The establishment of the Hong Kong-Shanghai Stock Connect programme, the new cross-border investment channel designed to allow investors in Hong Kong and the mainland to trade specific listed stocks in each other’s market, is pushing custodian banks to design creative solutions to overcome significant technical and operational issues involved in this pioneering effort.

Since this is the first time such a cross-border investment channel will exist, participants and potential investors in the Hong Kong-Shanghai Connect scheme are facing a number of challenges related to the securities trading rules, capital gains tax and clarity of title. As of press time, the implementation of the scheme, expected in October this year, has been postponed indefinitely.

While the overall objective of the scheme, which is to allow cross-border access to equities trading for investors on both sides of the border may be beneficial to all participating parties, it also raises challenges covering taxation as well as differences in regulation, trading practices and trading hours, among others.

Even if all the remaining concerns are resolved overnight, experts agree that with such a massive and untested securities/stock trading scheme being implemented for the first time, this means that the first year or two will be a learning curve for all participants including regulators, brokers, traders and investors, on how the scheme can properly work.

There are two sets of service providers involved in the Hong Kong-Shanghai Connect – the custodians/sub-custodians and the brokers.

These providers overlap in some aspects since a number of custodian banks offer both custodian and brokerage services. It used to be that these services were siloed in most custodian banks but in recent years, there has been a trend for custodian and broker units to leverage off each other.

In the case of this scheme, it’s clear that custodians and brokers have to find new ways to work closely together to overcome some of the unique technical and operational aspects involved in this ground-breaking programme.

Lawson: Delivering stock in advance of sale is a no-no to traders

Pre-delivery issue

One issue that highlights this is the requirement involving pre-delivery of stocks by the seller to the broker before the sale of the stock takes place. Under this requirement, sellers of stocks, principally institutional clients of the custodians and the brokers, that want to trade using the Hong Kong-Shanghai Connect must transfer the shares from their custodian bank to a broker before 7:45am on the day they plan to execute a trade. This requirement is unique to the programme and is not a normal practice in other exchanges.

Critics argue that transferring shares to a broker before a sale takes place can leave the trade vulnerable to information leaks and other counter-party risks. The pre-trade transfer of securities/stocks also involves increased costs.

The pre-trade requirement under the Hong Kong Shanghai Connect is due to a segregation of securities in the China market that doesn’t exist in Hong Kong.

When trading securities in the Shanghai stock exchange, for example, the segregated account of the depository, the seller of the securities nominates a broker and the securities are segregated so that the broker can always identify which stocks are available for sale by this particular seller.

In Hong Kong, there is no similar mechanism such that the brokers effectively have no way of knowing what securities are available for sale by any of their clients/seller.

Also, in the China market, at present there is no concept of uncovered/naked short selling (short selling shares that have not been positively determined to exist) or “fail” trades (when a seller does not deliver securities or a buyer does not pay owed funds by the settlement date). Hence, the only way to ensure completed transactions under the Hong Kong-Shanghai Connect is for exchange authorities to take a snap shot of the securities held by a market participant intended for sale on a particular trading day.

This means that if a particular set of stocks is not clearly held by the seller when the exchange authorities take the snap shot, these securities cannot be sold on that day.

Drumgoole: Providing a single point of reporting and custodian protection

Thus, the Hong Kong-Shanghai Connect has to come up with a similar mechanism that will allow the brokers to determine what stocks are available for sale by market participants during a trading day and the solution they came up with is the pre-trade delivery of the stocks.

Pre-trade delivery of stocks, however, involves heavy risks on the part of the seller. Most securities sellers and market participants would prefer to keep the securities with their custodians instead of transferring them to the broker before a sale takes place.

In addition, the exchanges also require delivery-versus-payment (DVP) for the stocks that are sold. But since pre-delivery is a mandatory requirement of the Hong Kong-Shanghai Link, custodians and brokers are trying to find solutions that will comply with this requirement but minimize the risks. DVP is intended to minimize if not eliminate risks.

Currently, there are two possible models/solutions that sellers, custodians and brokers can use to comply with the pre-delivery requirement.

The first model applies to sellers whose brokers do not have affiliated custodians. Under this approach, the seller has to pre-deliver the stocks to the broker. The broker then has to transfer the payment directly to the seller through their local real time gross settlement (RTGS) system.

Because of the risks involved in the pre-delivery and the payment scheme, this is not something brokers and sellers want.

The second is a solution which will effectively address the pre-delivery requirement as well as facilitate DVP settlement.

The J.P. Morgan solution

J.P. Morgan is one of a number of custodians to formulate a solution where the latter will appoint an affiliated broker to effectively safekeep the A shares on behalf of the custodian and the bank.

Bailey: Institutional clients do not want others to know what they’re doing

To benefit from this model, the seller must use the relevant custodian and their affiliated broker for custody and execution respectively. The arrangement removes the need for pre-delivery of stocks and allows for DVP settlement.

“All the reporting is still consolidated through the custodian entity back to our end clients. We can monitor exactly what they have with the broker, so they’ve got a single point of reporting plus the protection of the custodian entity that they’ve appointed in the local market,” says Michael Drumgoole, Asia-Pacific head of the direct custody and clearing (DCC) business at J.P. Morgan.

Drumgoole, Andrew Lawson, senior product manager for J.P. Morgan’s global custody business, and Elvis Goh, product manager for sub-custody in Hong Kong, along with their business partners in J.P. Morgan’s brokerage unit, were primarily responsible for crafting this solution that involves the use of the bank’s custody and broker affiliates in a way that will comply with the pre-delivery requirement.

Lawson admits that the model restricts a seller to using only J.P. Morgan as custodian and broker but he argues that the benefits outweigh the risks.

“The way the regulations are written, clients (sellers) were being asked to have a crystal ball. They were being asked to know when they wanted to trade a stock tomorrow. Delivering stock in advance of a sale is really a no-no for traders. So under this model, the ability to pick up the phone to J.P. Morgan brokerage at any point during the day and just having that ability to immediately place a sale order is hugely important to a client and hence that was the genesis for a coordinated model,” Lawson explains.

“Institutional clients do not want others to know what they’re doing. They want some level of confidentiality. They want to tell people just in time that they’re trading. Fundamentally, it’s just a pipe to settle trades with that nuance around how the market works,” says Laurence Bailey, Asia-Pacific head of investor services sales at J.P. Morgan.

Goh also argues that sellers of stocks would normally want their custodians to handle payments and settlement of securities particularly when these involve cross-border elements.

“I’m sure there are other sub-custodians out there who do not have an in-house brokerage affiliate. They have no choice but to offer the traditional model whereby they are subject to the pre-delivery and subject to settlement of cash outside the platform,” Goh notes.

Drumgoole, Lawson and Goh agree that a number of market participants may not be able to participate in the Hong Kong-Shanghai Connect scheme at its start because of technical and operational issues. But they are optimistic that such problems will be resolved gradually as the programme evolves and more market participants join.

In general, the custodians are making sure the procedures for the Hong Kong-Shanghai Stock Connect are in place to make it ready to operate from day one.

For some investors, having their secuities safekept at a broker or settled free of payment is a concern and in certain cases, a regulatory issue. Thus, custodians are looking for ways to ease this concern on the part of such clients.