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Bridging the differences between Hong Kong and Shanghai

Updated: 10 Aug 2014
Charles Li Direct Page

We've been very busy over the past couple of months preparing for Shanghai-Hong Kong Stock Connect.  Our team has held a number of briefings and seminars for market participants, media, and investors, and we're delighted that the response has been positive and many are excitedly waiting for the scheme to begin.

We have also received a strong response from brokerages.  Many have signed up to participate once the scheme starts, and we have scheduled market readiness tests for later this month.  Once they are complete, we will publish a full list of eligible brokers on our website.

That strong response also extends to the investor community.  Many people have told us they are excited about mutual market access and what the scheme represents in terms of the long-term development of China's financial market.  Some investors have also raised some good questions, namely pertaining to certain constraints under the scheme – things like investor protection, the quota system, pre-trade checking, and investor and stock eligibility.

Before I turn to these topics, it's important we talk about why the scheme was developed.  The Chinese market will open over time, but it will be a long and challenging process.  If we wait for the Mainland market to align with Hong Kong's, we could be waiting a decade or longer.  So we had to figure out a way to connect the markets while respecting the differences between the current regulatory regimes in the Mainland and Hong Kong.  We needed to build a bridge connecting the two markets without fundamentally changing them.

However, it's not perfect.  While we have managed to find a solution to most of the challenges of aligning two very different markets, some of the differences were so significant that our solutions will inevitably constrain the market.  I know that these constraints aren't ideal, but considering the magnitude of the scheme and what it represents, in terms of progressing China's financial market opening and enhancing Hong Kong's role as a global financial hub, I believe that it is important to move forward rather than let such an important opportunity pass us by.

The constraints of the scheme at launch are necessary to get it off the ground, but I'm confident that over time, once people become more familiar with the scheme and the risks involved with cross-boundary investments, these constraints may eventually be removed.

Three areas of constraint are quotas, holiday arrangements, and trading mechanisms.  I'd like to explain why these constraints are in place and what they are meant to accomplish.

Will investors be protected by their home market when they invest across the boundary?

One of the main principles of Shanghai-Hong Kong Stock Connect is "home market rules".  That means investors must obey the rules of the market they are investing in, which is no different than if investors buy shares in London or New York.  They will also be protected by the regulators of the market they are investing in.  For example, the CSRC will be in charge of regulating listed companies in the A share market, but it cannot regulate listed companies in Hong Kong for Mainland investors.  So when Mainland investors buy shares in Hong Kong through the scheme, they have to obey the rules of the Hong Kong stock market and will be protected by the SFC.  The same also works in reverse.

In terms of investor protection, it's important that investors taking part in the scheme understand the risks.  Regulators can protect investors from losses from unlawful activities and can punish market malpractice.  But investors also need to be clear about the rules and regulations of the market they are investing in.

I should particularly note that the CSRC and SFC deserve our gratitude and respect for their leadership and foresight in developing Shanghai-Hong Kong Stock Connect.  They took on a lot of additional regulatory responsibility and challenges so that investors from both sides are afforded the opportunities and convenience of mutual market access.

Why are quotas imposed on the scheme?  Will they be removed in the future?

The quota system is a key component of the scheme designed to minimise any potential unforeseen risk of excessive capital flows.  It is in place for the initial stage to regulate the pace of capital flow and ensure the scheme is rolled out smoothly.  I believe the quotas may be expanded over time depending on market conditions, or removed altogether.

You can read more details about how the quotas are calculated here.  (Page 6)

Is the current quota allocation unfair?

Not at all.  Unlike the QFII system, which grants quotas to individual institutions, quotas under Shanghai-Hong Kong Stock Connect are granted on a "first come, first served" basis.  Quota allocation is based on the timing of buy orders, regardless of size or other factors.  Orders submitted through the scheme will be subject to a throttle control mechanism, which works the same way regular orders are handled in the Hong Kong market.  In other words, there are no inherent advantages for any particular broker or investor.

In order to prevent "placeholder" orders, we will strictly monitor buy orders to minimise the price gap between the orders and the most recent transaction prices.  Furthermore, cross-boundary investors will not be able to modify orders after they are issued.  Instead, the investor will need to cancel the first order and issue a new one, thus re-entering the queue.

Why is Shanghai-Hong Kong Stock Connect closed over so many holidays?

The scheme will only be in operation on days where trading and clearing arrangements are open in both Shanghai and Hong Kong.  This is to reduce the burden, in terms of cost and staffing, that market participants would have to bear to execute trades across the boundary when the local market is closed for a holiday.  Nevertheless, this is something we will continue to look at with market participants and the banking sector.  If there is demand for cross-boundary trading and settlement during holidays, and it's feasible, it's something that can be considered in the future.

How should investors manage risk if one market is closed for a holiday while the other remains open?

The holiday schedules for Mainland China and Hong Kong are posted in advance.  It is investors' responsibility to be aware of holiday arrangements and take appropriate risk management measures in accordance with their own needs.

How will pre-trade checking work in Hong Kong to comply with Mainland requirements?

Pre-trade checking is an example of a major difference between the two markets that we had to overcome.

Currently, Mainland investors are only allowed to sell A shares that are available in their stock accounts at the end of the previous day.  The pre-trade checking structure at every trading account in the mainland market is easily able enforce this rule.

However, investors in Hong Kong trade under the T+2 system, whereby investors can execute their trade at a time of their choosing; they don't need to transfer the stocks to their selling brokers until two days after the trade is executed.  It is also a common practice for institutional investors, in particular, to engage a custodian to perform share custody and transfer services.

Under Shanghai-Hong Kong Connect, CCASS will need to require international investors to instruct their custodian to transfer the shares to their selling broker before 7:30am on the trading day so CCASS can confirm the shares are with the selling broker before the market opens.  This facilitates HKEx and CCASS to trade and settle with SSE and ChinaClear in compliance with the Mainland trading rules.

If the relevant stocks have not been transferred appropriately and in time, the institutional investor will be unable to sell the shares on that day.  The same principle applies to retail investors, i.e. the retail investor will have to ensure that the shares are with his/her broker at the start of the trading day if he/she wants to execute trades in the A share market that day.

This trading practice will inevitably add an administrative burden to international investors who will need time to become accustomed to these trading rules.  Despite significant efforts, we will not be in a position to offer investors alternative solutions at the time of launch that will resolve this issue.  After the launch, however, we will begin to allocate resources to develop possible solutions to help investors minimise the inconveniences such a practice may cause.


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