The Shanghai-Hong Kong Stock Connect program, expected to launch this fall, will give many European and U.S. funds, managers and individuals their first opportunity to trade Shanghai-listed equities. Stock Connect represents a significant liberalization of the stock markets in the People’s Republic of China (PRC). Until Stock Connect’s debut, investment by non-PRC persons will continue to be restricted and may be conducted only through investment quotas granted by PRC regulators. These quotas have never been available to all fund managers – for example, hedge fund managers have generally been discouraged from applying. In contrast, Stock Connect is open to any institutional or individual investor that has a brokerage account with an eligible broker in Hong Kong.

How It Works

Stock Connect creates a link between the Shanghai and Hong Kong Stock Exchanges that will allow investors to use Hong Kong brokers to invest in certain Shanghai Stock Exchange (SSE)-listed securities (currently 568 stocks will be eligible for trading).1 Investors that already hold Hong Kong-listed securities will likely be able to continue using their existing Hong Kong brokers for Stock Connect – many of the largest Hong Kong brokers have already indicated that they will participate in the program.

While trades are effected through local brokers and will be subject to Hong Kong’s trading rules, individual holdings of Shanghai-listed securities must also comply with certain of the PRC’s securities laws, including position limits and short-swing trading rules. Trading is also subject to a daily “market-wide” quota of RMB 13 billion (approximately US$2.08 billion).2 If the aggregate amount of buy and sell orders (subject to certain adjustments) exceeds the daily quota, then further buy orders will be rejected (sell orders will not be affected).

Potential Drawbacks

There are still open questions about how Stock Connect will work. When an investor purchases Shanghai-listed shares through Stock Connect, such interest will be recorded in a book entry on the books of a local Hong Kong custodian. There is a question as to what this interest represents. Hong Kong’s clearinghouse will act as nominee for Hong Kong investors within the PRC’s clearinghouse, China Securities Depository and Clearing Corp. But it is unclear how the ultimate investors’ interests in Shanghai-listed securities would be treated, because the status of beneficial ownership under PRC securities laws remains unsettled. The tax treatment of Stock Connect securities also remains uncertain, although the Hong Kong Stock Exchange has indicated that clarification is expected when trading starts (or soon thereafter).

The structure of Stock Connect may itself create issues for UCITS or funds registered under the U.S. Investment Company Act of 1940. On the day before trading, Hong Kong brokers must submit to a “pre-check,” where they place securities to be traded in their own clearing accounts. During the time that such securities are in the brokers’ clearing accounts, funds (or other investors) would not have any claim to particular securities and such securities would be outside of custody. While such arrangements do not differ significantly from many developing markets, fund boards and fiduciaries should study the mechanics of Stock Connect closely before participating in the program.

Finally, Stock Connect may not be appropriate for funds that need guaranteed access to the PRC securities markets (e.g., ETFs or funds with rigid market allocations). Because Stock Connect’s market-level quota may be triggered by the actions of others, a fund will not be able to control when it can purchase securities. For such funds, the existing Qualified Foreign Institution Investor (QFII) or Renminbi Qualified Foreign Institutional Investor (RQFII) quota programs may be a better fit. Not all PRC securities are available through Stock Connect – at least not initially. Stock Connect is limited to only mid and large-cap equities listed on the Shanghai Stock Exchange, which is another reason that QFII and RQFII quota programs may be preferable for certain strategies.

Next Steps

Stock Connect is expected to launch this fall. Market participants should familiarize themselves with how Stock Connect works (and the associated compliance processes necessary to comply with Stock Connect’s legal and regulatory requirements). Advisers to 1940 Act funds may wish to approach their fund boards early. Because final regulations may not be released with significant lead-time ahead of Stock Connect’s official launch, the program may start slowly. Once it gathers steam, however, it has clear potential to result in wide-open doors to the PRC’s equity markets for the very first time.