Market participants were unsure what to expect when “Stock Connect” launched the morning of Monday, November 17, 2014.1 The program, sometimes called the Shanghai-Hong Kong “through-train”, provides a trading link between the Hong Kong and Shanghai Stock Exchanges that enables the participants of one exchange to trade certain equities on the other. With access to the Chinese securities markets still tightly regulated, Stock Connect represents a new route – and for some market participants, the only route – to trade Shanghai-listed equities. But the program relies on new infrastructure providing connectivity between the exchanges and a quota that limits total northbound and southbound purchases. On Day One, there were lingering questions about how such infrastructure would function in practice.
Day One of Stock Connect: Northbound Quota Exhausted
After the opening bell, northbound trading (i.e., purchases by Hong Kong and international investors of Shanghai-listed securities) was brisk. Under Stock Connect rules, buy orders are permitted only when a market-wide daily quota of RMB 13 billion (approximately US$2.08 billion) is available.2 Once the aggregate amount of buy and sell orders (subject to certain adjustments) exceeds the daily quota, then further buy orders will be rejected (sell orders will not be affected). On Day One, the daily quota was exhausted by early afternoon. By the second day, however, trading was more subdued and, with buy and sell orders offsetting each other, a significant portion of the daily quota remained at the day’s end. Subsequent daily trading volumes similarly have undershot the daily quota. Prior to launch, some market participants were concerned that Stock Connect securities would not be available when needed because of the operation of the quota. These concerns are particularly acute for trading strategies that require guaranteed access to securities (e.g., fixed-allocation or index strategies). Early experience with Stock Connect suggests that the daily quota may not raise issues under normal conditions; however, the quota limit remains relatively small. Any unusual market activity that heightens interest in Shanghai-listed equities could exhaust the daily quota.
Market Practice and Custody Issues
The structure of Stock Connect raises several questions about custody of assets – in particular, for UCITS and U.S. retail funds. In early trading, retail funds were largely absent. However, a subsequent announcement by the Luxembourg Commission de Surveillance du Secteur Financier indicated that at least some Luxembourg funds would soon be participating. Further, other UCITS and U.S. retail funds are actively considering the issues.
There are essentially two links in Stock Connect that attract concern: first, securities in the program may be required to be held in a clearing account (which typically is an account maintained by a broker rather than a custodial account) during a “trade pre-check” process on the day before a trade. Second, trades are ultimately cleared through China’s central clearinghouse, ChinaClear, with Hong Kong Securities Clearing Company Limited (HKSCC) acting as a nominee holder on behalf of the ultimate beneficial owners (e.g., Stock Connect investors). Stock Connect securities therefore may be outside of a fund’s custody, potentially from the day before the trade through delivery of the securities the day after the trade.
Market practice has responded quickly. To avoid securities leaving custody during the pre-check process, many market participants have opted to hold shares through Hong Kong-based custodians that have clearing accounts with HKSCC (thereby sidestepping the need to hold such securities in a broker’s clearing account). Other multi-party arrangements (e.g., tri-party agreements) may also be possible.
The status of HKSCC as a nominee holder continues to generate some concerns, because the concept of beneficial ownership is not well-developed under Chinese law. However, Stock Connect regulations expressly establish the concepts of beneficial ownership and nominee holders in China and provide that beneficial owners possess the rights and benefits of Stock Connect securities (including the rights to receive dividends and send voting instructions to HKSCC).3 Furthermore, if HKSCC were to become insolvent, the regulators have stated that Stock Connect securities would not be regarded as general assets of HKSCC. In addition, the risk of claims from other parties in China is somewhat limited by ChinaClear’s role as a clearing house – as long as a trade is conducted in accordance with Chinese trading rules, it is final.4
Next Steps and Remaining Issues
While the legal framework for custody appears to be in place at the highest level, market participants should recognize that certain Chinese securities and trading laws will apply. Violations of these laws can lead to restrictions on trading. To the extent that judicial enforcement is needed to enforce rights or obligations under Stock Connect, market participants should expect that Chinese courts may be less familiar with relatively new concepts, such as beneficial ownership. Market participants still on the fence about Stock Connect may need to speak to Hong Kong brokers, custodians and counsel to discuss the program. But, for everyone else, the through-train is running.
