Our panel of asset servicing firms discuss the promise and pitfalls of mutual fund recognition with China. Chaired by George Mitton
and Alan Chalmers
in Hong Kong.
(head of Asia-Pacific, BNP Paribas Securities Services)Elaine Liu
(head of China product strategy, HSBC Securities Services)André Durand
(Managing director, Hong Kong, Société Générale Securities Services)Colin Lunn
(head of fund services Asia-Pacific, UBS Global Asset Management)
Funds Global: Is mutual fund recognition the spur that will make Hong Kong’s fund industry automated?
Lawrence Au, BNP Paribas Securities Services:
The practice in Hong Kong is pretty manual for historic reasons, while in China, the system is 100% automated as far as the retail market is concerned. If mutual fund recognition works well, there’s a hope the Hong Kong industry will become automated too, but for that to work, it requires the fund distributors, fund managers, trustees and custodian banks to work together.
There hasn’t been enough momentum behind automation before. Mutual fund recognition is an opportunity but we will have to wait and see if it happens.
Elaine Liu, HSBC Securities Services:
Both sides’ market participants are working hard to establish a streamlined market infrastructure and test the operational procedure and flows for both onshore and cross-border transactions before going live.
The impact for the automation, basically, is on the TA [transfer agent] end. Both sides need to make sure the orders, confirmations and the fund data are transmitted cross-border smoothly and meet both markets’ timelines and practice.
André Durand, Société Générale Securities Services:
On the TA side, we have made huge improvements over the last few years. Two years ago, all my orders were by fax. Today, more than half go through automated channels. Hong Kong has made important steps, mainly with Taiwan. When we look at third-party distribution, the links between the TAs and the banks have changed dramatically already.
Concerning mutual recognition in particular, my understanding was that, in China, any single investor has to be in the books, which is what they do on the stock exchange. We are talking about 200 million-plus accounts in Shanghai and Shenzhen. It means if you have a fund here, in Hong Kong, and you want an investor from China, you have to open the register in their name, accept subscriptions and redemptions not bulked from the nominee distributor but in detail. In that case, there’s no choice but to have a tremendous improvement in terms of automation because of the sheer volumes.
Some people have thought, ‘I’ll go to Qianhai and recruit people to form a large, cheap team’. No, you can’t do that, because if you build a team to deal with 100,000 operations a day, and the next day you have a million, it explodes. It’s not only a problem of Swift. It’s also your system, your machines. Are they going to be able to face the volume?
I don’t know where we are with these discussions at the moment because, in Hong Kong, everybody wanted to have a set-up where you just deal with a nominee, which is much easier for the KYC/AML [know your client/anti-money-laundering] operations. In China, they have a market which settles in T+1, which opens accounts for every single investor and, from time to time, they want to stop malicious trading – whatever that means. Why would the regulator accept us not to have this detailed information?
Everybody should try to automate. Running a security services business, including TA and custody, the only way you can make money and make it scalable is to make it automated. The situation in Hong Kong is that you have to deal with a lot of different distributors, and some have no incentive to push for automation because of various reasons.
The current model for mutual fund recognition is that the CMU [Central Moneymarkets Unit] is offering a service called the Fund Order Routing and Settlement System, which was set up in 2009 but has not been widely used. This is the opportunity to make it popular because it’s the only way, or at this moment the official channel, to link with the Chinese system. It will be interesting to see whether through this opportunity we can push the industry towards using a much more automated channel, rather than faxes.
Funds Global: Who has more to gain from mutual fund recognition? Is it the mainland Chinese managers or is it the Hong Kong managers?
In the long run, both sides will win. Some people thought otherwise at first because, when the figures came out, there were only about 100 funds in Hong Kong that were qualified, compared with 800 in China. But if you include all the funds that are being marketed in Hong Kong, there are over 1,000. About 800 are Ucits that are based in Luxembourg, Dublin or the Cayman Islands. From a track record point of view, they are absolutely qualified. If you add those, it’s almost 800 versus 800, assuming the Ucits managers are willing to redomicile.
The mutual fund recognition scheme is very attractive to foreign fund managers. Currently, there are only two ways you can sell a mutual fund in China. You can establish a JV [joint venture] – as we all know, many did not work out – or try the new route of setting up a WFOE [wholly foreign-owned entity], hoping this model will allow you to freely market to China. Currently, there are some limitations. Mutual recognition means that you don’t have to do any of those two and, potentially, be able to market to China. In a way, it gives foreign fund managers an additional channel without a heavy presence on the ground to market to China. I think, eventually, it would still be a win-win.
For Chinese managers, obviously, they would also be able to distribute more funds into Hong Kong, not necessarily for the retail market, because it’s rather small, but,potentially for all the institutions, whether based in Hong Kong or from outside Hong Kong.
