By Nick Ronalds, Managing Director, Equities, ASIFMA
What could be simpler than opening a stock market? A lot it turns out. All the players — brokers, investors, the Shanghai and Hong Kong Stock Exchanges, regulators and other government authorities in Hong Kong and the Mainland, are engaged in intensive preparations. Along the way they’re finding enough quirks in the Stock Connect scheme to present some challenges.
Technical and legal challenges
One unique aspect of the scheme is the method of access. Elsewhere, if an investor in say, London wants to buy shares in a stock on the Tokyo Stock Exchange her London broker will execute the order by using a correspondent broker in Japan who is a member of the Japanese exchange. The Japanese broker executes the trade and provides clearing and related services for the London correspondent broker. For Stock Connect, however, the London broker would use a correspondent not on the Mainland but in Hong Kong, and the Hong Kong broker will execute “Northbound trades” (those headed to the SSE) via a special purpose vehicle (SPV) of the Hong Kong Stock Exchange rather than a mainland broker. In effect, the Stock Exchange of Hong Kong (SEHK) becomes the agent to execute and hold the SSE shares for all transactions.
Southbound trades, transactions by Mainland Chinese investors buying or selling shares on the SEHK, work analogously. A Chinese investor’s broker executes the trade using an SPV of the Shanghai Exchange. (See illustration)
Another jurisdictional quirk stemming from the structure of the scheme has to do with what lawyers call “security interest in property ownership”, which means, “how do I know the shares being held are legally mine?” What gives rise to the question is that the shares will be held, not by the investors themselves or their custodians, but by CCASS, the SEHK clearing entity, on behalf of the ultimate investors in an account within the Shanghai Exchange’s clearing entity Chinaclear. Developed country legal systems have long recognised such “nominee account” structures, where Bank A, for example, holds property such as securities that are recognised as belonging to the customer, the beneficial owner. If Bank A goes bankrupt, creditors can’t lay claim to the securities because they are not assets of the bank but of its customers. However, no such nominee structure exists under Chinese law. Hence investors and intermediaries are grappling with the question of how to protect their security interest in the shares.
This ambiguity can and doubtless will be resolved. The SEHK has made clear in public and written statements that it disavows any ownership claim on Stock Connect shares held by CCASS. The ambiguity will likely be dispelled when Chinaclear publishes provisions in its rules addressing the question. The CSRC approves Chinaclear’s rules so such a provision would have the sanction of Chinese regulation and settle the matter.
Another rather technical quirk has to do with the fact that shares bought and owned via Stock Connect are not fungible with those purchased onshore via such vehicles as QFIIs or RQFIIs. Brokers and customers need to treat Stock Connect A shares as separate from QFII and RQFII A shares all the way from execution through the middle and back office so that no possibility of intermingling exists. Aside from the need to re-program systems, this in turn calls for new “symbology” on the part of data vendors such as Thomson-Reuters, Bloomberg and others who have to create unique codes for the millions of securities traded around the world, such as RICs (Reuters Identifier Codes), SEDOLs codes, and MICs (Market Identifier Codes).
Uncertainty about taxes has also raised questions. A capital gains tax of 10% is in Chinese tax law but Chinese tax authorities have not been enforcing it for some years. In principle the authorities could announce retroactive collection of the tax. The trouble is should that happen, the investors who incurred the tax may or may not be in the market any longer, and brokers may well lack the information they need to calculate the tax even with the best will in the world. Customers can switch brokers, after all, or use more than one, so that none of the customer’s brokers have the full picture. Similar issues apply to business (VAT) taxes. The possibility that brokers could be held liable for customer back taxes that they can neither verify nor collect is an off-putting prospect for brokers’ risk and legal teams, to say the least. Clarification from the State Administration of Taxation would lift the uncertainty.
Differences in settlement and infrastructure will also call for some adjustments. In the Mainland market, Chinaclear knows the location of all stocks down to the client level. When a client sells, the shares in the account are earmarked. This prevents accidental sales beyond the amount owned and means delivery fails are impossible. However, Chinaclear will not be able to see through to the ultimate client accounts for Stock Connect because the shares are held in an omnibus account by CCASS, as described above. Hence, to prevent fails sellers will be required to pre-deliver stocks to their brokers at least one day prior to the sale. This runs afoul of customary practices and in some cases institutional investment policies. It also creates significant operational challenges for clients, brokers, and custodians—as well as additional costs.
Then there’s the settlement cycle. Chinese stocks settle and transfer from seller to buyer on the trade date, but money settles the following day, on T+1, a cycle known as “Free of Payment” (FOP), in contrast to the more usual Delivery vs. Payment (DVP) where stock and cash move simultaneously. Institutional clients accustomed to DVP have to decide whether one-day’s exposure to their broker is acceptable commercially and consonant with their investment policies. Alternatively the broker could finance the proceeds of a sale and pay clients on the trade date, creating synthetic DVP, but then the broker is out the money for a day. Brokers and clients can adopt various fixes, such as T0 payment and delivery, but any fix comes with some combination of credit risk, operational headache, and cost.
Dealing with quota
Stock Connect is a pilot project and initially, at least, a daily quota of 13 billion RMB and an aggregate quota of 300 billion RMB will set limits on Northbound purchases. (The Southbound limites are 250 billion and 13 billion RMB respectively.) The SEHK plans to disseminate remaining quota balances every five seconds. This creates execution risk as investors will have to take into account the possibility that an order may not be executed if either the daily or aggregate quota might breach its limit. As the pilot demonstrates success, the quotas will doubtless be expanded and eventually eliminated altogether. In addition, foreign investors may hold at most 10% of any company stock and must report their holdings to the CSRC when their holdings reach 5%.
Buying Renmimbi to pay for the SSE stocks also involves more than meets the eye. Northbound investors have to pay for their purchases or get paid for stock sales in offshore RMB, or CNH. CNH are RMB balances that have accumulated offshore over time as a result of trade. Although CNH and onshore RMB, or CNY, are both Renmimbi, CNH cannot be used for onshore transactions on the mainland and vice versa. As a result, the exchange rates of CNH and CNY often do differ slightly, and they also have different yield curves. This quirk means that the effective prices in terms of Northbound investors’ home currencies may differ from those based on the onshore exchange rate. Investor education on this point will be advisable and both brokers and customers will want to keep an eye on CNH liquidity as they plan their Northbound buying strategies.
The Shanghai-Hong Kong Stock Connect is a bold project, unique in a number of ways. Its structure and function features a number of quirks that over the long term will likely be mere blips in a historic initiative. The Hong Kong Exchange is working overtime to ensure success, engaging vigorously with the industry to educate brokers and clients and to address concerns. The Shanghai Stock Exchange, the world’s fifth largest exchange by turnover in the first half of 2014, is similarly engaged while adjusting its mindset to the novel prospect of a global customer base. Regulators in Hong Kong and Beijing are forging a closer relationship to make the scheme work. Stock Connect is a pilot, but the odds are high that it will evolve into a thriving two-way channel of investment into and out of China. Bringing stocks of the world’s second largest economy, largest by some measures, to investors around the world for the first time is bound to have a transformative effect on the global equity landscape for all players.
By Nick Ronalds, Managing Director, Equities, ASIFMA