ROUNDTABLE: Building a business case for automation

Asian passports, mutual recognition and the relative virtues of omnibus versus segregated accounts were all discussed by our Hong Kong panel, chaired by Nick Fitzpatrick and Alan Chalmers. Automation rooundtable dec1 Sebastien Chaker (head of Asia, Calastone)
Andre Durand (managing director, Hong Kong, Société Générale Securities Services)
Cindy Chen (country head, Hong Kong, Securities and Fund Services, Citi)
Alastair Murray (regional head of asset managers, sales and business development, HSBC Securities Services, Asia-Pacific)
Carmen Li (head of front office solutions, Caceis Hong Kong Trust)
Isaac Wong (director, product management/investment funds, Euroclear) Funds Global: Where are we now in terms of the operational issues involved with Hong China Mutual Recognition of Funds (MRF)? Sébastien Chaker, Calastone: The delays linked to this summer’s turmoil on the Chinese stock market have actually provided a few additional months for everyone to prepare and that’s been very helpful. We’ve been able to test everything with our Chinese counterparties.  With the MRF, there are different options for processing transactions, whereas with Stock Connect, there was one route and that’s how everybody had to operate. So when the funds are approved, clients that have finalised their testing with us will be ready and I don’t see any operational issues that could threaten this. André Durand, Société Générale: Yes, MRF does not have any operational issues any more. Instead it has a marketing problem in terms of finding a sales strategy for asset managers here in Hong Kong and in China. Isaac Wong, Euroclear: The big picture is that there are people who jump on new schemes, the first movers, but there are also a few fund managers and distributors that are still making sense of it and what it will mean in the long term. Right now there are restrictions in terms of which funds are eligible but in the next two or three years, there may be a second phase that will extend mutual recognition to other destinations – possibly London, Taiwan, Singapore or Luxembourg. But what the market needs is certainty about what is coming next. Cindy Chen, Citi: Some of the operational details were not released until very recently and while there are some operation issues to sort out and differences over cut-off times for subscriptions in the different markets, I don’t see any big operational hurdles. We expect testing to conclude by mid-December and the first batch of funds to be announced by the end of the year.  In terms of generating interest, the northbound channel allows foreign fund managers to access the China market directly, and it is interesting timing since markets are expecting further depreciation of the renminbi. In the past, when we saw the launch of the Qualified Domestic Institutional Investor (QDII), the renminbi was still appreciating, so the outflow was not very successful.  The weakening currency has created an incentive for Chinese investors to look beyond the domestic market, so some of our fund clients are optimistic about the northbound flows and want to get up and running as soon as possible. Timing is also very critical. With many of the Chinese schemes, the first movers reap the benefits. We saw that with Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) when the first round of funds to offer ETFs pretty much sucked up most of the demand from the entire market. Carmen Li, Caceis: I expect some operational efficiency such as the capital in/outflow, the know-your-customer (KYC) handling and the operational model, but it will take some time for the market to fine-tune the whole working process. And past experience with the RQFII and the QFII suggests that the Chinese government may want to roll this out progressively, which means education on both sides of the market will be important so that Chinese investors can get to know the Hong Kong market and vice versa. The most important element for the Chinese authorities is to have no drama. And at the same time, they will do their best help renminbi internationalisation. Chen: Given that the details were only released recently, most people are not focused on operational efficiency. We just want to get up and running on day one and the efficiencies will come later. There is a set format for sending data across the two markets and you cannot deviate from that, so getting a system to automatically generate those reports in the exact format may take some time, but then we need to be ready by the end of December when the first funds will start. So operational efficiency is a consideration, but it’s secondary. The timeline for the market to support our client and the fund is primary. Alastair Murray, HSBC: There is an elephant in the room. It’s not operational, it’s around distribution and differences between the KYC rules that apply for Hong Kong-authorised funds and those that currently apply for domestic retail funds in China. The Hong Kong Securities and Futures Commission (SFC) clarified in June that the existing KYC rules for Hong Kong-authorised funds would apply for distributions on the mainland.  