Colin Lunn, UBS Global Asset Management:
This will also help Hong Kong as a jurisdiction. Eighty per cent or more of asset management personnel in Hong Kong are salespeople. Mutual fund recognition will help deepen the workforce.
Being required to domicile and manage here will lead to an increase in the number of qualified portfolio managers and middle and back-office people here. In terms of building out the infrastructure in Hong Kong, that’s something positive.
The scheme has a clear benefit for Chinese managers in that their products will be subject to Hong Kong regulation. It is a regulatory environment that investors are familiar with. That gives Chinese managers a stepping stone in terms of brand-building globally.
I don’t agree with all that’s been said. My view is that mainland Chinese managers are in a better position to benefit from mutual recognition, but – there’s a but – “mainland manager” does not necessarily mean fully Chinese. Any successful JV today in Shanghai, or Shenzhen or wherever, will benefit as well.
The problem with mutual recognition is that marketing the funds in China will not be easy. You have to find the channels and, if you’re a pure Hong Kong manager who has never worked in China, it’s going to be challenging.
There are asset managers in China who won’t be successful in Hong Kong either. Simply having a fund in Shanghai and knowing the market does not mean a Hong Kong institution or retail investor will buy the fund. You have to prove you have a proper investment process, risk management and all these things. That’s where the JVs have a clear advantage, because they understand risk controls and developed countries’ cultures, be it from America or Europe.
In the beginning, JVs and big asset managers who have presences in both Hong Kong and China, and that run cross-border investments (such as QDII, QFII, RQFII, QDLP or Stock Connect) will have the advantage as they have teams and talent who understand markets. They have also established distribution channels and relationships with local managers and custodians who can be appointed as the distributors and master agents of mutual fund recognition, enabling them to move quicker.
But in the long run, local medium-sized fund managers will catch up along with the maturity of mutual fund recognition and the further expansion of China’s capital market.
Who is going to win? Mutual fund recogition is a long-term play and will create a win-win situation. Hong Kong managers are pushing to market their funds in China as more China investors look overseas due to the recent market volatility. Hong Kong funds and managers are more familiar and appealing to China investors compared to US, EU or other mature markets. Meanwhile, China mutual funds are attractive to Hong Kong investors because of the performance, despite the volatility.
Funds Global: What are the technical challenges involved with developing the Shanghai-Hong Kong Stock Connect scheme?
The extension to Shenzen is going to happen. It’s not a maybe. It’s just a question of timing, because they will be replicating what they already do.
The interesting thing is on the fixed income side, Bond Connect, but the issue is that, if you look at the fixed income market in China, less than 10% of bonds are traded on exchanges. The rest, 90% or more, are interbank bonds, based on an over-the-counter system. The technical issues are harder to overcome. The exchanges must become highly automated and be able to connect and trade.
Apart from Shenzhen, there are also talks about being able to include more stocks, IPOs [initial public offerings] and many other technical improvements. But, ultimately, if the bond market can be connected, that marks the comprehensive opening of the Chinese market.
The problem is not necessarily technical. We are dealing with a country which has capital controls. They don’t want to rush.
We’ve had a shaky Shanghai-Shenzhen stock market over the last two months. Stock Connect didn’t start quickly. There has been lots of volatility lately.
Because of this volatility, you won’t have a Shenzhen Stock Connect immediately, or the Bond Connect immediately. Everything will come step by step. Do the authorities feel comfortable, or do they have the feeling that Stock Connect is crashing the market because you have short sellers or whatever else? Yes, it is going to happen. I have no clue about the timeline.
After the Stock Connect programme, Bond Connect will be on the agenda of China capital market liberalisation. Recently the People’s Bank of China (PBoC) promulgated new rules for foreign central banks, monetary authorities, international financial organisation and sovereign funds’ investment in China’s interbank bond market.
The new rules allow investors to appoint the PBoC or licensed settlement bank to act as the agent for their interbank bond trading. Currently the investors are only allowed to appoint PBoC as their settlement agent.
The new rules abolish investment quota controls. The application process will be changed from approval to registration. Also, investors are allowed to trade bonds, repo, bond lending, bond forwards and other instruments. These changes should highly improve the efficiency of investing in the interbank bond market.
Although Stock Connect is a successful connect between exchanges in two markets, the interbank market trades over-the-counter instead of on exchanges and has different market practices and infrastructure. Technical issues and enhancement for the automation process for the Bond Connect will be more complex compared to Stock Connect. It will take time to develop the connection.
Funds Global: What potential do you see in the other “Connects” planned or operating in Asia that seem to have been inspired by the Shanghai-Hong Kong scheme, such as the Singapore-Taiwan Connect?
