By Cale McCulloch, Sales Trader, CLSA and Claud Zhong, Deputy Head of Trading, Citic Securities
A single trade execution platform and the use of customised algorithms can reduce the complexities of investing in China’s equities markets.
The inclusion of China A-shares in MSCI’s global benchmark equity index in May 2018 is prompting international investors to explore the optimal way to gain access to a market that they can no longer ignore. Passive funds linked to the index will need to meet a growing China weighting allocation, and active funds measured against the benchmark should, at least, have systems in place to gain exposure to A-shares in an optimal manner or risk complaints from their investors – as well as potential underperformance.
The investment case is also strong. China consumer confidence is recovering, evinced by a robust property market, a strong household appliance sector and booming ecommerce supported by Fintech innovation. Among traditional corporations, asset quality is improving while New Economy companies are driving the next stage of the country’s economic growth.
China reported economic growth of 6.8% for the third quarter of 2017, which was above the government’s full-year target. However, there are concerns about the risks of excessive debt and speculative investments, as recently expressed by the governor of the People’s Bank of China. The government seems prepared to confront those dangers.
During the past year the authorities have taken strong measures to curb leveraged M&A activity while President Xi Jinping emphasised the importance of financial security at the 19th National Congress of the Communist Party in October. Investors should be encouraged by the government’s commitment to resolving potential market risk.
However, China’s equities markets have idiosyncrasies that complicate the trading process that few in the international community fully understand. Liquidity is extremely volatile, there are multiple order execution nuances, market data snapshots can mislead and obscure liquidity, and technical restrictions restrict execution flexibility.
When correctly structured, international brokerages can alleviate the logistical strain by offering investors a one-stop trade execution platform for China equities. CLSA and its parent company, Citic Securities, already provide this service, but it has required a significant commitment in terms of cost and technology to create and implement the necessary platform.
Citic Securities accounts for about 25% of equity trade flows and assets under management in the Qualified Foreign Institutional Investor (QFII) programmes, and between 6% and 7% of domestic equities trading in markets dominated by retail flows. As a leading market participant, Citic Securities has excellent execution relationships with the domestic Chinese institutional investors and a close consultative relationship with the country’s major financial regulators. These corporate characteristics and assets, combined with the increased foreign institutional interest in China, were the catalyst for the commitment made by Citic Securities and CLSA to create the “One China Execution Platform” offering.
Overseas access to China onshore markets
China’s equity markets are underrepresented in terms of relative holdings by overseas investors, who account for only 3% to 4% of total daily turnover, compared with around 80% domestic retail market share. In addition, access to the domestic China equity market is fragmented. Licenced foreign fund managers can select from multiple structures such as the QFII and the Renminbi QFII (R QFII) schemes, which in practice tie their trades to a single broker, or the more recent Stock Connect channels to the Shanghai and Shenzhen exchanges.
Connect has undergone important changes since the launch of the pilot programme in November 2014 that provides mutual direct access between Shanghai and Hong Kong. Most notably, from 2016, investors could settle trades delivery versus payment (DVP) and safe-keep China A-shares by setting up a Special Segregated Account (SPSA). This has eliminated the need for the pre-delivery of shares that effectively forced them to execute trades through two or three dominant custodians.
A further enhancement in November 2017 introduced real-time DVP and improved automated cash prepayment services, which satisfied UCIT regulators in Dublin and Luxembourg who had been concerned with counterparty risk. The reforms are also consistent with the MiFID II provisions on achieving best execution by removing a de facto dependence upon custodian brokerages to transact orders – a point many institutional investors voiced concerns about. From November onwards institutional investors will be free to execute with their broker of choice on both the buy and sell legs from a best execution trading result perspective.
The MSCI announcement in June led to the opening of many more SPSAs, which has risen to around 2000. New investors often seek guidance on the mechanics of entering the Chinese market for the first time, and on the respective merits of the (R)QFII and Connect channels. In addition there are further complexities for money managers who have established (R)QFII quotas, but also want to trade via Connect in a consistent fashion, utilising one platform front, middle and back.
