During the month of October, you will be hard-pressed to find a more significant capital market development impacting not just Asia-Pacific, but globally, than the Shanghai-Hong Kong Stock Connect program.
For the first time ever, qualified institutions and individuals in mainland China and Hong Kong will be able to buy and sell shares listed on the Hong Kong Stock Exchange (HKSE) and the Shanghai Stock Exchange (SSE) respectively, subject to quotas.
The program will loosen restrictions on capital flows in and out of China, representing a move toward the long-awaited opening of China’s financial markets. It also paves the way for future mutual market access connections with other exchanges such as the Shenzhen Stock Exchange.
Importantly, it will yield benefits for both China and Hong Kong. China will gain access to a broader base of domestic and international investors. Meanwhile, Hong Kong will enhance its position as an international market centre, a gateway to the mainland and an offshore renminbi centre. The implications for the global capital market participants are huge.
Understanding the rules before playing
There are some general rules of the program that all participants need to play by. The program has been set up so the local market’s trading and clearing rules govern the transactions. Issuers will be subject to the listing rules and regulations of the market in which they are listed.
Investors trading eligible shares on the SSE (northbound) will have to abide by the local market and clearing rules in China and vice versa for southbound transactions. While all mainland institutional investors and qualified individual investors may trade eligible stocks listed on the HKSE through the SSE directly, qualified individual investors must hold an aggregate balance of at least Rmb500,000 in their securities and cash accounts.
Additionally, all Hong Kong and overseas institutional and individual investors may trade eligible stocks listed on the SSE through the HKSE directly.
From an operational perspective, trading may only occur when both the SSE and HKSE are open. There will be no impact to existing workflows, and all orders will be treated in the same manner regardless of the origin.
Eligible shares listed in Hong Kong are the constituent stocks in the Hang Seng Composite LargeCap Index and Hang Seng Composite MidCap Index. Also eligible are all H shares not included in these indices but have corresponding A shares listed in Shanghai. Eligible shares listed in Shanghai are the constituent stocks of the SSE 180 Index and SSE 380 Index. All SSE-listed shares not included in these indices but that have corresponding shares listed and traded in Hong Kong are also eligible.
Clearing and settlement will take place in the local market where investors are based through ChinaClear and Hong Kong Securities Clearing Company (HKSCC). The two clearinghouses will establish a direct link for cross-boundary clearing and each will become a clearing participant of the other. Only the net of the buy and sell orders in one market will be cleared and settled between the two clearinghouses at the end of each trading day. All transactions will be denominated in RMB.
Orders routed and executed through Shanghai-Hong Kong Stock Connect will be subject to a net maximum cross-boundary investment quota and a daily quota. This will be monitored in real time and used on a first come, first served basis.
From general rules to local trading rules
In general, exchange participants need to ensure investors only trade shares they are allowed to trade, they have sufficient funds in their account, and that aggregate amounts do not exceed the quotas. However in addition to this, northbound transactions must be monitored for compliance with mainland China’s local market regulations, including but not limited to short selling and day trading rules. These rules may at first glance appear simple to follow, but present challenges of their own.
For example, the rule on the restriction of naked short selling will present brokers with some monitoring challenges. Hong Kong and overseas investors are prohibited from naked short selling in SSE securities. Investors who want to sell shares will have to provide proof of their holdings on day T-1 or during a new, specially-created morning session on day T to ensure compliance with the rule. Currently, positions must be transferred to the clearing broker during one of these times for the investor to sell their shares on day T.
The rule itself seems simple enough; however, this requirement creates a less obvious implication: the possibility of information leakage leading to front running or insider trading. Parties could benefit from knowing that a large seller has a pattern of transferring holdings to their clearing broker before executing sell orders. Therefore participants must surveil not just for unintended violations of the rule, but also the potential for front running and insider trading. In a similar vein, day trading is not permitted on the SSE, meaning that Hong Kong and overseas investors buying SSE Securities on day T can only sell the shares on or after day T+1. Participants will need to monitor for violation of this rule and similar implications.
Additional challenges exist under Mainland China trading rules including price limits, restrictions on block trading, designated broker trading, margin trading and securities lending. All of these will need to be monitored to ensure compliance with local rules and regulations. Outside of the trading rules, brokers and investors will need to be mindful of various existing shareholder ownership and disclosure obligations.
Program expansion
Shanghai-Hong Kong Stock Connect paves the way for future mutual market access connections with other exchanges such as the Shenzhen Stock Exchange (SZSE). The same concepts that apply to the SSE would also apply to SZSE. There is also the potential to extend mutual links to exchanges that list other asset classes including futures and options, fixed income and other derivatives. Brokers will need to consider cross-asset surveillance implications such as monitoring derivatives and their underlying asset for manipulation.
In either case, adjustments will need to be made to accommodate the universe and type of securities, changes to trading models and rules, and cross-market or cross-asset implications. To cater for all of these, brokers will need systems that are adaptable, easily configurable and can scale up with the size and scope of the program.
Concluding remarks
There are still much to do before the launch of Shanghai-Hong Kong Stock Connect. All outstanding regulatory approvals must be granted, trading and clearing rules need to be finalized, and systems will need to be fully developed, configured and tested before they can go live. Exchange participants need to apply to participate and educate their clients about the program. In addition, there are unresolved issues regarding beneficial and foreign ownership rights as well as tax treatment. These will require concretely defined rulings by regulators and exchanges.
Shanghai-Hong Kong Stock Connect is an historical landmark project. No doubt its implementation will have a significant impact on Asia’s economy and the global financial markets. The onus though is on the industry following through with putting in place processes and systems to ensure market integrity.
Ulf Carlsson is vice-president and regional manager for North Asia and Japan, Nasdaq OMX; Michael Karbouris is head of business development, Asia-Pacific, Nasdaq OMX.
