China’s spectacular growth over the past decade has been one of the more successful emerging market stories of recent times. Yet, this growth in domestic wealth has so far had limited impact on the international equity markets, with cross-border investment flows remaining largely untapped due to strict capital controls. This may be about to change.
The Asian markets have traditionally been less homogenous than markets in Europe or the Americas, but a number of so-called ‘through train’ projects are bringing these relatively disparate markets closer together. A good example of this is a recent market structure pilot, called the Shanghai-Hong Kong Stock Connect initiative, which went live last month. The goal of this project is to strengthen the trading links between mainland China and Hong Kong by opening up their respective equity markets to each other.
While it’s too early to predict the impact that this initiative will have on cross border investment flows, the enthusiasm surrounding it seems justified if you consider the recent growth of Renminbi trading following its recent internationalisation.
The volume of RMB trading has almost tripled since 2012, with the Chinese currency poised to overtake both the Canadian and Australian dollar. However, this growth means that RMB still represents below 2 per cent of cross-border payments. The US dollar is in a highly dominant position at 42 per cent. Westpac is forecasting that China’s share of global GDP will be 15 per cent by 2018. It’s reasonable to assume that the volume of RMB payments could also rise to the same level – a possible seven-fold increase.
While the Renminbi growth has been a boon to the banks, similar initiatives in the securities markets have, until now, been lacking. The Shanghai-Hong Kong Stock Connect initiative could signal a rapid change.
When the project was announced in April 2014, the Hong Kong brokerage and custodian community made it their top priority. It has many compelling features – most notably, the hitherto restricted access to China stocks for overseas investors and, the demand from Chinese retail investors who’ll now get access to Hong Kong stocks.
While the positive impact of the project looks promising, there are challenges which may threaten its anticipated success. These challenges relate to the operational environment around the Shanghai-Hong Kong Stock Connect initiative. The Chinese market operates a uniquely fast settlement cycle of T+0. If you buy a stock today, you also have to pay for it today. The Chinese operating model, which remains intact within the Stock Connect, compresses this 24-hour window into approximately 30 minutes.
A good example of the operational complexity this creates is the requirement to move a stock from a custody account to a brokerage account prior to a sale. For an institutional customer, any sale requires two settlement processes: one free-of-payment delivery to the broker, followed by a delivery-versus-payment settlement with the counterparty.
This creates a unique set of challenges for post-trade processing. Omgeo, the global standard for post-trade efficiency across the investment industry, will look to address this by requiring clients to have their middle office processes completed by 7:45am local time on the trade-date. This timescale requires near real-time processing and full automation of the post-trade process, which is further exacerbated by the time-zone difference. Immediate resolution of a query will be essential to preventing a failed-trade scenario.
In the early days of Stock Connect, we haven’t seen explosive volume growth in the Northbound (Hong Kong-Shanghai) direction. Given the operational complexities involved, participants will tread cautiously to prove that the trading and post-trade processes do work. But, in the long run, this could be the start of something very big indeed.
Tony Freeman is executive director of industry relations at Omgeo