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Bond Connect: What it means and how it works

Updated: 08 Jun 2017
Charles Li Direct Page
Today we held the largest event dedicated to the RMB fixed income and currency space in Hong Kong, HKEX’s 4th annual RMB Fixed Income and Currency (FIC) conference. This year’s was the biggest yet with over 1,000 delegates and top minds coming together to shape Hong Kong’s role in the evolving Fixed Income RMB market.
 
The development of our FIC market is of the priorities in our Strategic Plan, and we’ve been making good progress. Our flagship product, the USD-CNH futures contract, has had the highest liquidity and distribution among the world’s exchanges over the last few years. In January, both volume and open interest broke all-time records, with more than 20,000 contracts traded and open interest of 46,000 lots. This year, we also launched new RMB interest rate and currency derivatives products, and we plan to launch the RMB-USD dual-counter gold futures contract in July and other new FX, rates and credit products in the future. This enhancement of our product suite aims to provide investors with a complete RMB risk management solution to hedge interest rate and FX exposure while holding Chinese bond assets.
 
While we continue to build out the product side, there was another topic on everyone’s mind today: Bond Connect. I was peppered with questions about the breakthrough cross-border scheme, particularly about how it will work and what it means to Hong Kong and the Mainland.
 
Bond Connect is a pilot scheme that will connect China’s interbank bond market with the world, giving international investors “Northbound” access to trade bonds directly on the China Foreign Exchange Trading System (CFETS) for the first time. “Southbound” trading will start later, giving Mainland investors the opportunity to trade in major overseas OTC bond markets.
 
Bond Connect represents a major breakthrough in the development of the China bond market, which is the world’s third largest after the United States and Japan. The market has been growing dramatically by 20 per cent year-on-year, reaching US$9.6 trillion in outstanding size as of March this year. Various factors are driving this growth, including the International Monetary Fund’s decision to include the RMB in its Special Drawing Rights basket, the RMB’s inclusion in emerging market bond indices, funding needs for China’s economic transition and strategic projects such as the Belt and Road initiative, green bonds and special project financing. 
 
Bond Connect isn’t the first time foreign investors will have access to China’s bond market, but we believe it will be the most significant. Right now, foreign investors can buy and sell bonds through the People’s Bank of China eligible-institutions scheme in the interbank bond market, known as the CIBM Scheme, as well as through the QFII and RQFII schemes. But Bond Connect will be different, and a much more convenient channel.
 
For instance, under Bond Connect, there is no quota or the need to stipulate an intended investment amount, which is required under the existing CIBM scheme. Also, while the access rules are the same under both schemes, we expect a simplified and streamlined admission process for Bond Connect.
 
Trading is also more efficient. Under the CIBM Scheme, an investor has to trade Chinese bonds through the use of an onshore bond settlement agent bank. The settlement agent bank will then negotiate with onshore dealers on the client’s behalf. Under Bond Connect, an offshore investor can trade directly with eligible onshore dealers through electronic request-for-quote and native interfaces of established electronic bond trading platforms. This is expected to enhance the price discovery and liquidity of trading Chinese bonds. 
 
Finally, investors have to open onshore settlement accounts with ChinaBond and the Shanghai Clearing House under the CIBM Scheme, while Bond Connect will allow investors to continue using offshore global custodians via the Central Moneymarkets Unit through the nominee structure. There are also mechanisms under Bond Connect to allow flexibility to use CNH or foreign currencies for payment. 
 
In sum, the scheme brings many benefits. Foreign investors account for just 2 per cent of China’s bond market, but make up about 30 per cent of the US market. There is substantial room for growth in China’s bond market, and Bond Connect could be a catalyst that unlocks that potential. Over time, Bond Connect will also internationalise onshore trading and settlement infrastructure, and help the onshore and offshore RMB markets converge.
 
With Bond Connect, Hong Kong gets an immediate and strong relevance in the fixed income space while HKEX expands the Mutual Market programme that began in 2014 from stocks into a new asset class. Bond Connect won’t bring HKEX significant revenue in the short term, but is a key strategic initiative that will see Hong Kong grow further beyond its traditional equities business and put an important foundation in place for HKEX’s further developments in FIC, particularly in derivatives.
 
Even more importantly, Bond Connect is a great example of the value that Hong Kong can bring to China’s development. China has built its own capital markets over the past 20 something years. With their deep capital, huge market size and late mover advantage, they have learned from the experience and evolution of major international markets and built their market top-down with a very different design.  It is a unique market that operates in a distinct way. Meanwhile international markets have long histories and their own market expectations and practices. Therefore as China continues to open and integrate with the global community, Hong Kong has a vital role to play to bring these two sides together, helping them connect efficiently and interact in a way in which both sides feel comfortable. 
 
Bond Connect is more evidence that China is accelerating the liberalisation of its capital market. It is also a great example of the benefits Hong Kong can enjoy when it creates value and builds connections between China and the international community. We have no doubt that China’s opening up will continue to bring Hong Kong new opportunities, although the pace will remain uncertain as the Mainland authorities do what they feel is best for the country, at the time they are most confident. We will continue to stay on our toes and work towards creating lasting value for international, Hong Kong and Mainland market users.
 
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