We’ve been busy preparing for the launch of Shanghai-Hong Kong Stock Connect since it was announced last month. We had a packed house of market participants on Monday to learn more about how the scheme works, and will hold more seminars in the weeks ahead. I want to use today’s blog post to set out the fundamentals of the scheme, so people can return to it at any time if they have questions.
What is Shanghai-Hong Kong Stock Connect?
Shanghai-Hong Kong Stock Connect is a mutual market access programme that will allow investors in Hong Kong and Mainland China to trade and settle shares listed on the other market via the exchange and clearing house in their local market.
Mainland investors who meet certain eligibility criteria will be able to trade eligible shares listed in Hong Kong, namely constituent stocks in the Hang Seng Composite LargeCap Index and Hang Seng Composite MidCap Index, and all H shares not included in these indices but that have corresponding A shares listed in Shanghai. It also allows Hong Kong and international investors to trade eligible shares listed in Shanghai, namely constituent stocks of the SSE 180 Index and SSE 380 Index, and all SSE-listed shares not included in these indices but that have corresponding shares listed and traded in Hong Kong.
Here is how the order routing and execution works:
What makes this scheme unique?
The scheme is a very significant breakthrough in the opening of China’s capital market. The programme was structurally designed to achieve the maximum benefits of a free and open trading market while maintaining adequate risk management parameters to ensure smooth and sustained governmental policy support. More specifically, the programme requires very limited changes to the existing legal and regulatory systems and market structures in each market, but allows investors to trade across the markets with minimum incremental costs or inconvenience. The following highlights the key features of the programme.
Order Routing in Gross for Maximum Price Discovery
Orders through Shanghai-Hong Kong Stock Connect will be routed to the other market for matching and execution. This means that price discovery will continue to take place in Shanghai for A shares as a single liquidity pool and similarly in Hong Kong for Hong Kong shares. The gross of all buy and sell orders under the scheme will go through the boundary, enhancing market driven liquidity.
Clearing and Settlement in Net for Minimum Cross-Boundary Fund Flows
Clearing and settlement will take place in the local market where investors are based and only the netting of the buy and sell orders in one market will be cleared and settled between the two clearing houses at the end of each trading day. In other words, for Northbound trades, ChinaClear will act as the host central counterparty and HKSCC will be a clearing participant of ChinaClear. HKSCC will take up the settlement obligations of its clearing participants in respect of Northbound trades and settle the trades directly with ChinaClear in the Mainland, while HKSCC clearing participants will settle the Northbound trades with HKSCC in Hong Kong.
The opposite will happen for Southbound trades. HKSCC will be the host central counterparty and ChinaClear will be its Clearing Agency Participant. ChinaClear will take up the settlement obligations of its clearing participants in respect of the Southbound trades and settle the trades with HKSCC in Hong Kong, while ChinaClear participants will settle Southbound trades with ChinaClear in the Mainland.
Also, when Hong Kong and international investors invest in A shares, ChinaClear will impose its own risk management measures onto HKSCC. HKSCC will, in turn, impose those risk management measures on Hong Kong clearing participants.
All RMB Conversions Happen in Hong Kong
All trades under the programme will be done in RMB. Mainland investors will use RMB to invest in Hong Kong stocks, with the exchange to Hong Kong Dollars taking place in Hong Kong by ChinaClear. Hong Kong and overseas investors must also use RMB to purchase stocks in Shanghai, with HKSCC paying RMB to ChinaClear. Unlike the QFII and QDII schemes, the RMB exchange will happen offshore, so it will not impact the onshore RMB exchange rate or China’s foreign exchange reserves.
The expected outflow of RMB from the Mainland and the expected inflow of RMB from Hong Kong will facilitate a healthy and significant offshore investment ecosystem for the RMB and help accelerate the internationalisation of the currency.
