
Of course, the eye-catching MSCI partial inclusion of A-shares in its benchmark indices this summer is significant and will attract foreign investors. However, despite the promise of faster MSCI inclusion than previously expected, foreigners’ relatively small size (3.7% of total tradable market) means their influence will be limited for the next couple of years at least.
Given MSCI’s endorsement of China Connect, foreign investors, including passive funds, have typically adopted this access mechanism to trade China A-shares. However, foreign investors still face considerable logistical and operational challenges accessing the market via China Connect in an efficient manner and satisfying best execution obligations. The magnitude of these challenges can vary depending on many factors including the number of sub-accounts, the use and costs of integrated broker model versus SPSA, the process of establishing SPSA sub-accounts, limited ability to trade on omnibus, tight custodian settlement cut off times, funding and CNH liquidity concerns, single-sided settlement. Success requires coordination and military-style planning across clients, their end clients, global and sub-custodians, brokerages and exchanges and this complexity requires expending human and financial resources.
Brokerages and foreign investors are required to set up with robust operating procedures. Proximity to the market helps provide reassurance. Many US- and Europe-based investors are understandably nervous about the operational risks, especially the certainty of trade settlement and integrating their Special Aggregated Accounts (SPSAs) within their back-office systems. Moreover, the broker-selection limitations inherent in the QFII and RQFII programmes arouse concerns that aspects of “best execution requirements” of MiFID II might be breached.
Dense and voluminous broker manuals are also off-putting. It makes sense, therefore, that investors collaborate with and use a broker who has a deep understanding of the technical and operational features of both the China market and how to access it seamlessly.
Haitong International considers the microstructure and liquidity of the equities markets in Shanghai and Shenzhen as particularly well-suited for electronic trading and algorithmic strategies. To simplify their China instrument order routing, some of our institutional clients have indicated they would prefer one broker FIX connection for care and electronic trading orders irrespective of whether they are trading on (R)QFII, B-shares or via China Connect and we are in process of implementing this facility. Looking further ahead we intend to deploy our electronic trading platform onshore to provide institutional clients WFOE operations the same execution tools as their offshore trading hubs.
Haitong International’s algorithms have been configured and adapted to handle some of the nuances between trading via China Connect and directly on the Shanghai or Shenzhen Exchanges. These include the three-second market data latency in Shanghai, client odd lot requirements and adaptable trading strategies, trading behaviour around limit up/down alerts, and local regulatory interpretation and market guidance on cancel/fill ratios, order submission numbers and close participation. Our China-focused quant models have shown encouraging results, for example during retail-centric liquidity bursts.
Haitong International also aims to utilise Haitong Securities onshore presence and relationships to assist clients to engage the regulators and the exchanges to shape discussions about the common challenges and concerns.
The introduction of the Shanghai exchange closing auction on the 20th August appears to be a good example of the Chinese authorities listening to international investors concerns and acting relatively quickly ahead of the next phase of MSCI A-share inclusion. Indeed, as the China markets open up to offshore funds, Haitong Securities onshore presence will be an important resource we hope clients will tap into as they increase their presence.
We believe that if foreign investors had three wishes to improve China market access, then amongst their priorities would be:
- an extended settlement cycle in line with other regional markets to manage cash flows and accommodate investors in non-time zone locations,
- the introduction of omnibus trading similar to the models adopted in other ID markets, and
- making it easier for participants to agree, transact and report block trades in A-shares. On this last wish, the provision for both foreign and domestic funds to transact block trades consistently (including within stock connect) will be a milestone, and already it seems a marker has been laid down with a $700 million block which was reported to the exchange on 8 August and appears to have been crossed between an offshore and onshore investor.
Clearly, brokerages and buy-side trading desks need to aware and prepare for the growth and changing composition of the international and domestic client base over the next decade, and be sufficiently agile to adjust to changes taking place in the structure of China’s markets.