In response, CLSA and Citic Securities restructured the entire algorithm system to address the specific conditions for transacting in the Chinese markets and so created the “One China Execution Platform”.
Simply replicating the existing CLSA algorithms was insufficient: Asian algorithms are inappropriate for trading A-shares because of the domestic conditions, rules and restrictions that apply. On the one hand, the Shanghai and Shenzhen markets (especially the index names) have some characteristics of a highly evolved market: high liquidity, tiny spreads, high trade frequency and small average trade size, but at the same time there is very low volume profile stability and high intraday volatility, which makes trading in Shanghai and Shenzhen more challenging.
This is where the onshore expertise of Citic Securities came into play. Citic Securities has effectively exported domestic execution knowledge in a CLSA package that international clients were familiar with.
Features of the “One China Execution Platform” include:
• Market data blind spots
The markets trade continuously, but market data is only distributed in three seconds snapshots. CLSA and Citic Securities’ algorithms are embedded with price and volume controls to manage the blind spots when the displayed order book data does not reflect the real situation on market.
• Individual investors dominating the market
Liquidity is sporadic in China because individual retail investors account for 80% of the market with liquidity occurring in clusters that are more predictable in the short-term than in other markets. Citic Securities’ understanding of this market segment means that the signal footprint of CLSA’s algorithm is reduced and prevents retail investors trading against institutional investors’ order flow. Controls over average daily trading volumes and specialised liquidity capture tactics enable CLSA and Citic Securities‘ algorithms to obtain the best trading result, not following the short-term herd trading mentality.
• Market order management
Order modification is not allowed in Chinese markets. Instead, amendments require the trader to cancel the original order and re-submit a new one, which results in a loss of queue priority and triggers potential regulatory issues if breaching cancel/fill ratios. The new algorithmic suite does not take the simplistic approach of crossing spread, but rather provides a service that offers a complex posting and queue management logic.
• Exchange enforces transaction limit
The exchanges also implement a limit on the number of order slices sent to the market at every minute and over the course of a day. Market order slice control is built and overlaid on algorithms to manage the maximum of new order slices being sent to market in a pre-defined time window.
“One China Execution Platform”
The “One China Execution Platform” provides one stop execution, order management and trade confirmation and settlement facilities for the Chinese market. Clients can send (R)QFII and Connect orders to the same dealing desk, working the same strategies, but deploying different underlying logic that is suitable for onshore (R)QFII or offshore Connect trades. This enables CLSA to maximise execution capability while providing client service at a single broker level, as an alternative to the complexity and inefficiency faced by institutional investors when spreading trades across several brokerages or trading strategies.
(R)QFII stock and cash automated checking occurs offshore with CLSA before orders are sent to the market, and an additional safety check is conducted at the slice level as orders pass through the onshore stock verification stage to ensure operational integrity. Clients also receive the same post-trade booking services as when they trade with CLSA in other markets, including FIX confirmations when required.
CLSA and Citic Securities’ algorithmic trading suite for the China markets include algorithms that operate throughout the course of the day, at opening, closing and auction, at specified participation rates and also opportunistic and liquidity seeking algorithms. The Float, FloatSniper and Dark algorithms have been removed from the China suite, with near touch style algorithms across all strategies disabled due to market regulations.
Recent market reports also indicate that the Chinese stock market regulator, the China Securities Regulatory Commission, may cooperate further with the Hong Kong regulator to implement an ID system for Stock Connect’s northbound trading in the first half of 2018. In this case, Connect trading may fall under the same regulatory supervision framework as (R)QFII with sensitive parameters such as order cancellation and order filling ratios being monitored, irrespective of which channel the client is trading through. The “One China Execution Platform” pre-empts this as the functionality is in place today, providing a strong competitive advantage.
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