The Gateway to Algorithmic and Automated Trading

Making Connections

Published in Automated Trader Magazine Issue 36 Spring 2015

The Hong Kong Shanghai Stock Connect is a significant step forward for Chinese markets, and a move in a larger strategy for China to open up its capital account and to internationalise its currency, the renminbi, writes Peter Barker.

Charles Huang, CEO, Bond Trust

The Connect opening heralds a major change in Chinese market structure. The combined market cap of the two largest mainland China stock exchanges -- Shanghai and Shenzhen -- together with the Stock Exchange of Hong Kong is $7.5 trillion, $0.2 trillion larger than the NASDAQ. When realised, the total listed market cap of these three linked exchanges would be the second largest in the world, behind only the NYSE.

Charles Huang, CEO of Bond Trust, a China-focused asset management company based in Hong Kong, said that so far the impact of the Stock Connect has been small in terms of the percentage of the total quota being used, but it represented an early step on the longer road of RMB internationalisation.

"For the capital account this is one of the first few tests the government is using in trying to internationalise the RMB. So by opening up the Stock Connect the capital flow will be more mobile and the RMB will be more open to the international investors," he said. "Even though the trading activity is not very big, the long term impact is pretty decent in terms of trying to internationalise the currency."

Julia Leung, Author and Executive Director, Investment Products Division, Hong Kong Securities and Futures Commission

Julia Leung, a former undersecretary for financial services and the Treasury with the Hong Kong government, currently the executive director of the investment products division at Hong Kong's Securities and Futures Commission (SFC), was deeply involved in setting up the Stock Connect.

Leung, the author of a new book "The Tides of Capital" about the financial crises of the 1990s and 2008 published by OMFIF (Official Monetary and Financial Institutions Forum), also reiterated the role of the Connect as part of RMB internationalisation.

Moreover, far from disappointing Chinese officials, its gradual start is a good sign, both for the Connect itself and for the further implementation of policy.

"The Stock Connect is still underutilised, I fully agree, but this is the way to go. It is important that you have this platform and I have a lot of confidence that institutional investors overseas will use this because it is a much more convenient channel to bring portfolio investment onto the mainland and vice versa.Leung said, "Stock Connect is part of the pilot, HK is being used as the pilot for the opening up or liberalisation of China's capital accounts.

"The pilot is working well, in the sense that there is no huge exuberance. The lack of exuberance is actually a very good sign, people are actually level headed about their investments. There is no rush into Hong Kong stocks from the mainland.

"This kind of exuberance is something that we would like to avoid. As long as it is orderly the channel is always there. You do not have to rush to get in, and it will not close up."

Total quota remaining balance for both northbound and southbound investment.
Brown -- northbound quota, total remaining
Purple -- southbound quota, total remaining
Daily figures. Note, the index on the left shows that the figures are in CNY and range from 200million to 296million

Daily trading volumes and growth of stock connect.


In terms of northbound and southbound flows, Huang noted some major differences.

From Hong Kong to Shanghai most traders are institutional traders already familiar with the Chinese market through the Qualified Foreign Institutional Investor scheme (QFII). Such participants have the knowledge to manage the arbitrage between A shares and H shares. Southbound flows meanwhile are smaller, reflecting both the investors' lack of experience of trading outside China and the large number of retail investors.

"There is a huge difference because most of the traders in China are retail traders and most traders in Hong Kong are institutional traders, so activities are very different. Retail traders in China are typically not very familiar with international markets. Also the RMB has been appreciating quite a bit so they are quite hesitant in terms of getting out of China and trading in the Hong Kong market," said Huang.

"So you see a really small flow southbound because the retail people are taking more time to get used to how to trade internationally."

But Huang believes that in the future the capital flow from the mainland will increase as investors become more familiar with outside markets and retail investors take the opportunity to diversify their investments.

"The RMB appreciation game is pretty much over so people in China will realise that you cannot finesse onshore anymore, you have to diversify the assets. So we see actually more capital outflow from mainland China to offshore in the recent months and we believe that in the future southbound trading will increase once people realise that is one of the ways to diversify investment," said Huang.

Yang Du, the head of the China desk in London at Thomson Reuters, said that many people expected Chinese investors to make greater use of the Connect but a combination of regulatory steps and the constituent parts of the southbound investor community had meant this expectation had not been fulfilled.

State Owned Enterprises (SOEs) listed as A shares are owned by China and their international investment decisions are not as straightforward as in the free market, said Yang.

Another type of investor would be asset management companies, but that is tightly controlled by Chinese authorities. "That is one of the key messages that the market would need to understand," said Yang.

