Expanding The Connect
Shane Neal, Head Trader at Matthews Asia, examines the enhanced model of the Shanghai-Hong Kong Stock Connect, and the drive towards Shenzhen.
Launched in November of last year, the Shanghai-Hong Kong Stock Connect (SH-HK Connect) initiative provides mutual market access between the Hong Kong Stock Exchange (HKEX) and the Shanghai Stock Exchange (SSE). This is undoubtedly one of the most interesting market structure developments I have seen in my career. The exchanges, regulators, banks, brokerages and fund managers have devoted vast resources to ensure its successful implementation. Many traders were tasked with understanding and communicating various new aspects of settlement mechanisms, taxation, and the securities laws, as the China model provided some unique features. At Matthews Asia, we began using the SH-HK Connect in the first half of 2015 as a complement to our investments in Chinese-listed A-shares via the Qualified Foreign Institutional Investor (QFII) program.
The enhanced model
An original feature of the SH-HK Connect trade workflow required sellers to transfer securities to be sold into the account of the executing broker prior to the trade as a way to ensure stock was available for delivery and reduce risk of failed settlement. Many fund managers had concerns that this pre-delivery of shares in free-of-payment method would lead to information leakage, and it could also conflict with custody compliance requirements in several jurisdictions. To address this concern, an integrated model of pre-trade checking was designed by banks that had the ability to link their execution and sub-custodian platform. This allowed for a fund’s assets to remain in custody as the broker could verify positions prior to trading without free of payment transfer. While effective in addressing the issues surrounding pre-delivery, an investment manager was left with a single broker trading solution based on a fund’s sub-custodial relationship.
The developers of SH-HK Connect more recently introduced special segregated accounts (SPSA), whereby investors open account(s) with a unique ID in the Central Clearing and Settlement System (CCASS) via their custodian, in order to keep shareholdings of investors separate. Once the SPSA accounts are open, a fund manager can link multiple brokers, which I believe is the best way forward for SH-HK Connect. This model could be enhanced to closely resemble other ID-based markets in Asia, with linked broker trading accounts and omnibus trading agreements maintained by brokers, as this is already familiar to most foreign investors.
Increasing investor participation
In order to attract more participation, regulators in China and Hong Kong have been receptive to feedback for reforms to the program, which is clearly set to develop and grow. A few issues continue to arise when discussing SH-HK Connect with those already using it and those still waiting for enhancements.
One challenge for international investors remains the T+0 settlement of securities, and T+1 settlement for cash, as it is not in-line with developed market practice, and creates operational challenges and potential counterparty risk. Investors with operations departments in other time zones may find it difficult or costly to accommodate. With foreigners making up a small portion of the market currently, it is unrealistic to think China will adopt an entirely new trade settlement mechanism. Hopefully, China can find a way to accommodate foreign investors while the market matures.
It also seems that the regulations governing stock borrowing and lending of northbound Stock Connect securities could benefit from modifications. At present, only SH-HK Connect exchange participants can lend SSE securities, but these entities aren’t typically capitalised for stock borrowing and lending operations, so short selling of SSE securities has been a non-event. An alternative arrangement may be to allow for the affiliate entities of the exchange participants in London or New York to conduct stock borrowing and lending operations.
Lastly, the daily trading limit imposed on northbound access was also highlighted as a “capital mobility” issue by MSCI in its recent decision to postpone the introduction of China A-shares into its global indices. Many investors believe this daily limit should be lifted because it is a great source of uncertainty for investors who need to trade near the close of day. As modifications and developments like these are introduced, the overall accessibility of the China A-share market for foreign institutional investors will likely improve.
There is no shortage of potential issuers or lack of liquidity in China’s A-share market, which are the two of the biggest challenges faced by many other global exchanges. Over 500 A-share IPOs are pending listing according to the CSRC website, so there is certainly interest among foreign investors to access the China’s IPO market. At present, SH-HK Connect participants are restricted from participating in China’s IPO market. QFII and RQFII (Renminbi Qualified Foreign Institutional Investors) investment schemes allow for investors to participate in IPOs, but it can be complicated and dominated by retail investors.
Additionally, it seems that both the regulators in Hong Kong and in China would have concerns about who is accessing an IPO via the northbound Stock Connect link and the protections required for investors in the primary market. Since investor IDs are not required to track northbound trading, it seems unlikely that the regulators would be able to open IPO participation outside the domestic market and QFII/RQFII investment schemes. Something interesting to watch for will be the eventual first rights offering conducted by an A-share listed company with shareholders via the northbound Stock Connect. This would be a good test for regulators and market participants and could be a stepping stone for future primary market developments.
The Shenzhen desire
The regulatory and technological framework for SH-HK Connect can be used to for additional trading links, like the much anticipated Shenzhen-Hong Kong Connect (SZ-HK Connect). The Shenzhen Stock Exchange (SZSE) is dominated by small and medium sized companies, as compared to Shanghai-listed companies, most of which are mature businesses. Access to trading SZSE listed securities had been limited to domestic and QFII/RQFII investors, so the SZ-HK Connect will increase the investable universe for many international investors into more diverse sectors and market capitalisations. The official launch date and details regarding the number of stocks available via the SZ-HK Connect are still pending, but I’d expect a similar timeline of events that preceded the Shanghai-Hong Kong Connect launch. First there would be a joint announcement by the HKEX and SZSE, followed by a period of systems testing, then publication of final rules and tax clarity, before going live. From my recent meetings with representatives from the CSRC and SSE they are clear in saying that the mechanism for any future trading links will be consistent with that of the SH-HK Connect. I would expect other major global exchanges have discussed their own links to China. This opportunity could also grow to include different asset classes as well. It’s possible to envision HKEX, as owner of the London Metal Exchange, making commodities futures trading available to mainland China.
These trading links and other future developments represent a significant step in China’s financial reforms and the opening of China’s capital markets.
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