Bond Connect: a new path into China's $9,300bn bond market

Links between different countries’ capital markets to encourage cross-border trading have a chequered history. The Asean Trading Link between Singapore, Malaysia and Thailand has no post-trade connectivity. MILA, Latin America’s integrated market, is hampered by conflicting national regulations. And London’s proposed tie-up with the Shanghai Stock Exchange (SSE) has been watered down to a global depository receipt scheme. 

Conversely, the Stock Connect between Hong Kong and mainland China is revolutionary. Hong Kong Stock Exchange’s (HKEX) link with SSE since 2014, and Shenzhen Stock Exchange, which was launched last December, are the world’s most ambitious and successful mutual market access schemes.

This is partly because they unlock foreign access to Chinese A shares – the world’s second biggest, yet essentially closed, equity market. But it is also because Stock Connect offers a completely streamlined service. Investors can trade, clear and settle via their home market intermediaries. From their perspective, they may as well be buying and selling local stocks.

Growing the Connect family

Stock Connect’s trading volumes have ebbed and flowed, but all major brokers have signed up and the teething problems – largely stemming from the markets’ different settlement cycles – have more or less been resolved. Now the plan is to roll it out to other asset classes.

HKEX’s charismatic CEO, Charles Li, has become the unofficial face of the Connect concept, publicly declaring plans to link markets in bonds, exchange-traded funds (ETFs), initial public offerings (IPOs), block trades, derivatives and commodities. As Connects are a joint initiative between the Hong Kong and mainland governments, regulators, exchanges, clearing houses and other infrastructure providers, Mr Li may not necessarily get everything on his wish list, but momentum is in his favour.

Hong Kong authorities want to cement the city-state’s status as a gateway to China. Mainland authorities are determined to get A shares into MSCI’s emerging market index and its bonds into the biggest fixed-income benchmarks: a prerequisite for both parties is more open capital markets.

Plans for a Bond Connect and ETF Connect are the most advanced, with China premier Li Keqiang announcing in mid-March that the bond link will launch this year. Hong Kong Monetary Authority has told The Banker it is working with mainland authorities on ways to improve connectivity between the two bond markets, but many bankers are scratching their heads about how these Connects will work, how popular they will be, and if they are actually needed.

Of all the links being considered, Bond Connect is the boldest. Like the rest of the world, some 90% of bond trading in China and Hong Kong is over the counter (OTC). Their small number of exchange-listed bonds will be added to the Stock Connect channel with relative ease, but Bond Connect is only worthwhile if it links OTC markets. That is a difficult proposition.

OTC markets consist of myriad trading platforms, clearing houses and custodians, and outside of closed markets such as China, national boundaries have little meaning. Their fragmented nature means there is no easily identifiable entity or infrastructure via which the two OTC markets can be linked. From China’s perspective, this entity serves the added purpose of ensuring that cash leaving the mainland to buy securities is repatriated once the securities are sold. This so-called ‘closed loop’ system ensures that Connects abide by China’s capital controls.

Competing models

Two models for connecting OTC markets have been proposed to the authorities. Hong Kong’s Financial Services Development Council (FSDC), an advisory body established by the government in 2013, has suggested that banks with operations in Hong Kong and the mainland be the lynchpin of the scheme, connecting investors in the two markets. The banks would be responsible for placing orders, trading, clearing and settlement, and acting as custodian. By managing the entire trade cycle, they would have full control of fund flows and can ensure they are repatriated.

FSDC committee member George Leung believes this would be easy to implement from an operational perspective. “Many banks are already set up to provide this platform, so if the scheme were approved it wouldn’t be hard for them to adopt it,” he says. “It just depends on the willingness of the two governments and their agreement on compliance, clearing and settlement discrepancies.”

The FSDC’s proposal, published in November 2016, focuses on retail investors. Mr Leung says this is because institutional investors have other ways to access China’s OTC market (known as CIBM) – most notably through qualified foreign institutional investors (QFII) and renminbi-qualified foreign institutional investors (RQFII) schemes – but he confirms it could be extended to all investors.