Distributors in China will now have to follow Hong Kong’s rules. The fund managers with eligible funds think they are in good shape operationally, but how are they going to get their agents and distributors to follow new KYC rules? It will be a real constraint on their ability to sell these funds. And they will have to be fairly selective in terms of who they partner with and the distribution will be limited, it won’t be wholesale, and they won’t be using a number of big-bank distributors going through their normal process. It seems to me that there is very little talk about this issue. Chen: One reason is that China is actually an end beneficial owner market. Each Chinese retail client investing into Hong Kong through Stock Connect already has an account at China Clear and that provides good transparency. However, if a Chinese fund is being sold to Hong Kong investors, you will go through a distributing bank, which will do its own KYC review. Chaker: Right now, everyone is focused on making it work for when the first funds are approved, so the focus is how are you going to transact and settle the first orders. But there are obviously a number of other aspects that will be very manual in the beginning, such as regulatory reporting around eligibility. For example, every fund must have 50% of their assets sold in Hong Kong, so there has to be a daily report showing your current position. The first stage is just getting it to work. Clients have signed a distribution partnership in China and they want to be the first to benefit from that. Custodians need to be ready and that means there will be a lot of work in the background to see how we can make this efficient in the long term. Funds Global: What impact has the Chinese equities crash had on MRF and Hong Kong-Shanghai Stock Connect? Li: From the Chinese government’s perspective, the recent equities crash demonstrated the robustness of the Stock Connect platform. It was business as usual on the platform without a single day of interruption. And I think it will reinforce its wish to take a conservative approach to rolling out the MRF scheme.  But in the longer term, when confidence in the economic outlook returns, I think both the MRF and Stock Connect will provide efficient channels to different types of investors. Chen: It has delayed the Stock Connect launch. If the market had not been volatile in the middle of the year, we could have been celebrating the launch of the Stock Connect before the end of the year instead of waiting for the first half of next year. The regulator wants more time to assess the impact of opening up new channels. The support of the Chinese government has actually helped to stabilise Asian markets in recent months; the Chinese market is up by 25% in the last two months.  However, foreign investors are still very cautious. The broad suspension of trading for 50% of A-shares is concerning because it impacts liquidity. The other concern would be renminbi depreciation, something that will become more likely if the US increases interest rates while China reduces interest rates. Wong: The summer crisis has caused China to face the reality of the investment world and its volatility. It has also exposed the regulatory discipline and governance of the Chinese regime for international investors. It has been a good case for everyone to observe and learn more about the opening up of the Chinese market. Chaker: For Chinese investors, this might be the best time to look at MRF and Stock Connect. The US Treasury estimated that there were capital outflows of $500 billion in the first eight months, but that was only the wealthy individuals who are able to get their money out of the country and to access offshore products. For the mass retail market, there are very limited opportunities to do that. So MRF and Stock Connect are cost-effective ways to access the global market at a time when their own domestic market is overheating and the renminbi is depreciating. Durand: For the non-Chinese players investing in China, there’s been a crash test and it’s been successful. There were tremendous disruptions in the market, with half of the stocks suspended from trading. We have had funds outside of China, ETFs and mutual funds, who had to come up with a NAV where there was no price available. But this has all stabilised and everybody has had the time to look at what risk mitigation they would put in place. Stock Connect may not have been as busy during this crisis as it was in April when all the quotas were filled, but it was still working with daily inflows and outflows. So I think the experience has been supportive in terms of participation. Funds Global: Are the different business models of intentional service providers still suitable for the Asian funds market or do they need to change? Murray: An international service provider needs to act locally, speaking the same language as the fund managers, lobbying the regulator for change in that market and thereby protecting investors from anything that would create a loss of confidence. But they also need to balance that with economies of scale and the use of low-cost, offshore processing centres.Getting this balance right is more important than ever as a greater emphasis is placed on regulation. But there is another elephant in the room and that is the cross-border exchange of data, where there is a need for further clarity around requirements. Specific markets try to ensure that business stays within their own jurisdiction and in some cases this is extended to data retention. That is not how big, international service providers or fund managers work. They want their data consolidated in a single, offshore location for the whole region and globally.  