China A-Shares lending slow to progress

China A-Shares lending slow to progress

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The lending of Chinese A-shares is the most exciting prospect for the securities finance industry anywhere in the world. Two initiatives are developing that could open the way for the lending of Shanghai-listed shares, but progress has been slow.

The first is Shanghai-Hong Kong Stock Connect, a pilot programme that went live in November 2014 linking the two stock markets, which has announced plans to open up a limited market in northbound securities lending as early as February. The second is the pilot scheme on mainland China, set up as part of a State Council-approved package of measures for liberalising the markets in January 2010, which remains limited to certain local brokers despite its multiyear gestation.

Shanghai-Hong Kong Stock Connect has been enabling investors in Hong Kong and mainland China to trade and settle shares listed on the opposing market via their home market exchange and clearinghouse, but it is only recently picking up traction after a surprisingly slow start. Trading is limited by an aggregate cross-boundary investment quota and to a specified range of listed stocks.

Nonetheless, it is a milestone in the region’s capital market liberalisation as a controllable and expandable channel for mutual market access between Hong Kong and the mainland, where authorities have kept a strong grip on yuan transactions. 

Stock Connect 

In January, Stock Connect issued proposals on stock lending but these have been deemed by some as unworkable. Its view of what constitutes securities lending is wildly out of kilter with the international industry standard. The proposals, published on January 23, demand that all lenders should be exchange participants despite the fact that exchange participants are uncapitalised entities. 

Moreover, it excludes other parties such as agent lenders, which are not even recognised as a potential partners even though they account for 90% of inventory to the developed nation stock-lending business. On these terms, even HSBC would be excluded. 

The Pan Asia Securities Lending Association (Pasla), which represents 62 – mostly global – financial firms present in the region, responded to the proposals in a written statement explaining the shortcomings of the proposals, suggesting that the model is so limited in its current form that it is unlikely that activity will get off the ground. 

Ariel Winiger, head of equity finance, Asia Pacific, at Societe Generale, says: “It was announced that covered short selling on eligible Chinese Stock Connect securities is tentatively scheduled to be rolled out in February 2015.” 

The rules of the exchange are still subject to the approval of the Securities and Futures Commission. 

“Under the proposed rules, it is uncertain whether it will attract much business because to be an eligible lender you have to be an exchange participant. Most brokerdealers and banks, though, transact their securities lending and hedging activities out of a legal entity that is not an exchange participant. 

“To have a meaningful lending inventory available for covered short selling, affiliates of exchange participants as well as custodian lenders and third-party agent lenders should be allowed to participate in this market,” adds Winiger. “As an industry, we have lobbied on this. We are hopeful the exchange is considering the industry’s suggestions. If they allow a functioning securities lending market to develop it will improve liquidity on all sorts of instruments and general volumes on Shanghai-Hong Kong Stock Connect.” 

There are also other secondary issues. The exchange is only allowing participants to borrow for the purposes of short selling, and financing-related transactions are not a permitted purpose under the current lending proposal, adds Winiger. 

One head of a delta one desk in Hong Kong says: “The exchange will have to revise the rules, once they realise no one is using it. These are the two main hurdles and until they are resolved, there is nothing much to talk about. The launch will likely be put back until after the summer.” 

Scott Sapp, vice-president at Hong Kong Exchanges and Clearing, told Global Investor/ISF that “short selling of A-shares via Stock Connect is pending system changes”. He says system testing was taking place in January and that the plan to roll out short selling of securities through the China Connect service in February remains in place. But he says there is an extensive list of systems checks and balances that need to be made to facilitate and control the process, adding:

“Implementation of some of the requirements… needs system support. Therefore, covered short selling of Shanghai Stock Exchange (SSE) securities is not available at the initial launch of Shanghai- Hong Kong Stock Connect. The Hong Kong Stock Exchange (HKEx) will keep the market informed of developments and the proposed timing of implementation.” 

The likelihood is that the initiative is playing second fiddle to the HKEx’s much-hyped trading link with its counterpart in Shenzhen, a launch that is critical to MSCI’s annual June review, during which the index provider will determine whether to include A-shares in its flagship Emerging Markets Index. An affirmative decision would drive billions of dollars into Chinese shares. 

The 1,600 stocks in Shenzhen are important not only because foreign investors would be able to trade the next generation of Chinese companies, such as software, tech and biotech stocks through the Hong Kong exchange, but because the scale would help alleviate MSCI’s concerns about liquidity. 

The Shenzhen launch is already expected to slip from June to the second half of this year, but a third quarter Shenzhen launch would not necessarily rule out inclusion in the index provided a formal commitment is made. Changes to the index will not take place until 2016, so Shenzhen could be operational well ahead of the time funds would be reallocating in line with the index. Longer term, securities lending is something Stock Connect will have to address and all parties have an interest in getting as much supply as possible onto the platform. 

“A stock borrowing and lending (SBL) market and short selling play a critical role in any equity market,” says Nick Ronalds, managing director, head of equities at the Asia Securities Industry & Financial Markets Association (Asifma). 

“For Stock Connect to develop and thrive, a well-functioning SBL and short selling market are a risk-management tool for brokers in the event of an operational problem resulting in a delivery fail. They play a risk-management role in many portfolios as well, for hedging and managing beta exposure. At present Stock Connect lacks the rules or infrastructure for SBL and short selling. The exchange is working to remedy this deficiency and when it is available an important tool for the evolution of Stock Connect will be in place.” 

Traditionally, international investors have gained access indirectly to the mainland’s securities markets through investment products such as qualified foreign institutional investor (QFII) funds, renminbi QFII (RQFII) funds and RQFII A-share exchange traded funds (ETFs). QFIIs are given a specific quota for their investments in the China A-share market, to be made onshore within China. Such investors tend to have long-term horizons and do not typically engage in SBL activities. 

