For all of those keen to trumpet the success of the Shanghai-Hong Kong Stock Connect link, there are plenty of cautionary ‘don’t run before you can walk’ warnings being fired at all those same enthusiasts.
The Shanghai-Hong Kong Stock Connect link is a cross border initiative that allows investors in the Shanghai Stock Exchange to trade shares on the Hong Kong Stock Exchange and vice versa using local brokers and clearing houses.
However, suggestions that the initiative should be extended to new asset classes are being met with some resistance.
The link has encountered problems from the outset, and market participants are stopping well short of declaring the connection a resounding success just yet.
However, while talk of extensions to new asset classes may be premature, it is certainly an intriguing prospect.
Stock Connect has had an unexpectedly shaky start with institutional investors hesitant to participate thus far. This doesn’t mean the buy-side aren’t ever going to trade through Stock Connect, as many firms conducted a lot of work to prepare for day one back in November, but issues such as pre-delivery rules, which prohibit the buy-side from selecting brokers, freely persist.
So while current progress represents a steady stroll at best, the possibility of extending Stock Connect to derivatives, bonds and commodities could be seen as a full-blown sprint.
These extensions are seen by many as a natural progression though, and ultimately an inevitable and necessary development.
“The general feel is that they want to see how things go as they progress the opening up of the markets,” says Richard Byworth, managing director, head of multi-strategy sales, Asia Pacific global markets at Nomura.
“There is definitely clearly a willingness to open up the market and see this continue. I think we will see futures come through the Connect. It will be the biggest derivatives market in Asia by a country mile.”
Charles Li, chief executive officer at Hong Kong Exchanges and Clearing (HKEx) said earlier this year that “if cash equities are the trunk roads supporting capital flows between the Mainland and international markets, equity derivatives are the junctions and slip roads that help regulate the traffic.”
If there were to be a chief of Stock Connect optimism it would undoubtedly be Li, although, some might say that his analogy highlights the importance of including derivatives in the link.
A place for derivatives
China’s equity derivatives market has been growing rapidly in recent years, drawing the gaze of foreign investors. The inclusion of the products on Stock Connect could be the catalyst for buy-side participation in the link.
“At the moment we are working on trying to access futures for our clients,” Byworth says.
“The launch of the CSI 500 was last week and we want to be involved heavily and give our clients access to those futures.”
Laurent Cunin, head of prime services, Asia Pacific, Societe Generale, says that access to Chinese derivatives represented the number one request from buy-side clients.
“There is a huge demand from the buy-side for China and for many of them it is their top priority.”
He added that the easier the Chinese market is to access, the more the buy-side will benefit.
“The more mainstream it becomes the more it will grow,” he explains. “The opening up of the Chinese markets used to be a mirage for a long time with people asking ‘will it ever happen?’. Well, today it is happening.”
The inclusion of derivatives on Stock Connect will also strengthen the case for China’s A-Shares to be included in major global indices such as MSCI and FTSE, according to Eva Fu, product marketing manager at Fidessa.
“Equity derivatives are a must as they will help the A-Shares be included in the MSCI index,” she says. “Bonds and commodities could also come in a lot later on the Stock Connect.”
Recognising the challenge
Part of the challenge in keeping the buy-side grounded in their hopes for a derivatives Connect lies in the operational challenges we mentioned earlier in this piece.
Until institutional investors begin using Stock Connect more regularly and balance out the retail participation it is unlikely derivatives will be included.
Rebecca Terner-Lentchner, head of policy and regulatory affairs at the Asia Securities Industry & Financial Markets Association (ASIFMA), believes there is a long way to go before derivatives can be included.
“The buy-side is keen for anything that works with Connect, but there are still some challenges with the operational model from their perspective, the vast majority are not connected yet.
“The players that are would have to understand the risk management tools much better and they would have enormous margin requirements.
“They [China] have to develop their futures markets. There is a lot of work from the capital markets to do in advance of rushing a different asset class on that is quite immature.”
Neil Sheppard, APAC equity strategist at Nomura, agrees, highlighting the current problems around Connect and how they could hamper a derivatives inclusion right now.
“There are a few current issues with Stock Connect over the speed you can trade, when you get into products like derivatives you need to have greater ability to manage your exposure, so I think there needs to be a more advanced programme just for trading equities first,” he said.
“It is a step-by-step process, each step needs to be fully functional before we can move forward.
“They have been extremely good at soliciting feedback from exchange participants as to how to improve it on the legal, side and tax issues. So hopefully they will get it right.”
So if derivatives are not the next asset class included in the Connect, then where do we turn next? Fixed income, commodities and perhaps even exchange traded funds could present easier possibilities.
China’s commodities market is seen as more established than it’s equity derivatives space, while ETFs present a safer product. Speaking to a range of industry experts, the general feeling is that fixed income could be the next step forward.
“Potentially in a situation where there is significant volatility, I think the risks are substantial and I don’t think that is good for market development or as new and fragile from the Chinese regulatory perspective,” says Terner-Lentchner.
“I think we have lots of different options to increase asset classes such as fixed income like a bond Connect. Shenzhen-Hong Kong Connect is coming online so you can have small to mid-sized caps available for international investment.”
“With derivatives there is enthusiasm and demand for it, but I don’t think the capital markets on China’s side is ready and the users utilising Stock Connect is retail at the moment.”
Ultimately, it seems as though the inclusion of these asset classes rests firmly on ironing out initial problems with Stock Connect and increasing buy-side participation.
The first step towards this could have occurred in April when the new trade settlement system known as the Special Segregated Account Model (SPSA) launched in a bid to fix the problem of position checking when selling northbound shares.
The new model places custodian banks at the centre of the reforms. Investors are able to set up a dedicated account for their portfolios and ownership, under the custodian bank. That same account will also be used as the executing brokerage account.
The existing problem was that investors had to previously use an executing broker, which must be the same firm as their custodian, or, had to transfer those shares to the broker the day before.
Speaking at a roundtable event, Barnaby Nelson, head, investors & intermediaries, transaction banking, Greater China & Northeast Asia, Standard Chartered, said that there were no longer any “critical points pending” in relation to the development of Stock Connect.
“One of the challenges was that there was this broker/custodian lock-in, so non-custodian and non-prime brokers weren’t able to participate and benefit from the opportunities that Stock Connect presents,” he added.
The expansion of Stock Connect remains in limbo, with development needed to beget more development. It is just a matter of time though before the buy-side start to see some of these much sought after new products available to trade from China.