Bond Connect will feed Hong Kong’s desire to become a hedging centre for China risk, but some believe the city-state should step up its efforts now. Danielle Myles reports.

Could Hong Kong become Asia’s equivalent of Chicago? The case for the city-state to become a derivatives hub has strengthened as China accelerates opening up its capital markets to foreigners. Overseas investors want exposure to the world’s second largest stock market and third biggest bond market, but not without efficient hedging tools, of which there is an undeniable shortage.

“A major reason many investors aren’t accessing the market now is because it’s difficult to hedge. Onshore interest rate and foreign exchange markets – if they do exist – are not very liquid, and in many cases foreigners can’t access them directly,” says Mark Austen, CEO of the Asia Securities Industry & Financial Markets Association (Asifma).

Hong Kong market snapshot

FIC focus

The Hong Kong Stock Exchange (HKEX) is attuned to the opportunities this presents. While its mainland strategy over the past two decades was to provide a venue for Chinese companies to raise capital, increased cross-border flows means a major focus for it now is risk management tools.

“The opportunity has arisen for us, because of where we stand, to get into those businesses and cater to what China and the rest of the world going into China will need over the coming decades,” says James Fok, HKEX’s head of group strategy. “What we constantly have our eye on is the market in financial derivatives, because as the renminbi internationalises, there will be more use for those products.”

HKEX’s overarching goal to diversify away from cash equities and build its derivatives offering includes launching an A share derivative, but the real focus is the much bigger market in fixed income and currency (FIC) derivatives. This is a sticky business so there is a first-mover advantage, and HKEX faces competition from Singapore, which is also vying to become a China hedging hub.

This raises the question: what has held it back? The answer is Bond Connect, the proposed link between China and Hong Kong’s over-the-counter and exchange-listed bond markets .

A prerequisite?

HKEX started looking at China-related derivatives a few years ago when it launched its US dollar/offshore renminbi future. “[But] it became very clear that while we could put out these products, there was unlikely to be huge demand simply because there wasn’t enough cross-border investment in the fixed-income market,” says Mr Fok. “Until that happened, we knew there wasn’t really going to be a market for these products.”

With mainland and Hong Kong authorities now working on a fixed-income equivalent of the successful Stock Connect scheme, HKEX sees the time approaching when it can push China interest rate products and expand its offshore renminbi currency pairs. Indeed, one of its primary motivations for Bond Connect is that it offers a way into FIC derivatives.

But some say a cash market is not a prerequisite. Asifma has called on Hong Kong authorities to deepen and promote its derivatives offering for years, noting that other derivatives hubs have no market in the underlying. Foreign investors in Indian government bonds, for example, hedge foreign exchange exposure in Singapore.

“Hong Kong has a lot of potential as a derivatives centre. It could almost become to Shanghai what Chicago is to New York,” says Mr Austen. “China can control the cash market, but for derivatives you need robust legal infrastructure and strong rule of law. It will take some time for China to develop that, but Hong Kong already has all of this in place.”

Logical location 

Mainland China authorities are relaxing entry restrictions for its onshore hedging markets, most recently opening its domestic foreign exchange market to certain overseas private sector investors. But the buy-side needs a stable hedging environment, and must be reassured that they are complying with the (sometimes opaque) rules. Developments over the past 18 months suggest that in China, this is not a given.

In mid-2015, mainland authorities clamped down on CSI 300 futures trading to stop speculators betting against the collapsing equity market. Last year, foreign investors were given access to the onshore interest rate market to hedge interbank bond exposures, but a lack of clarity around what qualifies as hedging means few of them have taken advantage.

Hong Kong is the logical place to establish a China hedging hub. It must push ahead with bond futures, interest rate contracts, credit default swaps and foreign exchange derivatives to take leadership of this nascent market.

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