THE Stock Connect, a mutual access scheme that allows Hong Kong investors to access the China equities market and vice versa, achieved a breakthrough year in 2017. It may be in for an even better year if things go as planned in 2018.

However, a number of challenges still have to be addressed before the Stock Connect can be truly successful.

Under the Stock Connect, the Hong Kong Exchanges and Clearing (HKEX) acts as a super broker and super clearer for overseas investors who want to invest in Chinese A-shares. The Shanghai and Shenzhen stock exchanges perform similar roles, assisting Chinese investors who want to invest in Hong Kong stocks.

“This super broker, super clearer model allow overseas investors as well as Chinese investors to trade as if they’re trading in their own home securities. It is the infrastructure of the exchanges and the clearinghouses that are really converting and translating the two systems,” explains HKEX chairman Charles Li to attendees of the Asian Financial Forum 2018.

The Stock Connect became a necessity for overseas investors that seek access to China equities, but are not ready to change their own trading processes, infrastructure, legal systems, and market dynamics to comply with the peculiarities of the Chinese securities trading system.

“Everybody wants to trade with China but they don’t want to build physical infrastructure in China. They don’t really want to open accounts and be subject to a different set of rules, procedures and laws,” Li says.

More important, Stock Connect makes it possible for China to do cross border trading and clearing of securities without having to completely do away with existing capital controls.

In 2017, two things happened that made the Stock Connect, perhaps the biggest story in China’s and Hong Kong’s equity markets. These were the implementation of the real-time delivery versus payment (DVP) mechanism and the announcement of the inclusion of 222 China A-shares in the MSCI Emerging Markets Index.

 

The situation changed dramatically on November 20 2017, when, after lengthy discussions between the regulators and market participants, the Stock Connect finally implemented R-DVP which effectively eliminated counterparty risks by requiring payment upon delivery of shares.

Before the R-DVP’s implementation, there was a time lag of four hours between delivery of the shares and payment resulting in counterparty risk which was unacceptable to overseas mutual funds, particularly the UCITS funds.

 “Real-time DVP allows real-time settlement of cash and securities from 16:45 to 19:00 (HK time) by batch, whereas under the SPSA model, investors were subject to a maximum four hour intra-day counterparty risk,” says Alessandro Silvestro, head of sales, insurance and director of securities services for Hong Kong at Standard Chartered Bank.

Positive reaction to the R-DVP from overseas investors was immediate particularly from the Central Bank of Ireland (CBI) and the Commission de Surveillance du Secteur Financier (CSSF) of Luxembourg. Both had previously banned UCITS funds in their respective jurisdictions from using the Stock Connect because of the counterparty risk issues involved.

“When it comes to funds from highly regulated jurisdictions such as UCITS, we had concerns about using the Stock Connect. That concern has been removed with the implementation of R-DVP,” says Rakesh Vengayil, Hong Kong CEO and Deputy CEO in Asia Pacific, BNP Paribas Asset Management, which services UCITS funds.

In fact, on the same day of the R-DVP rollout, the CBI and the CSSF immediately validated the Stock Connect, effectively allowing UCITS funds to use the scheme, thus, paving the way for their investment in Chinese equities.

“The fact that on November 20 both Ireland and Luxembourg immediately validated the DVP mechanism on the Stock Connect, that wasn’t an accident. That was a lot of work for us with hundreds of emails going back and forth to make sure they understood the whole machinery of the Stock Connect. It was instant approval and you never see instant approval from regulators,” says Barnaby Nelson, managing director and head of securities service, Transaction Banking Northeast Asia, and Greater China of Standard Chartered Bank.

MSCI inclusion

The rollout of the R-DVP was actually in preparation for the forthcoming inclusion of the 222 China A-shares into the MSCI Emerging Markets Index in May 2018.

Before the MSCI announcement, the Stock Connect has been plodding on quietly since the launch of the Shanghai-Hong Kong Stock Connect in November 2014. The launch of the Shenzhen-Hong Kong Stock Connect in December 2016 beefed up volumes for the Stock Connect programme as a whole, but inflows were weaker than expected.

However, the announcement of the MSCI inclusion made in June 2017 with its proposed target date of implementation originally set for June 2018 (it has since been moved to May 2018) prompted bullishness in the markets and generated a sense of urgency among participants.

“It all started very quickly around the time of the MSCI announcement. Suddenly the Stock Connect became very real for everybody. There were a lot of things that got fleshed out,” says a banker who participated in the discussions.

The resolution of the counterparty issue with the implementation of the R-DVP and the instant approval of the UCITS regulators fanned excitement around the Stock Connect.

A number of fund managers have registered with the Stock Connect as a result. “We foresee that demand will be gradually picking up. We have quite a few clients asking us to set up their accounts first and then to wait until the launch date of the MSCI inclusion. This is a good sign rather than everybody waiting until the last minute and then setting up the accounts,” says Patrick Wong, head of China Sales and Business Development at HSBC Securities Services.

In terms of volume, data from the HKEX indicate that Shanghai Northbound turnover (buy+sell) surged 250% to 211 billion yuan in November 2017 from 82 billion yuan in December 2016. Although it dropped by 34% to 138.7 billion yuan in December last year, it was still 169% more than the level a year ago. Although a positive development the MSCI inclusion is creating a big problem for the Stock Connect, fund managers note.

They say the inclusion of the 222 A-share stocks in the MSCI EM index in May may create liquidity problems for users of the Stock Connect unless they are allowed to use onshore renminbi (CNY) for financing their trades in addition to the offshore renminbi (CNH), which they currently use.

When the MSCI inclusion happens, investors and fund managers will have to rebalance their portfolios to match the asset allocation of the MSCI EM index. Essentially this means that the

fund managers have to raise their allocation to China A-shares by 5% on or before May 2018.

With so many investors and fund managers buying A-shares at the same time, the issue is whether there will be enough CNH in the market to finance the expected increase in trading volume particularly during the “rebalancing weekend” or when the MSCI inclusion takes place officially. It remains to be seen exactly how much CNH is going to be used on a T+0 basis on the weekend of the MSCI rebalancing. The prospect of a shortage of CNH has raised concerns among investors, brokers and custodians who, together with the Hong Kong Monetary Authority (HKMA), are currently rushing to work out solutions that will allow users of the Stock Connect to tap CNY as well as CNH for liquidity in financing their Stock Connect transactions.

For now, the issue of liquidity is somewhat alleviated by the fact that the trading volume is capped at 13 billion yuan per day, the daily quota set by the Stock Connect.

“Before the MSCI inclusion, the daily quota functions as a check on the system because at any given day all the banks (in Hong Kong) need to do is find 13 billion yuan in net liquidity and send it to China for settlement of the trades,” says Cindy Chen, country head, Hong Kong Securities Services, Citi.

 This daily quota remains despite the removal of the aggregate quota (maximum cross-boundary investment quota) in December 2016. The Northbound Aggregate Quota is set at 300 billion yuan while the Southbound Aggregate Quota is set at 250 billion yuan.

 “If you look at what the market estimates in terms of net inflow that may result from the five percent MSCI inclusion, it’s anywhere from US$10-17 billion. In theory, if everyone happened to rebalance at the same time you could potentially use up the quota. The market doesn’t like this uncertainty,” Chen says.

Chen cites the Bond Connect as an example of a trade scheme that has no quota. Bond Connect, launched in July 2017, allows bond investors from China and overseas to trade in each other’s bond marketst.