Sylvain Thieullent, Horizon Software
"...it is an important economic change particularly for RMB internationalisation."
Traditionally, Hong Kong has been the faucet out of which money flows from China. That kind of plumbing is exactly what the government is keen to re-engineer and, as a priority, China wants to internalise flow by diversifying products and investment vehicles.
Garth Ballantyne, head of trading at global agency broker Auerbach Grayson, said that the highly anticipated Shanghai-Hong Kong Connect link is more geared to the domestic retail investor and intended to pull China's currency back into the mainland.
From a US-based institutional investment point of view, there are unacceptable risks with how the link is designed.
A fund, Ballantyne explained, would have to block shares to a broker the day before the trade date, which ultimately means that money does not get delivered until much later.
"If you're an institutional money manager, you are looking at 30 to 48 hours of exposure to a broker. If they happen to (default), there is not a clear picture of what the recourse would be," he said. "You cannot do it as a compliance or risk management issue the way it is set up right now."
It's such a problem, he added, that people are not willing to look forward until there is a solution. But there are other wrinkles to iron out, for example, how capital gains tax is going to be calculated.
"Whose responsibility is it to let the government know which account is trading? There is not 100% clarity on this and it seems like they've left quite a bit hanging out there," said Ballantyne.
As another example, there are fund flow limitations from Hong Kong to Shanghai at 13 billion yuan ($2.1 billion) a day and at 300 billion yuan in total. In the other direction that falls to 10.5 billion yuan a day and 250 billion in all. These limits are net, so trading volumes can be higher than the caps. Still, this could create its own problems to manage, Ballantyne said. Trading could be suspended until more sell orders come in and then, which orders get filled? "I get the feeling people are not satisfied with the information flow," he said.
Ballantyne will be watching for a tighter spread between the Shanghai shares (A shares) and Hong Kong shares (H shares) as a signal that the Connect is running efficiently. The technology, he added, is not really a concern.
"There is a lack of trust, of ability to take that kind of risk against a broker, so it really is a risk management issue that has to be solved first, and then you have to see how the technology works," he said.
Preparing for lift off
In August, technology vendor Fidessa announced that five Hong Kong-based brokers were signing up for the link using its technology. Fidessa spent a lot of time working closely with both exchanges and customers to address the complexities that brokers wanting to use China Connect face, the company said in a statement. This included designing the right algorithms to cater for the wider spreads, transient liquidity and volatility associated with trading the Shanghai market.
Since the Connect was announced in April, Citi's team has been pressing hard to meet the launch date. Benoit Dethier, head of Client and Sales Management, Financial Institutions, Spain, joined the Asia Flow Desk a few months ago, when Stock Connect became a top priority. "That is where investors in Europe are most demanding in terms of information," Dethier said.
Citi's solution to the clearing and settlement problems was to rearrange different elements of the institution. Citi Global Markets will give up clearing membership, and Citibank NA, as the custodian and service provider, will become the clearer in the Hong Kong markets.
With this change, explained Dethier, the securities that the investor has with Citibank NA as global custodian are automatically available for selling, and the broker complies with the obligation that the securities are in position to be sold before sending the instruction to the market.
"We are the very same entity being the clearer of the broker and the custodian of the investor," he said.
Using this approach, Citi also avoids problems with a 7:15 to 7:45 am (HK time) window created for the transfer of securities. The problem is that there's no time for traders to react to market announcements, which Citi's research shows tends to happen between 9 and 10 am.
"You can only sit and observe the market going down, and that's not something that institutional investors will want," he said. "So, under (our) model… the securities are available, prepositioned at all times." That means if bad news arrives, clients can rush a sell instruction.
Dethier pointed out that the six-month development time was extremely challenging and required raising budgets mid-year as well as tackling logistics. But the will was there, because China is just too big to ignore and solutions had to be found.
"There are already many institutions where the front office side has instructed the back office to be ready," he said, adding that this is particularly challenging considering that rules are still being drawn and the launch date has not been officially announced
Given the urgency, interest and the strategy in place, Citi is making all efforts to be ready and propose an efficient solution to its clients from day one, Dethier noted.
Currently, foreign investment in China's A-share market requires government approvals under the QFII (Qualified Foreign Institutional Investor) and RQFII (Renminbi QFII) quota systems. In general, large asset managers with a dedicated A-share fund, or large investment banks, use that quota to trade on their own account or allocate to clients.
