By David Gilmour, Principal, Deloitte Are the Tracks ready and clients on the station ready to board? In April 2014 at the Asian Economic Forum in Boao, Premier Li Keqiang announced the launch of the Shanghai – HK Stock Connect Pilot scheme. The scheme was proposed to be launched in October 2014 (subject to final confirmation), six months from when it was announced. It is worth noting that this so called “Through Train” stock trading initiative was proposed seven years ago but was put on hold for a number of reasons. Subsequently, the Chinese regulators allowed limited access to the offshore equities markets by creating the QFII and QDII schemes. As you would expect, with the tight timeframes involved, many market participants have been preoccupied with overcoming the challenges to prepare for the new scheme and secondly to confirm readiness, especially in the context of managing the different types of risks and briefing all clients about the implication of participating in the scheme. Some of the critical areas that are being considered include: • Trading – Order execution is the first hurdle. Two industry wide connectivity tests with the Hong Kong Stock Exchange have been scheduled for August and September. For stockbrokers hoping to become the first batch of entrants, they need to enhance their internal system to cater to the different trading rules while creating new stock codes to separate holdings and establishing internal control and procedures to perform pre-trading checks as required by the Shanghai Stock Exchange. Considerations – have business requirements been written? Have all systems been enhanced? Have internal UATs been completed? • Pre trading rules and checks – prior to any buy order placement, the broker will need to confirm that the client account has the required amount of RMB/CNH. Likewise, the broker will need to confirm that shares are available in the client account prior to any sell order placement. Whilst common in the stock exchanges in Shanghai and Taipei, it is not the current requirement in the Hong Kong market. Participants will need to ensure that internal risk management, credit and settlement systems can cope with the new requirements before they can consider going live. For Hong Kong investors, the scheme implies that they cannot perform short selling and intraday turnaround trades. Considerations – have business requirements been written? Have all systems been enhanced? Have all operations procedures been updated? Have all internal sign offs been obtained? • Ownership – the scheme states that all stocks will be held in an omnibus account at CCASS under the account of the HKEx clearing entity. The use of the proposed nominee structure is not unusual in developed markets but such structure does not exist under the Chinese law as all stock holdings in China are held at the investor level. HKEx has stated that they do not and will not have any ownership over the shares but until the Shanghai depository “Chinaclear” updates the existing rules the ownership of shares will still remain ambiguous to investors. Considerations – have legal and compliance reviews of existing client documentation been conducted to ensure alignment with the ownership rules? Have the risk and compliance departments been consulted on the implication of omnibus holdings? Has operations department considered how to report to clients under the new account structures? • Settlement – there are differences in the settlement structures between Shanghai and Hong Kong. The Shanghai settlement mechanism does not follow the current Hong Kong settlement cycles. The main difference is that Chinese stocks settle and transfer on trade date with the money settlement occurring on T + 1. This means it is not a delivery versus payment structure and clients will have a credit exposure to the broker for one day until the final settlement. There may be various workarounds between the clients and brokers but these are not currently clear and any structure will create risk, operational challenges and additional costs. Considerations – have settlement processes been reviewed and updated? Have your reporting and settlement systems been enhanced? Have you connected and agreed with other market participants, such as custodian service providers over the procedures for the future? Have you obtained the sign off from operations and risk management departments? • Fungibility of Shares – another important issue for investors is that shares purchased via the Shanghai – Hong Kong Stock Connect program are not fungible with shares bought onshore via QFII and RQFII vehicles. Therefore shares cannot be comingled and it is expected that different code / symbols will need to be established to enable participants to easily separate the trading and holding of shares. Considerations – Have client briefings been conducted? Have new codes been established to separate the onshore / offshore holdings? Have databases been updated for all systems? Have procedures been agreed to track holdings? • Quota Risk – the initial quotas for Northbound trading are set at RMB 13 Bio per day and RMB300Bio in aggregate. Southbound limits are set at RMB10.5 Bio per day and RMB 250bio in Aggregate. Aggregate quota control only applies to buy orders, sell orders will be allowed regardless of the quota levels. The aggregate quota will be calculated at the end of each trading day. Daily Quota is calculated real time during the trading day. There are 3 scenarios brokers and investors need to note if the daily quota is <=0: • The exchange will reject all new buy orders during the pre-opening session • Suspension of all buy orders input during the market hours • Buy orders already input in the CSC before suspension will not be affected Quota information: The HKEx proposes to distribute market updates to brokers every 5 seconds. Brokers will need to monitor these limits and be able to capture updates to their execution and risk systems. Considerations – have business requirements been written, systems enhanced and internal UATs completed, client reporting defined and designed, risk sign offs obtained, operational procedures updated and clients briefed? • Foreign Ownership Another key issue to address is the foreign ownership limits. Brokers and clients will need to monitor the foreign investor holding limit per the mainland regulations. Following changes to the official limits (June 2014) are set at 30% for the total holdings by all foreign investors in a single stock. And the single investor limit per stock is set at 10%. Investors need to track limits across all holdings i.e. (QFII Qualified Foreign Institutional Investor+ RQFII Remimbi Qualified Foreign Institutional Investor + SH – HK Stock Connect holdings) , i.e. all accounts held with custodians and brokers if more than one is to be used. Considerations – have business requirements been written, systems been enhanced and internal UATs completed, client reporting defined and designed, risk sign offs obtained and operational procedures updated? • Tax – another critical area that needs clarification is Capital Gains Tax (CGT). It is stated in Chinese law that there is a 10% CGT but Chinese tax authorities have not been strictly enforcing the collection of the CGT. The use of multiple brokers may complicate the tracking of tax obligation and it is possible to be imposed by back taxes after all positions have been sold and cash-settled. The market is still awaiting clarification from the State Administration of Taxation to enable brokers and th
eir clients to understand the procedures and implications of participating in the pilot scheme. Hong Kong brokers will need to ensure that they fully explain to clients the known situation and anticipated risks before the scheme goes live. Considerations – have business requirements been written? Have tax consultants been engaged? Have all systems been enhanced and internal UATs been completed? Has client reporting been defined and designed? Have you obtained sign off from internal Tax department? Have operational procedures been updated? The overall reaction from many market participants to the prospect of more free and open access between the two exchanges has been extremely positive, ironically as it was in 2007 when it was first proposed. Up to 100 brokers have expressed their interest in being the first batch of participants in this pilot scheme. The pilot scheme between Shanghai and Hong Kong is another groundbreaking step to open new opportunities for Mainland and international investors and create a viable mechanism for investing in Mainland stock markets with offshore RMB. The Through train is coming, are you ready to be on board?