Stock Connect: Will Fund Managers Hop on the HK-Shanghai Express?

Mainland China is trying to make it easier for foreign fund managers and other investors to access the local market, but so far teething pains are preventing a huge uptick for the so-called Shanghai-Hong Kong Stock Connect program launched last November.

Although heavily hyped by China and the international financial press, legal and operational experts caution that the new initiative still needs work before it’s ready for prime time. No one appears to be betting that the new express route to the Shanghai exchange will outrun the legacy QFII regime any time soon.

The Stock Connect program gives China a controlled mechanism to open its equity capital markets to foreign investment and boost further development of the offshore renminbi business in Hong Kong. Subject to daily aggregate quotas, Stock Connect allows foreign fund managers and others to use the so-called “northbound leg” to trade in corporate shares on the Shanghai exchange through Hong Kong brokers. On the so-called “southbound leg” mainland investors can trade shares on the Hong Kong exchange through mainland China brokers. The addition of a leg to the Shenzhen exchange is now being discussed as well, but until current issues are ironed out, it may suffer the same initial lackluster results with foreign investors as the Shanghai exchange.

“In offering an additional means by which foreign investors can access the Shanghai stock exchange, China is understandably taking a cautious approach, but fund managers have to stack up the legal and operational challenges of Stock Connect against the QFII program,” says Keith Robinson, a partner at Dechert LLC in Washington, D.C.

Under the QFII or the qualified foreign institutional investor regime established in 2002, foreign fund managers can invest in mainland China after filing the necessary documentation with the China Securities Regulatory Commission to be categorized as a QFII. Once that designation is won, each fund manager must then obtain an investment quota from the State Administration of Foreign Exchange and may trade up to the limit of the quota, which puts no restrictions on daily trading activities. The People’s Republic raised the total foreign investment quota allowable through QFII from an initial US$30 billion to US$80 billion in 2012 and US$150 billion in 2013.

Chinese regulators have also simplified the QFII process by requiring far less paperwork than originally. Instead of asking for audited statements for the past three years, the Chinese regulatory agency now accepts the past year’s statement. In addition, rather than requiring proof of custodian bank agreement, only a letter authorizing the custodian bank to provide services will be necessary. What would take up to 18 months could now take only six, two US fund management compliance directors tell FinOps Report.

The Stock Connect program enables foreign investors to bypass the QFII process to trade in shares listed on the Shanghai Exchange, known as Series A shares, through Hong Kong brokerage accounts. However, the People’s Republic has set a limit on all Stock Connect transactions, regardless of how many investors are involved, to 13 billion yuan a day. On a day of active buying and selling, a foreign investor placing a buy order might be out of luck if the daily total quota limit has already been reached.

“Early experience with Stock Connect shows that the daily quota hasn’t been surpassed under normal conditions, but the limit remains small and could be problematic during active trading periods,” says Robinson. So far, the limit has only been hit during the first trading day last November as the result of pent-up excitement which quickly fizzled.

Key Roadblocks

Even if the foreign fund manager is in luck and isn’t hampered under the pooled quota system, there is a critical intertwined legal and operational issue which is reportedly delaying participation by foreign fund managers. Because the settlement cycle in China is based on same-day settlement for shares and next-day settlement for cash, the shares and cash must move separately. That’s a far cry from the internationally accepted delivery-versus-payment methodology.

Practically speaking, it means that fund managers selling shares of Series A stock on the Shanghai exchange must allow their local custodian bank in Hong Kong to transfer their shares to account of their Hong Kong broker at Hong Kong Securities Clearing Company (HKSCC) on the day before the sale is made. Should the Hong Kong broker go bust between the time the shares are sent over and the time the sale is made, the fund manager could be in the hole for the entire amount.

The reason: the foreign investor’s account is held in an “omnibus” account at China’s central securities depository in the name of HKSCC. Historically, Chinese securities law has not acknowledged the idea of beneficial ownership.  Although the rules of the Stock Connect program do consider HKSCC as the nominee owner of shares on behalf of ultimate beneficial owners, it remains to be seen whether such an interpretation will be upheld by the People Republic’s court system and regulators, legal experts tell FinOps Report.

“Some local custodian banks have made accommodations by providing local brokerage services which will offer fund managers with some comfort, but that’s not a complete panacea,” says Roger Harrold, a director with consultancy AlfaSec in Singapore, which specializes in securities operations. Notably, HSBC, Standard Chartered and BNP Paribas Securities Services have local brokerage affiliates as well as Hong Kong-based custody services.

Hesitant Regulators

Still, the US Securities and Exchange Commission hasn’t provided any US registered investment advisers with clear guidance and most European regulators have been hesitant to give European-domiciled funds which fall under the continental UCITS regulation their blessings to participate in the Stock Connect program.

“A number of Luxembourg UCITS have already seen the opportunity that this represents and sent their applications to the supervisory authority and the first one has been approved,” says the Association of the Luxembourg Fund Industry (ALFI) in a statement issued in early December 2014. However, it did not name the UCITS-eligible fund or specify just how many were interested.

A recent survey by the Hong Kong Investment Fund Association (HKIFA) found that only 13 of the 41 member firms which responded are participating in Stock Connect, and even so on a limited basis. Participants in the trade group’s study were primarily global asset management companies, including regulated funds, pensions and other institutional mandates, representing approximately US$20 trillion under management.

Although a statement issued by the HKIFA earlier this month sounds optimistic about the prospects for Stock Connect’s future success, it cited the uncertainties over the beneficial ownership of shares, segregation of accounts and pre-delivery of stock as the top reasons its members aren’t eager to fuel Stock Connect’s engine. Over 80 percent of authorized funds in Hong Kong are UCITS-eligible and any investment funds which fall under the European designation must comply with strict legal requirements ensuring the ownership rights of investors.

Current participation in Stock Connect pales in comparison to the over 200 firms have received QFII status. Traditional long-only fund managers and other regulated funds and pension mandates remain hesitant about Stock Connect, says the HKIFA’s Chairman Bruno Lee in a recent statement.

While European and US fund managers are not likely to abandon their participation in the QFII program in favor of Stock Connect any time soon, Stock Connect could offer additional opportunities for QFII participants. “For those already registered as QFIIs, Stock Connect will likely be an excellent way to increase their investment in the Chinese market,” acknowledges Patrick Wong, head of China sales and business development for HSBC’s securities services unit in Hong Kong. “Stock Connect should be considered a supplement to, rather than a replacement for the QFII regime.”

AlfaSec’s Harrold also recommends that foreign fund managers take into account just how much they want to invest into mainland China and if they want to diversify beyond Series A shares on the Shanghai exchange. “The QFII regime remains proven and traditional fund managers should not withdraw from the process prematurely,” he agrees.

In the short term, Stock Connect’s sweet spot could well be hedge fund managers or high-net-worth investors wanting to dip their toes into the Chinese market, legal and operations experts tell FinOps. Based on its early track record, opportunities for speculation have been drawing the early adopters.

“Given the recent inception of Stock Connect, the lack of clarity regarding beneficial ownership issues and the absence of any direct relevant guidance from the SEC, US fund managers and their boards should inform themselves of how Stock Connect works and carefully consider their compliance and disclosure obligations before diving in head first,” warns Robinson.

As a compliance manager at a US mutual fund complex tells FinOps: “We’re certainly interested in the mainland investment opportunities, but not at the point of taking action on Stock Connect.”