Barnaby Nelson of Standard Chartered Bank looks back over 90 days of Bond Connect to assess the future of China’s latest market access scheme.
The latest access channel between the Hong Kong and China financial markets went live on July 3 with the launch of the northbound Bond Connect – connecting international investors with the China Interbank Bond Market (CIBM). Previous China market access platforms – such as Stock Connect – have typically started slowly as investors exercise initial caution, before attracting proper momentum.
The early signs in the latest ‘Connect’ undertaking appear promising with turnover climing from RMB 7 billion of turnover on day one to over RMB 12 billion in recent weeks: from over 150 investors who are registered to use the access channel1. These are unprecedented transactional volumes in comparison to previous market openings in China, and while trading activity has fallen slightly since, it remains stable.
It is anticipated that the number of Bond Connect registered investors will rise to between 400 and 500 by year-end. If these numbers are reached, the Bond Connect programme will have surpassed the number of registered investors under each of the established Qualified Foreign Institutional Investor (QFII), RMB Qualified Foreign Institutional Investor (RQFII) and the CIBM Direct schemes within six months. But what have been the core drivers for this interest, and what improvements and remedies need to be made?
Jumping at the opportunity
China’s $9 trillion bond market has long been underweight by foreign institutional investors but this is likely to change2.
Standard Chartered Bank, for example, has helped support a number of clients with Bond Connect trading including China Merchants Securities, GF Global Capital, Manulife Asset Management and Taikang Asset Management in Hong Kong3. Following day one, Standard Chartered has held market briefings in every leading global RMB investment centre during the first two weeks of trading, revealing unprecedented interest in this new mechanism. This is down to several factors.
First, the launch was well handled by the People’s Bank of China (PBOC) and Hong Kong Monetary Authority (HKMA). Their proactivity and transparency created predictability, which allowed financial institutions such as Standard Chartered to fully support Bond Connect’s implementation seamlessly.
The regulators have aimed to use Hong Kong as an ‘adaptor’ to CIBM under Bond Connect – striving to find areas which can be adjusted to assist with integrating international investors into a historically domestic market. The option to settle on a T+2 cycle was introduced in time for launch and was used by 80% of the market on day one. This demonstrates the lessons learnt from Stock Connect where the mandatory T+0/T+1 settlement cycle caused significant challenges for international investors.
Second, registration for Bond Connect is also straightforward, with authorisation usually granted within two weeks. Whilst the time it takes to apply to trade directly onshore through the CIBM has improved, Bond Connect offers an offshore, fairly frictionless solution which is appealing to international investors.
Julia McKenny, Head, Market Advocacy, Securities Services at Standard Chartered, said: “Many institutions simply prefer to access China’s bond market through Hong Kong, where they have established custodian and banking relationships and understand the Common Law legal system.” Flows through Bond Connect “will jump significantly” as passive funds increase their exposures should China be included in major bond indices such as Bloomberg Barclays, Citi and JP Morgan. “These passive providers will want quick entry into the market through Bond Connect as opposed to CIBM, at least initially.”
Lastly, end investor demand for returns has played a major role in driving fund managers into the Chinese onshore bond market. Yields in onshore corporate debt are more attractive than US Treasury Bills or European sovereign debt instruments, which pay out limited or even negative interest.
The development continues…
Bond Connect is still in its initial pilot phase, and industry experts are working closely with clients and regulators to ensure that the platform evolves quickly to meet with a range of international regulatory standards.
“Standard Chartered has played a unique role in working with the industry and key regulators to ensure that the Bond Connect is quickly recognised as an investment mechanism for European-domiciled funds, under the terms of UCITS V and the Alternative Investment Fund Managers Directive (AIFMD) and we continue to lead the industry and regulatory discussions to facilitate resolution,” said McKenny.
Following the publication of the ‘Bond Connect and UCITS V’ position paper, Standard Chartered has facilitated briefings in London, Luxembourg and Dublin to ensure that the mechanism and its development were fully understood by key regulators and industry leaders. These discussions have highlighted a small number of high-priority development requirements, which are now being worked on.
In particular, a short-term concern raised is settlement risk, and the absence of true delivery-versus-payment (DVP) for one of the two bond depositaries in China, although industry experts are confident this shortfall will be resolved during 2017. A system enabling true DVP for depositaries is a core requirement for key regulatory approvals, as it will minimise counterparty risk for managers of UCITS and AIFs, and their depositary service providers, who take on liability for assets held in custody.
Also ongoing is confirmation of how beneficial ownership rights will be enforced and whether the HKMA’s Central Money-Markets Unit (CMU) will be recognised as a Central Securities Depository (CSD) under UCITS’ definitions. As with Stock Connect, these issues depend largely on legal validation of existing processes and clarification by the HKMA on this matter is expected imminently.
Taxation has also been an area rife with equivocality. Investors using QFII and RQFII have long questioned whether they need to accrue for withholding taxation or if they are required to unwind previous accruals. While Stock Connect provides an exemption on the issue, there is still limited understanding about how withholding tax is treated.
“As with all new mechanisms, other smaller operational challenges remain, such as the ability to block trade using the electronic RFQ platform, for example. But the strong performance of trading on Day 1 of the Bond Connect is strong evidence that even today’s pilot model is robust and usable for international investors,” commented James O’ Sullivan, Head of Securities Services Hong Kong & Head of C&C Product, Greater China and North Asia at Standard Chartered.
Much more to come
Initial interest in Bond Connect has been strong. With more key developments still to come in 2017, we expect interest to convert into significant volume growth very quickly as the leading international fund domiciles begin to endorse the Bond Connect. With leading players in Europe and China clear on what needs to be done, we should expect UCITS regulators to be able to move quickly towards approval of the Bond Connect for funds under their supervision.
Three months into trading now, we have indeed witnessed the successful launch of a unique access mechanism for China and Standard Chartered remains front and centre in continuing to contribute to its success.
Barnaby Nelson is the Regional Head of Securities Services for Greater China and North Asia at Standard Chartered Bank
1 – Standard Chartered Global Research (September 1, 2017) - China - Update on Bond Connect activities
2 – Standard Chartered (2016) – RMB Investors Forum White Paper: Rise of Next Generation China Access
3 – Standard Chartered (July 3, 2017) – Standard Chartered supports clients on Bond Connect debut
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