On April 11, 2014, the China Securities Regulatory Commission (CSRC) and the Securities & Futures Commission of Hong Kong (SFC) announced in a joint statement (the Announcement) a trial trading program known as Shanghai-Hong Kong Stock Connect, which will allow two-way cross-market stock investment by qualified Mainland Chinese and Hong Kong investors.
According to the Announcement, the pilot program will operate between the Shanghai Stock Exchange (SSE), the Stock Exchange of Hong Kong Limited (SEHK), the China Securities Depository and Clearing Corporation Limited (ChinaClear) and the Hong Kong Securities Clearing Company Limited (HKSCC). SSE and SEHK will allow investors to trade eligible shares listed on each other’s markets through local securities firms or brokers.
Shanghai-Hong Kong Stock Connect will be established in accordance with existing rules and regulations and operational models governing trading and clearing in each market. The program comprises a Northbound Trading Link and a Southbound Trading Link. Under the Northbound Trading Link, Hong Kong investors will be able to place orders through their Hong Kong brokers and a securities trading service company to be established by SEHK, which will route orders to trade eligible shares listed on SSE. Under the Southbound Trading Link, eligible Mainland investors will be able to place orders through Mainland securities firms and a securities trading service company to be established by SSE, which will route orders to trade eligible shares listed on SEHK.
Principal Elements of the Program
The Announcement sets out five principal elements:
- Applicable trading, clearing and listing rules. Trading and clearing arrangements will be subject to the regulations and operational rules of the market where trading and clearing take place. Listed companies will continue to be subject only to the listing and other rules and regulations of the markets where they are listed. The program will only operate on a day which is a trading day of both SSE and SEHK and when clearing arrangements are in order.
- Clearing. ChinaClear and HKSCC will establish a direct link for cross-border clearing. Each of them will become each other’s clearing participant to provide clearing services for Shanghai-Hong Kong Stock Connect.
- Eligible shares. Under the pilot program, shares eligible to be traded through the Northbound Trading Link will comprise all the constituents of the SSE 180 Index and SSE 380 Index, and shares of all SSE-listed companies which have issued both A shares and H shares. Shares eligible to be traded through the Southbound Trading Link comprise all the constituent companies of the Hang Seng Composite LargeCap Index and the Hang Seng Composite MidCap Index, and shares of all companies listed on both SSE and SEHK. The scope of Shanghai-Hong Kong Stock Connect is subject to further adjustment following launch of the pilot program.
- Quotas. Trading under Shanghai-Hong Kong Stock Connect will, initially, be subject to a maximum cross-border investment quota, together with a daily quota that will be monitored on a “real time” basis. The Northbound Trading Link will be limited to an aggregate quota of RMB300 billion (approximately HK$377.7 billion) and a daily quota of RMB13 billion (approximately HK$16.4 billion), and the Southbound Trading Link will be limited to an aggregate quota of RMB250 billion (approximately HK$314.7 billion) and a daily quota of RMB10.5 billion (approximately HK$13.2 billion). Quotas may be adjusted in future.
- Eligible investors. Initially, the SFC requires Mainland investors participating in the Southbound Trading Link to be limited to institutional investors, and those individual investors who hold an aggregate balance of not less than RMB 500,000 in their securities and cash accounts. In theory, QFIIs and RQFIIs are eligible institutional investors.
The combined daily trading cap of RMB23.5 billion (approximately HK$29.6 billion), as noted by commentators, is equal to about 20 percent of the combined average daily trading turnover of SSE and SEHK. Because the Announcement did not provide details of the program, it is currently unclear how the quotas will be allocated. One speculation is that the quotas will not be specifically assigned to specific investors. Rather, all qualified investors will be able to place orders until the applicable daily or aggregate quota has been reached at any given moment of trading.
Implications of the Program
The pilot program represents another major move in China’s ongoing efforts to open up its capital markets. Currently, international institutional investors may only access China’s A-share market through two regimes: the Qualified Foreign Institutional Investor (QFII) and the RMB Qualified Foreign Institutional Investor (RQFII), which allow licensed foreign institutional investors to invest with foreign currencies and offshore RMB, respectively. It is hoped that launching the Shanghai-Hong Kong Stock Connect will improve the investor profile of SSE and enhance the market’s liquidity and general vigor, which could increase the attractiveness of SSE to domestic and international investors.
From Hong Kong’s perspective, the program underscores the Chinese government’s support of the SEHK, the largest public financing venue for Chinese companies outside of the Mainland. The hope is that the program will strengthen the competitiveness of SEHK and further consolidate the position of Hong Kong as an international financial center.
The pilot program will also help promote the internationalization of the RMB and reinforce Hong Kong’s status as the primary offshore RMB business center. Under the program, Mainland investors will be allowed to directly trade on the Hong Kong stock market using RMB. Initial inquiries with regulators indicate that Hong Kong investors may choose to trade in the Shanghai market using either offshore RMB or HK$. The expanded investment channels available for offshore RMB funds should facilitate an orderly flow of RMB funds between the two markets.
From a technical perspective, the enhanced market connectivity between Mainland China and Hong Kong will help narrow and if the program develops critical mass eventually eliminate the valuation gap between Mainland A-share and Hong Kong H-share dual-listed Chinese companies, which currently usually trade at different prices.
Challenges Facing the Program
The securities regulatory regimes and legal systems of Hong Kong and Mainland China differ significantly and in order for the trial program to work regulators will have to address significant challenges. The Announcement makes clear that to ensure orderly market operations and prudent risk management, Shanghai-Hong Kong Stock Connect will only be launched when all necessary arrangements have been put into place. For example, relevant trading and clearing rules and systems will have to be finalized, regulatory approvals must all have been granted, and market participants will also have had sufficient opportunity to configure and adapt their operational and technical systems. According to the Announcement, the preparatory work leading to the launch of the new program is expected to take about six months and specific information will be announced as the work progresses.
One of the key challenges facing the CSRC and the SFC will be effective cross-border enforcement regarding any misconduct in connection with cross-border trades. According to the Announcement, regulators will improve existing bilateral arrangements to strengthen enforcement cooperation in a number of areas, including referral and information exchange mechanisms concerning improper activities, as well as investigatory cooperation in relation to cross-border illegal activities.
Commentators agree that the Hong Kong stock market is more transparent and mature than its Mainland counterpart and that the CSRC is still playing catch-up in terms of enforcement. If the two regulators are able to collaborate in their efforts to uncover violations and enforce against false or misleading disclosures, insider dealing and market manipulation, the infrastructure of the Mainland’s A-share market could be strengthened. Overcoming the differences between the two legal and regulatory regimes will, however, be a major test for regulators.