In addition, Yang said, the foundation of the Stock Connect sees the People's Bank of China (PBOC), the central bank, looking to boost RMB denominated international financial instruments, and stock markets are one of the most convenient areas to open up to achieve that goal.

Yang said, "From that aspect you can link into the current commodities contracts denominated in RMB (and) you can link into the offshore RMB bonds market. That is important as it shows China actually needs incoming investment more than overseas investment opportunities.

"In China the capital market has over-capacity issues at this stage, but the PBOC and the CBRC (China Banking Regulatory Commission) would not allow Chinese capital to flow outside Chinese so freely and easily just yet."

Also retail investors in China are mostly retired individuals sitting in the exchanges, who are happy to trade on stocks whose brands they recognise, but are not comfortable with stocks they do not know.

Institutional investors outside China had been able to invest in the mainland before, through the QFII scheme, but the annual quota is limited and non-institutional investors have not been able to use it. Hedge funds have also largely been excluded, as they are not seen as long term investors by the Chinese authorities. The number of financial entities with QFII status had risen to 254 by September 2014.

In addition, foreign investors could use firms holding offshore renminbi in Hong Kong to invest in mainland bonds and stocks under the Renminbi Qualified Foreign International Investor (RQFII) programme.

Up to the end of August, China's State Administration of Foreign Exchange had sanctioned a total of 278.6 billion yuan ($44.6 billion) in Renminbi QFII quotas to 81 financial entities.

Huang said, "For smaller accounts who could not access QFII before, it is a better way, a cheaper way, to access Chinese A shares. As a result we see basically a drop in the premiums of ETF traded in Hong Kong and also a drop in the fees charged by the banks on their QFII quota and the Renminbi QFII quota."

Cumulative trading volume of the SH-HK stock connect and growth of the stock connect. It can be easily seen both directions are picking up steadily and the north bound volume is more than south bound.
Source: Thomson Reuters

Price difference between Shanghai and Hong Kong Stock Exchange can be illustrated by the movement of Hang Seng China AH Premium Index. The higher the index, the more expensive A shares are relative to H shares.
Source: Thomson Reuters


Trading volumes on the Connect are stable, said Andy Maynard, global head of trading and execution at CLSA, a brokerage and investment group.

"If you look at the quota and the take-down now of the northbound business it is pretty stable. There is a lot of demand there that will just continue to trickle in," he said.

But southbound business is a different story. "It has not been anywhere nearly as successful," Maynard said, in part because Chinese retail investors do not yet have enough incentive to look offshore.

"Southbound is 90 percent retail led, and people have their own home market that is going up massively. So why on earth do they need to take a risk and go and invest in stocks they do not currently know (or) understand…when they can make much more money by day-trading their own market?" he said.

Now that the Stock Connect is open he expected stronger demand northbound, especially from "the long-only, deep-value investor, long-term horizon type trader…who is waiting to trade, but unable to push the execute button just yet. They know the stocks they want to buy they just do not have the approval to do it yet for a number of reasons".

Saketaram Soussilane, North Asia sales director at Paris-headquartered Horizon Software, a global provider of electronic trading technology for banks, asset managers and proprietary trading firms, said the Stock Connect has attracted traders interested in getting direct China equity exposure without needing to hold QFII quota.

"One interest is in getting long on China (long trend following) without having to get a QFII quota. Another interest is in the A shares versus H shares arbitrage. Some client could be interested in long China equity exposure. That is now very easy to achieve," he said. "Another client could be interested in Shanghai-Hong Kong arbitrage. When comparing big market caps on both markets - such as banking, the insurance sector, or petrol related companies - we can see that H shares are always cheaper, than A shares."

Because of this, long-short strategies are becoming increasingly popular in Asia.

"You can achieve easily this kind of arbitrage through Stock Connect," said Soussilane.

Taking the examples of Bank of China, Petrochina and China Life Insurance, for example, Hong Kong shares are cheaper, by between four percent and seven percent, than A shares. Playing the spread can be attractive especially when you factor in the funding cost, which is higher in China onshore.

Short selling is not allowed on Shanghai stocks, but is allowed on the Hong Kong exchange, and Soussilane expects it to be introduced for Hong Kong investors this quarter for A shares.

"Being able to short sell will improve the liquidity, as participants will not need to hold an inventory to be allowed to sell," Soussilane said.

Saketaram Soussilane, North Asia Sales Director, Horizon Software


Huang believed that for the Connect, the experiment has only just begun: "Probably there will be a lot more types of trading, including more stocks and including maybe some sort of stock option or futures trading. So I think the government will probably be trying to innovate by allowing more types of trading in China."

