Luxembourg's new UCITS approval may be Stock Connect's salvation

A positive decision by Luxembourg's securities regulator about the beneficial ownership provisions of the Stock Connect could lead to an injection of UCITS interest in the programme.

Demand from Luxembourg may hold the key to future improvement in volumes in the Shanghai-Hong Kong Stock Connect, the access mechanism which has largely been neglected by local investors in the fortnight since inception.

Luxembourg funds can now use the Stock Connect programme according to local lawyers Arendt & Medernach – although specific conditions will apply to each applicant. Irish and Cyprus UCITS funds were already permitted to use the Stock Connect, but in terms of potential flows they are small compared to Luxembourg funds, which account for approximately 80-85% of European UCITS assets under management.

According to Arednt & Medernach,,  the Commission de Surveillance du Secteur Financier  (CSSF) , the securities regulator in Luxembourg, has said it will let UCITS funds (Undertakings For The Collective Investment Of Transferable Securities) invest in China via the Stock Connect. 

It had equivocated previously. Luxembourg law says that funds are not allowed to buy funds where they aren’t recognised as the beneficial owner of the securities. At first that law was deemed to conflict with the legal framework of the Stock Connect, where beneficial ownership is less clear.

“There are a huge volume of Luxembourg managers keen to take on some basic China exposure,” said Barnaby Nelson, regional head for Northeast Asia and Greater China transaction banking at Standard Chartered. They’re the first injection of quota consumption, predicts Nelson. “There should be some moment in Q2/2015 when those managers will jump in, individually in a small way, but forming cumulatively a much larger amount.”

The Stock Connect trade on the first day of launch was rebalancing the premium and discount between the two markets, and once that was accomplished, the next big trade had to conceptualised. It is not clear what that big idea is yet, although last Monday did see more Stock Connect activity after the previous Friday’s 40 basis point cut in lending rates.

The outstanding issue of tax had been solved, for now at least, when it was announced that taxes would be waived until further notice on A share trades across all access schemes.

Such UCITS funds  are not necessarily China-focused. If they were China-themed, then they logically would already have some operating arrangement in place, such as a QFII programme.

“Most UCITS funds have a 5% discretionary exposure that they can take to anything to they want,” said Nelson. “There are a lot of global and Asian funds saying they’d be happy to rack up exposure to Stock Connect A shares without having to rewrite their prospectuses.”

Funds could express a China view in another way, such as via P notes or red chips.

Nelson said that in his firm’s experience the P Notes desk was busy during the Stock Connect launch period, which is the reverse of what one might expect if P Note users were thinking about possibly getting into direct stock investment.

His interpretation of that unexpected activity is that P notes have no ambiguity regulatory-wise about how they can be used, although such derivatives though cannot be used in the portfolio of long only funds and UCITS funds in Europe, only for institutions acquiring them using their own money.