However, Stock Connect is not necessarily making QFII access unviable and there are still Shenzhen shares and convertible bonds that cannot be accessed through the link at the current time. 

Structural differences 

A securities lending framework would oil the operational wheels in fundamental ways, according to Eugenie Shen, managing director and head of asset management group at Asifma.

“With the structural differences between the China onshore investment structure and the Stock Connect offshore investment structure … foreign investors may need to borrow securities to avoid pre-delivery to reduce counterparty risk exposure to the brokers.” 

She says this is due to the requirement for the pre-delivery of shares by foreign investors to brokers before a trade order can be placed, and uncertainty over whether that trade order will be completed due to the daily quota limit. “So SBL may be more important under the Stock Connect structure for foreign investors.” 

Securities lending applications also extend well beyond the physical shorting of shares. “The rules need to allow fundmanagers and their custodians to lend out Chinese stocks to borrowers, something not permitted at present,” adds Asifma’s Ronalds. 

“Developed markets also allow agency stock lenders, firms specialising in brokering SBL business, to facilitate the SBL market. Once the rules and players are in place, important trading strategies become available. Investors would be able to manage their exposure to Chinese equities with more control. The classic strategy is to go long stocks or sectors you think will outperform and short the ones you think will lag. Such strategies can be done on a market-neutral basis, with a long bias or a net short bias. The ability to short is a valuable tool for investors seeking customised exposures to the market and to risk.” 

These developments are also facilitating other options. Zubair Nizami, vice-president, global securities lending, at Brown Brothers Harriman, says: “As one would expect given the strong level of interest in the Connect scheme, prime brokers are offering short access to their end users through synthetic transactions , by offering short exposure utilising the long inventory that is being acquired through northbound trading. 

“In this sense, this is not too dissimilar to what is offered in other markets, where access to securities lending is limited or is in its nascent stages. We expect this trend to continue for the foreseeable future until we see a loosening of the securities lending rules currently outlined in the Connect scheme, or an alternative offshore lending model is developed by the regulators.” 

Developments such as the Shenzhen link would also help complete the suite of products, says Nick Lewis, head of equity financing, Asia ex- Japan at Nomura. 

“While the first step was only to allow purchases and long sells between both Shanghai and Hong Kong, the anticipation of extending to Shenzhen as well as SBL activity is expected to transpire in the near future. With the recent announcement of allowing ETF options in the short term as well as bonds and ETFs later in the year, this could complete the product suite where QFII has traditionally been the route of access. The allowance of synthetic shorts is the first step toward this objective, which has created more liquidity not only on index constituents, but also via ETF hedging.” 

On the mainland, a pilot securities lending programme has been in place since August 2012, originally involving just 11 selected Chinese banks. The initiative was a pet project of Guo Shuqing, former head of the China Securities Regulatory Commission (CSRC), who saw securities lending as an important part of the journey to internationalise the renminbi. As expected, the scheme’s development has been rigidly controlled by Beijing. 

The very first phase of the pilot project was limited to allowing brokerages to borrow money, not shares, from institutional investors. A centralised lending exchange now makes shares sourced from banks, insurers and fund management firms available to qualified fund managers in China, which borrow them for a fee. The eligible pool of shares included 90 listed blue-chip companies, equivalent to roughly 50% of China’s A-share market capitalisation. 

The pilot scheme did not develop significantly over the following two years and Shuqing – his hands full trying to breathe new life into the country’s beleaguered stock markets – moved on after 17 months. There was even some speculation that anticipation of the new rules was a contributory factor to the Chinese stock markets’ poor performance. 

Then last year, the CSRC announced that the pilot programme had been extended to double the number of brokerages and it had made the entry thresholds lower. There are now 40 eligible stocks on the Shenzhen Stock Exchange, while eligible collateral includes cash, government bonds, ETFs and other listed funds as well as listed bonds and shares, with varying levels of haircuts. 

However, one head of equities at a global bank who recently met brokers in the region says while they are all looking at China’s nascent securities market, liquidity is poor and fees in turn are extremely high, creating a circle of limited usage. The cost of borrowing is three to four times as high as it is in developed markets and securities brokerages do not have a substantial amount of proprietary inventory to lend. 

The CSRC is looking to address these weaknesses by developing a bilateral SBL framework onshore, which will permit domestic securities companies to provide securities lending business to QFIIs. It has also set up a programme providing training for 75 securities companies on margin trading and short selling. 

Mainland pilot scheme 

Martin Corrall, chairman of Pasla, says: “Currently onshore SBL in China facilitates margin financing intermediated by the China Securities Finance Corporation (CSF) as a central counterparty, but this is only available to onshore market participants. 

"The CSF is planning to develop a bilateral SBL framework onshore, details of which are yet to be announced. The Pasla board members and I met the CSRC and the CSF last year and it is encouraging that a bilateral model is being considered onshore. It will be interesting to see how this develops together with SBL through the Shanghai-Hong Kong Connect route.”

Not everyone is so confident that this will provide a quick solution, however. Brown Brothers Harriman’s Nizami says: “While foreign investors are strictly prohibited from participating in the domestic scheme, there are several other limitations to the model for domestic investors – collateral requirements, loan tenures and restrictive lending fees – so there is a lack of liquidity given that insurance companies and mutual funds are also excluded. 

“While there has been some discussion that the regulators are considering developing a bilateral offshore lending model for international investors, we believe that the development of such a model will naturally take some time before it is deemed attractive for international firms.”


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