A number of depositary banks in Luxembourg say it is safe to trade in the Hong Kong-Shanghai Stock Connect programme, despite investor-protection concerns for Ucits funds. Nick Fitzpatrick finds out why.
Comfort levels in Luxembourg with China’s stock link programme are not quite at 100% – but the industry has found a way to allow Ucits funds to use the mechanism.
The Shanghai-Hong Kong Stock Connect system, introduced in November 2014, allows foreign investors to buy Chinese A shares listed in Shanghai through the Hong Kong Stock Exchange.
Luxembourg’s regulator, the Commission de Surveillance du Secteur Financier (CSSF) is said to be in ongoing discussions with Chinese authorities and the Luxembourg funds industry about some of the concerns that Stock Connect raises for investor protection.
However, the CSSF told Funds Europe on March 10 that it had approved four Ucits to invest through the China link programme and that a few other applications are in the process of gaining approval.
The regulator points out that it has not voiced concerns about the trading link and describes Stock Connect as an “interesting additional tool for Luxembourg Ucits funds to access the Chinese stock market”.
But a CSSF spokesperson adds: “For the time being, it seems however that the current operational structure may cause concerns to certain depositaries, as they do have to ensure that the operational set-up enables them to comply with their duties and obligations under the European regulations.”
Depositaries are under stricter liability rules, meaning they have to restitute assets should they be lost. The CSSF also notes that the regulatory framework for Ucits funds will become more strict from March 2016 when the Ucits V Directive is introduced.
Chris Edge, Luxembourg head at HSBC Securities Services, says: “Like any depositary in Luxembourg, we operate under strict obligations to safeguard client assets and so we have to ensure new mechanisms such as Stock Connect are structured for our clients, consistent with these obligations.”
The trading process means assets from a Ucits will be out of safekeeping by the fund’s custodian, and with the broker, for longer than normal.
Edge says: “For example, the mechanism requires securities to be delivered to a broker before receipt of cash, creating a credit exposure with that broker.”
Another issue is ownership of the securities.
Amanda Cameron, managing director and general manager of JP Morgan Bank, Luxembourg, says: “The issue for Ucits investing via Stock Connect is a settlement model that makes it difficult for fund managers and custodians to monitor and control assets due to ownership rights and pre-delivery requirements.”
The issues of pre-delivery and ownership combined form a counterparty risk problem. What happens if a broker’s business fails when it still has hold of the assets and cash?
Nonetheless, certain depositary banks with brokers in their wider organisations say they are able to support Ucits funds in this environment.
The Stock Connect link, which also enables investors in mainland China to buy and sell Hong Kong-listed shares through a portal in Shanghai, means that foreign investors do not need the ‘RQFII’ licence – the standard official government quota for investing in renminbi assets. This is one of its major attractions.
But investor-protection concerns were raised within days of Stock Connect going live in November last year.
Luxembourg – chief defender of the Ucits reputation – has €2.7 trillion of Ucits assets under administration and even has a ‘fast track’ for funds meeting criteria to seek approval for doing business through the system.
The situation is different in Ireland – which, as the second-biggest nation to be identified with providing services to Ucits funds sold across the world, has €1.3 trillion of Ucits assets domiciled there. The Central Bank of Ireland is not known to have approved a single fund yet, despite receiving applications.
In the standard delivery-versus-payment (DVP) model of execution, securities would move to the broker at the same time, or close to, cash moving to the seller. Stock Connect, on the other hand, requires securities to be placed with the broker one day ahead of the sale. Settlement would be a day after the sale, so there are two days in which the broker could fail.
Against this background, and the question of how far Chinese beneficial ownership laws are in step with rules in other counties, in December last year the CSSF approved asset manager Investec to use Stock Connect within its Luxembourg-domiciled Ucits Global Strategy Fund range. Announcing the launch in February, Investec said it believed it was the first global fund manager to have the Stock Connect capability. The custodian is State Street Bank Luxembourg.
Marty Dobbins, country head at State Street in Luxembourg, says he expects to go live with several other clients in the next few months. “The CSSF has given us a clear understanding of their expectations for segregation versus DVP, investment settlement, prospectus and Kiid [key investor information document] disclosure,” he says, adding that State Street is ready to support Ucits in the Stock Connect environment.