This is an issue that I think needs more discussion. There may be clear rules around private, individual data or personally identifiable data but when it comes to the investment data and positions data, the regulatory requirements and the enforcement of those rules around the region are diverse. Chen: It comes back to operational efficiency. If the regulators were less protective, it would actually better allow providers to improve their operational efficiency. Moreover, regulators may be uncomfortable allowing data to be shared beyond their borders, so providers need to set up lots of local systems for each country.  If more cross-border sharing of data is allowed, the greater economies of scale and operational efficiencies can be achieved by the providers. It is also better for business continuity if you have your data backed up in another country. Wong: As an international service provider, we would welcome a level of data disclosure based on an omnibus structure, but the current discussions in a few Asian countries are around using a segregated account structure, which really goes against the operating principles in the international market. They want to know who’s behind the investments that flow through to the particular countries. So the industry is facing a challenge in talking to the regulators and the local central securities depositories (CSDs) about the spirit of the international practices. Chen: Many emerging markets such as China India, Korea, Taiwan and Vietnam are concerned about foreigners pulling their capital quickly from local banking systems, which may destabilise the local market. Thus, they have some sort of capital controls imposed and required investor  ID to be set up for foreign investors to better monitor the impact of their activities on the local market. So China may influence Hong Kong to adapt their model in a way and get the benefit of a full transparency model where the regulators do not have to go through layers of intermediaries to find out who the end buyers are.   But then again, international practice is more efficient in reducing settlement movements and increasing STP, so there’s an argument for both. A segregated approach may also be very costly for many established economies that have traditional technology that is not set up to cope with segregated accounts for billions of investors.  Whereas China is a new market set up with the latest technology and it is able to cope with individual accounts. The debate is ongoing and China will have to reach some common ground that gives the regulators the transparency it wants but does not put too much pressure on the international community in terms of the efficiencies we enjoy today. Chaker: It shows how technology will quickly change this whole industry. The Chinese model where the market operates on an individual basis for funds is ultimately best for everyone, including fund managers who benefit from real-time information about their investors. It is based on efficiency and the technology is there to replicate a model like China, globally.  So, yes, there is a debate on how much pressure we can put on the international market to change but in the long term, the change to the China model of segregated but automated accounts will happen.  Funds Global: What progress has been made on automation in other Asian regions like Taiwan, Singapore and Korea? Chaker: The progress in the last three years has been quite phenomenal, especially in Taiwan and Singapore, where we’ve seen them move from virtually nothing to the point where, by next year, they could surpass European levels of automation. And I don’t think the market fully realises that yet.  What has changed in these markets is that now there is technology that allows distributors to get automation with minimum IT development or cost and that didn’t exist five years ago. Hong Kong was behind in terms of automation and there was no pressure for them to change, but the MRF has changed that. They have to adopt automation and I think it will explode next year in terms of STP rates. Wong: All the different countries have taken a different approach to automation. In Korea and the local onshore market, it is mandated that every order, post-trade, has to be processed through the Korean Securities Depository’s (KSD) own centralised system, FundNet. You don’t get a choice and that has worked well for them. Now, in the last five years we have seen the KSD try and apply the same platform and approach to the offshore investment world. So this is an example of a regulator taking a tough stance. This is in contrast to Singapore, where the Monetary Authority of Singapore (MAS) has looked at the case for automation and decided to leave it to the industry. You also have Taiwan and the Taiwan Depository Trust and Clearing Corporation (TDCC), which is taking a semi-automated route towards the order flows of offshore providers. And finally you have Hong Kong, where the Hong Kong Monetary Authority (HKMA) has taken a very open approach to automation. It has had its own fund-routing system, the Central Moneymarkets Unit, in place for more than five years but the take-up has been slow. It is voluntary, so the HKMA has to sell the benefits to the commercial and custody banks, but I believe that the MRF will create a push for more market participants to opt for an automated route. Li: In the next generation, automation will be the dominant practice of the market. In past years we have seen that the use of automation