The FSDC proposal could be a boon for bigger banks, but has its critics. Benny Mau, chair of the Hong Kong Securities Association, says: “It excludes brokers that don’t offer the full suite of post-trade services in both markets. I don’t think it’s a very practical solution.”

The other model, being worked on by HKEX, would see the exchange partner with one or more electronic trading (e-trading) platforms, which would provide the OTC trading venue for Hong Kong’s side of Bond Connect. HKEX would act as the aggregator, connecting the city-state’s OTC market with CIBM. The objective of this model is for international investors to continue trading OTC exactly as they do today – using the same channels for settlement and custody – but with the added benefit of access to CIBM.

Design priorities

Policy-makers are yet to publicly endorse a Bond Connect model, but Mr Leung points out that it is possible both could be adopted. “By proposing multiple channels, we give regulators in both markets a choice as to which to implement. We don’t care if this or another scheme is used, or if both are created and banks can choose between the two depending on where transaction costs are lower,” he says, stressing the ultimate objective is access to China’s bond market.

Whatever the model, it must learn from the Stock Connect experience. For instance, one of its outstanding wrinkles is that EU funds’ beneficial ownership rules clash with HKEX’s use of an omnibus account, via which shares are registered in the exchange’s name.

“Historically what has undermined the Connect initiatives is not China or Hong Kong regulation, but offshore regulation,” says Barnaby Nelson, Standard Chartered head of securities services for greater China and north-east Asia. “The regimes governing the real buyers and sellers – so UCITs V, the US 40 Act and the Luxembourg framework – will need a good level of scrutiny and proofing to make sure the model works.”

Internal competition

A more fundamental issue is whether Bond Connect is needed. Last year, China launched CIBM Direct, a scheme that allows foreign institutional investors to buy mainland OTC bonds with no licence or repatriation restrictions, as long as they register with a mainland broker and custodian (which takes two to three months).

This is a significant step up from QFII and RQFII (a licence for which can take six months) and some believe it diminishes the value of a Connect. The Asia Securities Industry & Financial Markets Association supports Bond Connect, but it has its eye on the bigger picture. Its chief executive, Mark Austen, says: “Our big focus has been on direct access into China’s fixed-income markets. In our view, the relaxation of CIBM restrictions – effectively allowing investors to trade if they open an account with a settlement agent onshore – is the preferred solution.”

China is improving CIBM Direct, most recently allowing foreigners to hedge foreign exchange (FX) risk onshore, but for most investors the scheme is still far from plain sailing. Bloomberg and the big e-trading platforms are not in China, so investors need new avenues to get pricing and issuer information, and a lot of liquidity is found in chat rooms which, following the global benchmark rigging scandals, many asset managers and big brokers have banned their traders from using.

There are logistical issues, too. Every trade must be manually recorded in a central trading database known as CFETS, and every fund requires its own settlement account. For those that invest on a large scale and via multiple funds, these issues are more problematic than navigating the trading environment.

“The interbank market is robust and the framework works. It’s really the logistics of account opening, and the downstream process of clearing, settling and recording trades that are hurdles,” says Sam Kim, BlackRock's head of trading and liquidity strategies for Asia-Pacific.

Some technology firms are developing straight-through processing solutions to speed-up the CFETS process, and Mr Kim says these would solve a lot of their issues.

More avenues the better

Despite CIBM’s opening, Cindy Chen, Hong Kong head of securities services at Citi, remains in the pro-Bond Connect camp. She believes the ability to trade via offshore intermediaries, with no overheads or interaction with mainland processes, is compelling and will attract new investors.

“At the end of the day, institutional investors are under pressure to reduce cost,” she says. “Accessing China onshore bonds directly through QFII, RQFII or CIBM still requires significant resources and work to set up. But under Bond Connect, it is expected that you get similar ease of access as Stock Connect.”

CIBM Direct is restricted to institutional investors, but Mr Leung notes that the internationalisation of the renminbi means firms of all sizes are increasingly exposed to the currency, citing the example of small and medium-sized enterprises.

“The renminbi is one of the biggest currencies for global payments, and while many companies hedge their FX risk through institutional investors, smaller companies can’t,” he says. “Before they can accept renminbi as a trading currency, they need a channel to invest surplus funds. That can be provided by Bond Connect.”

