Hong Kong Connect: More Questions Than Answers
With Emma Quinn, Head of Asia Pacific Trading, AllianceBernstein
There was a lot of excitement when the Hong Kong-Shanghai Connect scheme was initially announced because QFII and RQFII have a lot of restrictions. It’s difficult to get quota, and for repatriation, the daily or monthly flows depend on which licence you have. Everyone was very excited to hear of another mechanism to access China, but once people got into the detail, there were some things about the structure that would mean that QFII and RQFII are definitely going to remain a key element of institutional access to China. The Connect will stay as a second product, simply because there are things that the long only buy-side need clarified or changed in order for them to actually transact using the Connect.
The A-shares will sit in China within the Hong Kong Securities Clearing Corporation’s custody account, with their name on the share register. Under Chinese property law, the share register is the way to legally recognise ownership and, there is no concept of beneficial ownership being different to legal ownership. This means that if I ever had to get into a dispute in the Chinese courts, it is unclear how my ownership rights would be treated. It has not been confirmed that I will have control over the voting rights. Capital gains tax is still to be clarified by the tax authority.
Even if I wanted to use the Connect, I can’t physically do so. Say hypothetically I have 15 accounts with different global custodians. First of all I need to set up some sort of sub-custodian relationship across the board. Since there is a requirement to have the stock in the brokers account pre open on T, I’ve got to get all these accounts to agree that I can set up a sub-custodian relationship so I can transfer my shares to that sub-custodian, probably on T-2 depending on where the custodian’s located.
This is not a process that we have in place here, or in any other market. It makes it almost impossible to implement because we ask, “Is this really how we want to be spending our time and resources when we have QFII?”
So there are the structural challenges, and then there are the technological challenges as well. For example, if I have my QFII account and then the same account also wants to deal in Shanghai on the Connect, I have to then differentiate between those two holdings. So when it comes onto my blotter, I then have to know that some are .HK and some are .SHH in the same names. The Shanghai holdings I can only trade through one broker even though it says I can trade it with three. The Hong Kong holdings I need to have some way to show which broker (if I decided I wanted to set up a multiple sub-custodian relationships to get best execution and trade with more one broker) I actually placed shares with one or two days before I can sell. I also just don’t know two days before what we’re going to sell and as a consequence, I can’t react to market events when I’m selling.
And, my personal view is that many of these will remain outstanding for a while.
Because of the MSCII decision not to include China in the emerging market indices there is definitely more time and a firm incentive to have a look at the structure. I think the long only buy-side managers would say that this doesn’t give them a clear way to access the Chinese market, especially with concerns around the capital gains tax and the ownership questions that remain.
October is not very far away. From a broker point of view they’re trying to ready themselves because there are a lot of hedge funds that can trade on swap, so they’ll do it that way and get around the pre open position check requirement. The fact that they can work around having to set up the custodian relationships by using swaps is something like a prime broker relationship. For a long only account this is something new; for hedge funds, it’s not. So for hedge funds this is probably an easier way to access the market, and for brokers it may be a way to free up some quota capacity for their QFII to redeploy into the fixed income markets. So the brokers are trying to work it out but I haven’t had a broker yet come to me and say “I’ve got the answer”.
I think we also want clarification on what stock codes will be used and how we’ll make sure of that in our systems. There is also the Free of Payment (FOP) issue. I transfer my shares, will I get the cash the next day? Do I have to go back and check to see whether I’m allowed FOP and what technicalities follow, whether I need some sort of legal document around that? Do I just set up a Renminbi cash account for each client account? How much more counter party risk, ownership processing, and paperwork is there around the beneficial owner in China? How can I ensure that we don’t buy and sell the same day? What happens if, in the morning, I buy for an account, then, in the afternoon, I get a cash float and I have to sell out? Am I allowed to do this under the rules?
Quota and benchmarking
One key area is around the quota, and around benchmarking on the MSCI index includes China; you benchmark to the close because you want to have the position by the open of the next day. The daily quota gets used up in the morning, so therefore you can’t enter any more buys orders, what do you do? You can’t put in any market price on close orders. There could be a chance that there is still quota left for the close but if everybody piles in on an inclusion day, or the day before an inclusion day and the quota is gone and you cannot get your buy orders in, you can’t meet any benchmark.
The daily quota is based on buy orders minus sell executions with an adjustment made for unexecuted buy orders once the order has been cancelled. There are concerns that some could enter out-of-market buy orders to use up the quota, even though the exchange are going to be monitoring.
There is progress on many of these issues, and the industry and all the associations are working together. We all like the concept and we all want an easy way to invest in China, but we have to think about alternate ways of achieving it and improving on the process.