Closed Loop Fund Flow Supporting Prudent Risk Management
The design of the programme is such that fund and securities flows are insulated in the closed loop of the two settlement systems. Once Hong Kong and international investors sell their A shares or Mainland investors sell H shares, the money flows back to their home market bank accounts. Funds from the sale of shares cannot be used for speculation in other asset classes, such as real estate in the destination market. This design ensures that the programme is used exclusively for the purposes of investment activities between the two markets and cannot be used for other purposes as such money laundering and hot money asset speculation.
"Home Market" Rules Apply
When we drive in different countries we need to follow the rules of that country, and Shanghai-Hong Kong Connect is no different. Investors must abide by the rules in the market in which they’re investing.
Specifically, this can be reflected in the following three ways:
Firstly, listed companies remain subject to the listing regulations in the market in which they are listed and investors from the other market will no longer be able to rely on their own home market regulators for investor protection other than through mutual enforcement assistance programmes by the two regulators.
Secondly, trading and clearing participants are still subject to the rules and laws of the markets where they operate.
Thirdly, the trading and clearing rules and practices of the home market where the trades are executed will not be altered because of the programme. However, where there are differences, the relevant regulators may require their local participants to comply with certain local rules as well.
Both sides’ exchange and clearing company have an equal vested interest in the scheme as all trading and clearing revenues are shared equally, no matter where the majority of the trades may be executed. In fact, the entire scheme was designed symmetrically. Both sides have the same rights, responsibilities and obligations. If one side benefits, the other side benefits. If one side has a concern, it will be a concern for the other side as well. It is completely reciprocal.
This design also means regulators have a huge incentive to cooperate and ensure that their home market investors are adequately protected in the destination market and their home market trading is protected against market misconduct from participants based in the originating market.
Quotas for a Smooth and Stable Launch
Orders routed and executed through the Trading Links will be subject to a maximum cross-boundary investment quota, together with a daily quota that will be monitored in “real time” and used on a "first come, first served" basis. The quotas are in place to pace out the initial launch smoothly to avoid undue market volatility in the short term.
In the initial phase, Southbound trading of SEHK Securities will be subject to a daily quota of RMB10.5 billion and an aggregate quota of RMB250 billion, while Northbound trading of SSE Securities will be subject to a daily quota of RMB13 billion and an aggregate quota of RMB300 billion. As I mentioned earlier, calculations will be based on "netting" of buy and sell orders, which means the quota should be able to support much larger trading volumes.
Scalable in Size, Scope and Markets
Quotas are only one of the initial restrictions on the scheme, with the others being investor eligibility for Mainland investors and eligible stocks. These requirements are also in place to ensure prudent risk management at launch. Assuming a successful launch and smooth running of the programme, and subject to regulatory approvals, these restrictions are expected to be phased out over time.
What does this mean to Hong Kong and Mainland China?
Some commentators have characterised this programme as a government initiative to boost the domestic A share market or a supportive policy in favour of Hong Kong. While the announcement of the programme did provide short-term positive momentum in market sentiments both in Shanghai and Hong Kong, the significance of the programme is much broader and deeper. In many ways, it is a major step in the journey towards China’s financial market opening and the internationalisation of the RMB.
The Mainland benefits from the scheme by opening to a much broader international and institutional investor base while enabling greater diversity in the portfolios of Mainland investors. It creates a mutually accessible, comprehensive, closed-loop, scalable, and controllable scheme for the very first time that lets the market take on a more vital role and creates additional room for the further opening of China’s capital account.
Hong Kong will also secure significant strategic benefits from the programme in consolidating its position as the international market of choice for the Mainland to go international and the China market of choice to access China. It also enhances our position as the world’s primary offshore RMB centre, increases liquidity and broadens our investor base. It even paves the way for possible mutual market access across other asset classes and connecting with other markets in the future.
We first welcomed H shares to Hong Kong in 1993 in a scheme that, with hard work and patience, contributed massively to Hong Kong’s success over the past 20 years. If we nurture and grow Shanghai-Hong Kong Stock Connect in the same way, I’m confident it will have an even more transformative impact on Hong Kong and Mainland China.
For now, our first priority is to help prepare the market thoroughly to ensure a smooth launch later this fall. I look forward to continuing to keep you posted on all key developments in this important journey.