The overarching argument of Bond Connect proponents, though, is the opportunities presented by China’s bond market. At $9300bn it is the world’s third largest, yet less than 2% is owned by foreigners. The renminbi’s depreciation has subdued appetite for China fixed income at present, but bankers and asset managers are bullish about the longer term. China’s efforts to grow green finance, municipal bonds and new types of securitisation suggest it will soon be home to one of the world’s most vibrant bond markets, and for foreign investors, the more inroads the better.

ETF Connect: a no-brainer

While Bond Connect has divided opinion, ETF Connect is considered a natural extension of Stock Connect. ETFs list and trade in a similar way to equity, so it can use Stock Connect’s existing infrastructure. There are some operational issues – Hong Kong-listed ETFs, for instance, settle within two days of the trade date, while in China it changes depending on the underlying security, and whether it is listed on SSE or Shenzhen – but these are not insurmountable. Its launch is purely a regulatory and policy decision, and those involved are quietly confident it could be this year.

The biggest flows will be southbound. As HKEX-listed ETFs can be based on underlyings from around the world, an ETF Connect will give some mainland investors their first exposure to European and US securities. China’s rising middle class has built a pool of disposable income that is looking for an alternative to A shares.

As a retail-orientated product, ETFs are a good fit. Kinger Lau, Goldman Sachs’ chief China equity strategist, believes ETF Connect would be well received by A share investors. “Some domestic Chinese investors think investing in single stocks via HKEX is risky as there is no daily limit up/limit down, so they may prefer to get exposure through ETFs, especially those with international underlyings such as the FTSE 100 and S&P 500,” he says.

There would also be northbound demand. There are HKEX-listed ETFs that provide broad-based China exposure, but they pale in comparison to the range of specialist ETFs listed on the mainland. Access to these would allow foreigners to make more targeted bets on China’s growth. 

A potential stumbling block is eligibility requirements. Ms Chen gives the example of Hong Kong and China’s mutual recognition of funds (MRF) scheme, which permits cross-border distribution of funds, but only if they meet certain requirements including size, domicile and track record. If MRF rules were applied to ETF Connect, she says only 15 of the 150 listed on the HKEX would be eligible to trade.

IPOs and block trades

Ironically, the Connects that Hong Kong bankers are most excited about are beyond the horizon. An IPO or Primary Connect – allowing new listings on HKEX, SSE or Shenzhen to be sold directly into the other market – could end HKEX’s dominance by mainland companies. “To develop Hong Kong as an international financial centre, the Primary Connect would potentially have the biggest impact,” says David Lau, JPMorgan’s head of global investment banking for Hong Kong. “It could draw many foreign companies to list here as it will enable them to get exposure to a new investor base: People’s Republic of China investors.”

But sceptics note that world-class private companies do not need Chinese funds. And for mainland listings, foreign investors would have to acclimatise to mainland protocols and compete with local asset managers that have huge assets under management. “It requires a lot of work for international investors/funds to set up to participate in China’s domestic IPOs, but the reality is that IPOs in China are [often] hugely oversubscribed, so the allocations are quite limited,” says Nicole Yuen, Credit Suisse’s head of equities Greater China. “Today, QFIIs and RQFIIs can already subscribe to IPOs, but very few of them do so because of the limited immediate benefit.”  

She believes a Block Trade Connect has the most potential. It would be easy for brokers with operations in both markets to line up a buyer and seller, and it would help big institutions in China that are looking to sell large holdings, and international investors to acquire blocks at a particular price.

Build it, they will come

Stock Connect does not guarantee the success of links in other asset classes, but it has laid the groundwork. It has created a precedent for regulatory co-operation and helped bring A shares, and China capital markets more generally, into the mainstream. “People are now willing to entertain the concept of investing in A shares rather than simply dismiss them as high risk and something that doesn’t concern them,” says Gary Monaghan, investment director at Fidelity International. “Over time you can foresee them being considered as a regular investment as you would a Japanese or Indian stock. The investor psyche is definitely changing.”

The Chinese mainland’s and the Hong Kong authorities’ commitment to Stock Connect has made it succeed where other links have failed. Nothing less should be expected of the next additions to the Connect family.