According to some of Luxembourg’s fund servicing chiefs, it would appear that the safest way possible for Ucits funds to trade on Stock Connect is when the custodian and broker are in the same business entity. That way, the securities and cash stay in the same sphere and make DVP possible.
BNP Paribas Securities Services has been most active in marketing this solution, though JP Morgan and HSBC also have similar models.
Jean Devambez, global head of product and client solutions at BNP Paribas Securities Services (BNPPSS), says a Ucits fund can “not generally” invest through Stock Connect. “If you look at the standard situation, there are still ongoing discussions with the CSSF about the DVP and beneficial owner issues.”
Explaining the shortcoming of the trading process, he says: “When you use a broker in the market, you are compelled to deliver the securities that you want to sell a day before to the broker, so the broker can check that the seller has the appropriate provision. That’s an issue for funds because they are the owners of the security, but the securities are no longer with the depositary and instead with the broker. This is what the CSSF is not happy about.”
The solution rests on depositaries being able to provide access to brokers to client accounts in the same group.
Devambez says: “We can give our broker access to the accounts of our clients so the broker can check they have the right provision. The securities don’t go outside the organisation.
“On top of that, the transaction will be settled in our books between the client and broker and it will be DVP.”
The set-up meets the CSSF’s requirements, according to Devambez, and BNPPSS has two clients on Stock Connect.
Cameron says JP Morgan has its own sub-custodian in Hong Kong and a brokerage business in the region. A number of sub-custodians are used in mainland China.
“A custodian without its own broker has additional risk due to the question of ownership,” she says, adding: “There are plans to remove the requirement for pre-delivery on sales, which would reduce the problem.”
In the meantime, she says the custodian-broker model eliminates the need for pre-delivery.
HSBC is a significant actor in the mechanism, says Edge. About 30% of northbound volumes through Stock Connect are flowing through HSBC as a custodian.
Northbound trading refers to trades for foreign investors accessing Shanghai through Hong Kong. Southbound trading is for Chinese investors investing in Hong Kong shares. As a result of these facilities, the programme has become informally known as the ‘through train’.
Daily volume on northbound trading for February was around 5 billion renminbi (€727 million).
“We have both a broker and a sub-custodian in the same entity in Hong Kong, meaning we always retain the assets in our custody network and have the ability to offer a same-day net settlement of both cash and securities,” says Edge.
The issue of beneficial ownership is another matter and refers to whether investors will retain beneficial ownership of Shanghai shares owing to a complex system of ownership.
Edge says the enforcement of beneficial ownership rights is the primary remaining concern, which the Luxembourg industry is focused on now. He adds that the industry is “working rapidly towards a solution”.
Chinese law provides that the account holder at ChinaClear, the Chinese clearer, is deemed to be the owner of the securities. But the structure is complex. Under the Stock Connect mechanism, securities are held in China, but in the name of the Hong Kong Securities Clearing Corporation.
Edge says the Luxembourg industry has engaged with the Securities & Futures Commission of Hong Kong, along with the Hong Kong Stock Exchange, to implement a “suitable mechanism to ensure Ucits rights may be enforced”. He says good progress has been achieved.
The CSSF is said to be satisfied that Ucits trading can go ahead in Stock Connect as long as the risks are disclosed to investors and that the depositary ensures these risks are mitigated.
Investec would not comment on specific details about its approach to trading through Stock Connect. A spokesperson says: “Each firm seeks individual approval from the regulator, reflecting the fact that each firm’s circumstances and issues are different. Therefore we would not be able to comment on a private dialogue between ourselves and our regulator.”
Kieran Fox, head of business development at the Irish Funds Industry Association, says: “We are aware there are applications currently with the Central Bank for Ucits that intend to access Stock Connect – however, we aren’t aware of the status of any of these individual applications. We have engaged closely with the relevant authorities, including the Hong Kong Exchange, which will be in Dublin [the week of March 9] and we are facilitating a series of meetings and discussions with them when they are here.”
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