Already this year the authorities have sanctioned and allowed into operation ETF option trading in the Shanghai market, and Huang predicted more innovation on the way to allow large institutional investors to trade new futures and options contracts in China.

"That is still lacking currently so that probably will be something which the government will do to try to fill the void this year," he said.

Huang also forecast that both north- and southbound trading will rise, with Chinese investors realising the potential of moving capital offshore and investing and investing back in A shares through the Stock Connect.

"More retail traders in China will take up the opportunity to trade offshore and more small medium accounts offshore will be able to trade A shares in China so I expect the quota to be used more this year," said Huang.

CLSA's Maynard was optimistic about prospects.

"If you ask me, what will it mean in five years' time, do I see QFII or QDII (qualified domestic institutional investor, for mainland investors seeking to invest in Hong Kong) collapsing, do I foresee a Greater China exchange? Probably not. But 10-15 years out, probably yes. That is what makes it so exciting, it is the precursor of a bigger opening of China. I guess this is the baby step towards that to a certain degree. It is exciting to watch. I think what the Stock Connect symbolises is much more than the actual number of dollars trading through the pipeline now," he said.


The Stock Connect has proved stable and it works - results that Chinese officials had planned for. And the next step is already clear.

While the Hong Kong Shanghai Stock Connect is focused on larger cap names, the Hong Kong Shenzhen link would likely focus on the Shenzhen Exchange's Small and Medium Size Enterprise Board and its NASDAQ-style ChiNext board.After an announcement by Chinese premier Li Keqiang at the beginning of January on a visit to Shenzhen that "a stock connect between Shenzhen and Hong Kong should be next", it looks highly probable that it will go ahead, with officials in Hong Kong and the mainland meeting to prepare.

For Maynard, Shenzhen joining the Connect would really begin to open up Chinese markets.

"You cannot do China without Shenzhen. I would not say it is 50/50 but it is 60/40. To me Shenzhen take-up will be as well-received as Shanghai is now, the bigger problem will be on the custodial side and the settlement side and the fund-advisory side.

"If they follow a similar procedure in terms of settlement then the take-up will be slow. If they widen the scope of the investable stocks in the universe that are acceptable more so than Shanghai, then I think it will be successful.

"The hedge-funds will be able to get involved quickly. They will do it, or people who are more nimble and have got more free rein in terms of their own investment mandate will get involved," he said.


The Stock Connect now gives international investors access to 568 stocks on the Shanghai exchange (A shares), and it also allows Chinese investors to trade in shares on the Hong Kong exchange (H shares). The macro quota for northbound is 300 billion yuan ($48 billion), and southbound is 250 billion yuan ($40 billion).

Hong Kong and international investors can now trade up to 13 billion yuan ($2.08 billion) a day in Shanghai listed A shares, while mainland investors can trade up to 10.5 billion yuan ($1.68 billion) a day in Hong Kong H shares.

Uptake since the November launch has been slow, but this has not disappointed officials and regulators. Northbound (Hong Kong to Shanghai) volumes far exceed southbound (Shanghai to Hong Kong). On February 10 purchases of Shanghai stocks through the Stock Connect passed the 100 billion yuan ($16 billion) mark.

Li Xiao Jia, the CEO of HK Exchanges and Clearing said in January that the range of the Hong Kong/Shanghai Stock Connect is expected to be extended in the future to derivatives, new shares, commodities, interest rates and exchange rates.

Li also said that the Shenzhen link would be the second step in the Stock Connect. He did not commit to a timetable but said that the Hong Kong/Shenzhen Stock Connect was "now at the final stage of its in-depth research, which will enter the implementation stage soon".


The Stock Connect is an environment suitable for algo trading, but the regulatory environment on the mainland means that shares are settled on the trading date with cash settlement on T+1, which is not suitable for high frequency trading.

Charles Huang, Bond Trust CEO, said, "Algorithmic trading in China it is still not very popular yet. However the institutional investors offshore have been trying to use this tool for Chinese A shares for a while, so we believe that basically the Stock Connect will help algo trading down the road. However, the larger accounts are not really using algo trading as much as offshore yet, but I think the trade is on the rise."

The Stock Connect does not affect the existing domestic settlement rules in Shanghai.

Huang commented, "The Stock Connect scheme does not really change the T+1 for stock trading in China, so it is still the same. So you cannot really do HFT in the stocks in China yet. It has not changed anything in terms of the HFT market in China. It is not very feasible right now."