The Shanghai-Hong Kong Stock Connect makes sense because of the capital controls in China. If you don’t have capital controls, a Connect doesn’t change much. Any asset manager who wants to invest in Taiwan, even if it’s based in Singapore or in Hong Kong, has a broker in Taiwan and can deal in Taiwan. So the only difference that it makes is that, in that particular case, the retail investor having an account in Singapore, has an easier access to Taiwan. So that’s great. We open the markets. We facilitate trading across the region for the retail investor. I like it but, on a professional point of view, it doesn’t change anything.
Institutions can go straight into many of these markets. Why do you have to go through Singapore to trade Taiwan or vice versa? For the retail market, you have to ask, how big is it and how does it work, and is a Connect interesting to them? If you look at Singapore and Taiwan, recently you’ve had some interesting exchanges of words between the two markets. Who is responsible for the low volumes? You can see that there is a lot more at stake there, whereas with Hong Kong and China, being one country albeit two systems, the relationship is totally different.
For markets connecting to China, as long as China remains a closed or semi-closed market, and not a freely accessible market, whether China connects with Taiwan, with Singapore, or with London, it still makes sense.
Funds Global: How significant is China’s planned Qualified Domestic Individual Investor programme, or QDII2?
The QDII2 programme is among a number of China financial reforms this year aimed at further opening up China’s capital account. The programme will mark the first time mainland high-net-worth individuals can invest in overseas markets directly. Individuals will have more platforms to invest overseas in addition to QDII, Stock Connect etc. The investment scope is expected to be wider than QDII, permitting the investment in stocks, bonds, mutual funds, insurance, financial derivatives and real estate rather than just overseas securities and bonds.
Sitting in Hong Kong, there is not much of a role we can play in this programme, apart from maybe in the receiving end, if a fund manager or a private bank launches a QDII2 product that requires services from us.
It will be interesting to see whether this time it is going to be successful because this is a second push. The first QDII never succeeded. I would also argue that high-net-worth individuals already have a lot of money outside China. Look at Hong Kong. Many are complaining that mainland Chinese investors are buying up all the properties. A lot of the money is out here, do you need a QDII2?
Funds Global: How has the recent volatility in the Chinese stock markets affected investor sentiment and investment flows among your clients?
Ninety per cent or more of the Chinese stock market is retail-driven. With such high levels of day-trading volume, it is unsurprising that volatility remains high. China needs to increase institutional volumes and diversify away from retail. If this does not happen, these violent swings will continue.
My clients have not been the source of massive outflows but I’ve seen some performance impact and some valuation challenges around suspended stocks. In terms of flows, most investors are in there for the long run. I don’t think there’s been a massive pullback on the part of institutional investors.
A lot of people forget that China is still an emerging market. If we look at the development of the stock market in Asia, every single market has gone through these stages. Just look at Hong Kong. It crashed in the 70s, the 80s, the 90s. Every time there’s a crash, it’s the same remark – we need to bring in institutional money to stabilise it – which means that you have to define the rules of the game much better, with more transparent policies and all that.
You can argue that this is the first time a major crash in China is happening. There may be a few more crashes before you gradually come to maturity. My view is that the government, or the regulators, may have also underestimated the seriousness of the problem building up in the market until the crash happened.
It’s complex because, apart from the normal share financing activities, you have the trust companies and shadow banking providing further leveraging. Nobody knows exactly how many multiples we are talking about. When you have to go through several layers, nobody has a clue what the exact extent of the problem is, and that is something the regulators have to do something about.
Funds Global: Do you agree that the Chinese authorities have eroded trust by intervening in the markets during the recent volatility?
If that eroded trust in the market, I have a question: Is there any government intervention in the market that does not erode trust? When we look at the zero interest rate policy, that has also a huge impact on the markets, bond and equity, worldwide. What’s happening in China is much less of an issue than zero interest rates, in my view, in terms of systemic risk and eroding trust. For people who are serious about China, in terms of investment – I’m not talking about the retail investors in China, who make up most of the market – this is just a glitch.
Lunn: Anybody who knows the market is in for the long term.
What we don’t know yet is whether we will see 2007 repeated, basically a bubble and then back down and then nothing happens for a couple of years. That’s because of the retail investors and how they react. I have seen figures that say about 180 million people invest in the stock market. There are more than 200 million accounts but some have several accounts, one in Shenzhen, one in Shanghai, whatever.
If we look at investors in America, which is the most developed stock market in the world, the number of individual investors is much smaller. People go through mutual funds. In China they don’t, which is good news for the industry because I would argue that about 80% of them should not have a stock market account. They should have investments in mutual funds.
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