HK exchange to upgrade China Stock Connect trading link

HONG KONG — The Hong Kong stock exchange (HKEx) will roll out an upgrade to its equity trading link into China in the next few weeks, something analysts hope will give global asset managers the green light to start using the facility.

Launched in November, the so-called Shanghai-Hong Kong Stock Connect has been hailed as a landmark opening of domestic Chinese markets, enabling international investors to trade onshore equities without a special licence for the first time.

However, due to operational problems with the scheme, many large fund managers have stayed on the sidelines, relying on the long-established quota system for accessing the Chinese market. Activity through the Stock Connect has been lacklustre, with only banks and hedge funds taking part.

The main problems centre on the ownership of securities and the settlement of trades. Investors must transfer shares they wish to sell to their custodian bank or broker before the start of the trading day for the stock exchange to verify that the seller owns the asset.

This gives the custodian temporary legal ownership of the security, increasing counter-party risk for the seller in the event that a custodian unexpectedly runs into trouble. Since the financial crisis, investors have become more cautious about counter-party risk, even if only for a few hours during the execution of a trade.

Trade settlement is also an issue. Currently, buyers take hold of securities on the day of a trade, but sellers must wait another day to receive the cash. Once again, investors, when selling shares, are left exposed to the possibility of counter-party failure.

However, market participants hope a coming operational change — first flagged in January and now in the testing phase — will help fix both issues, paving the way for the world’s largest fund managers to embrace the scheme.

The main change will allow investors to keep their shares, but enable the stock exchange to peer into their accounts to confirm their holdings. That, in turn, will make it possible for most brokers to offer a synthetic early settlement of trades, in effect fronting the cash to sellers a day ahead of receiving it from the buyer.

Currently, this synthetic settlement is available only through the handful of investment banks that have both custodian and equity trading businesses.

“It doesn’t solve all the issues,” said Mr Stephane Loiseau, head of Asian cash equities at Societe Generale. “But everyone is quite bullish that this second version will help, especially for those (institutional) funds that have been effectively barred up to now.”

But challenges for asset managers are likely to remain. Many have mandates that prevent them from investing in the Chinese mainland, so they must redraft these rules before they can start buying through Stock Connect.

A shortage of English-language research on Shanghai-listed stocks is another problem, while legal questions remain over certain shareholder rights, such as being able to sue a mainland Chinese company.

HKEx plans to open a second link into the Shenzhen stock exchange this year and hopes to add other asset classes — such as equity derivatives and fixed income — further down the road. THE FINANCIAL TIMES