The Connect link will not likely make a difference to these players, said Simon Male, head of Asian equity sales for Auerbach Grayson, but it could potentially open up the market to firms that are not sufficiently large to have dedicated funds, or do not want to go through the hassle of getting a QFII quota, or are unable to get access from any of the large banks.
In general, the best companies list in Hong Kong, but that doesn't mean there isn't interest in a few purely A-shares listed stocks garnering interest - consumer-related companies selling spirits and liquor, or dairy, for example. More importantly, there are well known brands in mainland China that are only listed on the H-share market and trading interest is sure to follow, Male said.
But with quotas in place, it is unlikely that the Connect link will have a major impact on liquidity.
"I suspect it is not going to make a huge difference. Will it improve liquidity for the domestic mainland investors who are already investing in A-shares? My guess is probably not," Male said. Moreover, pre-funded trading models would not be ideal for fast trading.
"I am not entirely sure that China wants to encourage quick arbitrage. They are trying to encourage institutional and longer term investment interest in their markets," he noted. Still, the A-share market has been extremely hard to access for foreign investors.
In other words, it's not really about improving liquidity but a whole step forward.
Systematic trading remains very limited in China, and this is unlikely to change as a result of the Connect link, said Sylvain Thieullent, head of electronic trading at Horizon Software. Large firms like Citic and CICC are involved but exchange technology is quite old, he added. "Intraday arbitrage? Forget about it," he said.
Horizon Software is in the ETF and options business, and has advised the Shanghai Stock Exchange on best practices from an IT perspective as well as product design perspective. Horizon's experience includes Hong Kong but also Asean nations such as Malaysia and Indonesia.
Thieullent expected the Connect link to roll out like the two-year-old Asean trading link.
"I don't think it will be a massive revolution…it will simplify all the rules for a portfolio manager in China and make it easier to unload the hedge of the product," he said.
"It is true that the scope of investment possibilities will be broader with the link but if the target was initially investment in China, you will keep your existing set up and I do not see new investment business being created," he said.
However, it may well become cheaper and easier from a compliance perspective for a Hong Kong portfolio manager to trade mainland Chinese stocks. At the same time, mainland Chinese traders looking for some liquidity to hedge derivative products might benefit from Hong Kong as a liquidity pool.
"So at the end, it is an important economic change particularly for RMB internationalisation," he said.
In the bigger picture, Thieullent also pointed out that the "reason for existence" of Hong Kong is challenged by government initiatives to diversify past the island's offshore presence. That goes beyond the Connect link as China allows free trade zones and boosts commodities exchanges.
"It is clearly a sign from the Chinese government to tell (the) Hong Kong government and people that they are not alone anymore, and their exclusivity in the long run is going to be challenged," he said.
Auerbach Grayson's head of trading Garth Ballantyne said that Hong Kong's status as a financial centre is "definitely trending downwards" as China opens up.
At time of writing, tensions were easing from activist protests in Hong Kong demanding greater control over democratic development for the former British colony. Reuters reported that the nine-day old protests being watched across the world have disrupted businesses and helped wipe close to $50 billion off the value of shares on the Hong Kong stock exchange. The World Bank has said the protests were hurting Hong Kong's economy, although the impact on China was limited so far.
So far, the stand-off between protesters and authorities is not affecting staff in Hong Kong, Ballantyne added.
Simon Male pointed out that it is going to be a long while before Hong Kong's superior infrastructure can be surpassed. "In a completely free market situation, Hong Kong still has a pretty strong case to win out, in the same way that New York held its own in the US and London in Europe," he said.
Citi's Dethier said that Stock Connect is an important component of RMB internationalisation, and it would be a big boost to its emerging market status if FTSE includes China A-shares in global benchmarks. Of nine criteria, FTSE finds the market lacking on two aspects - one is the freedom of repatriating capital, and the other is its T+0 settlement mechanism. Dethier pointed out that for the latter, the world is moving more in-line with China's approach rather than the other way around.
But the future prospects for Hong Kong as a financial centre are sure to continue being questioned as China opens up.
"What happens in Hong Kong is what Beijing allows to happen (and for) China, Hong Kong is like an open air laboratory. It's where they launched RQFII, so when the RMB qualified for institutional investor programme, they started with Hong Kong. It is the test laboratory for market opening."