has been growing, but there is still room to expand. Today in Asian markets, labour costs are comparatively low, so market players have not focused on developing automation and instead have put their focus on other areas like sales and marketing or product development. I agree that a regulatory-driven model would help to advance the whole automation effort. Chaker: But if you look at the TDCC’s system, it is used by the whole market because it is an efficient model, not because it is mandated. Taiwanese distributors and fund managers can still use faxes. We have to remember that the regulators are not there to mandate the use of systems. Their role is investor protection and market stability. If nothing is broken, even if it is inefficient, it’s not the role of regulators to step in. I’m surprised that despite the fact that the industry complains about there being too much regulation, some believe that we should also regulate post-trade processing operations.  Korea is not a big issue because it is mostly a domestic market, but just imagine if every domestic market imposed its own solution on the market. How would an Asian passport work in that operating environment? It is vital that we as an industry solve this issue and do not turn to regulation if we cannot get enough support from the market. Durand: The fragmentation of the market explains why we have a lot of non-automated transactions. As a transfer agent (TA), when you work with different counterparties, different formats, different TAs and different fund managers, having a standard with each of them is not easy to put in place. But as soon as there is a business case for automation, we will have the various providers and bodies like Swift all pushing for it, so there will be no need for regulation because the drivers will be purely operational. Yes, there will be a cost involved, but the market can assess if that cost is outweighed by the operational benefit. The day when that investment is clearly a value proposition is the day the market will go for it. Funds Global: Where next for the various fund passport initiatives and the idea of the pan-Asian funds market? Murray: Obviously the Hong Kong-China one is going ahead. The Asia Region Fund Passport (ARFP) looks likely to succeed, despite Singapore dropping its participation. It has recognised that tax needs to be tackled and it has also got Japan involved. But it all goes back to the same issue – that these are different countries with their own disparate priorities. We all want it to succeed because it would be good for the industry, but there is also a healthy amount of scepticism about how all the different countries will agree and who will benefit the most.  At the moment it will exist as a Memorandum of Understanding but if, for example, a country is not getting any business out of the ARFP, how keen will it be to allow another country’s funds to be distributed there at the expense of its own funds?  The reason that the MRF has received so much interest is because of the close links between China and Hong Kong and the common drive to make it successful, regardless of who benefits more at the expense of the other. That is similar to what happens in Europe where member states follow a single directive. Wong: There are some markets looking to internalise some of their funds within Asia, which makes sense. A parallel development to the ARFP is happening in Korea. The KSD launched an industry group called the Asia Fund Standardisation Forum, which has brought together 11 local CSDs including the HKMA, the TDCC, China Clear and the CSDs in Indonesia and Thailand. They have a grand vision of developing a processing standard for the Asian funds community, so naturally the starting point is Korea’s model. It is not necessarily linked to the ARFP and it is at a very early stage, but something like this would certainly help facilitate cross-border flows within Asia. Chaker: The China-Hong Kong initiative is not really a passport, it is a bilateral agreement between a market of 1.3 billion people and a market of 7 million people. But it is just a starting point rather than an end game. We have heard about it being extended to the UK, Singapore and Australia. The size of assets under management included in the ASEAN markets is probably too small to gain any real traction.  The ARFP is more interesting because it includes some heavyweights such as Japan, South Korea and Australia. There may be some scepticism about how it will work, but when I arrived here two-and-a-half years ago, nobody believed at all in the idea of an Asian passport and now they are taking it seriously. And I believe the competition from the China-Hong Kong MRF development is actually helping to replace that absence of an EU-like authority because no one wants to be left out. That is certainly why Japan got involved in this initiative recently. It is all positive news for Asia because right now, there is no such thing as a Pan-Asian funds market. Chen: One of the reasons that Stock Connect will work is because it is not just about linking market infrastructure, it is about making an inaccessible market more accessible.  Previously, if you wanted to trade A-shares, you needed to be a qualified institutional investor from an approved QFII/RQFII market and go apply for a licence from the China Securities Regulatory Commission SRC, a quota from the State Administration of Foreign Exchange and approval from the People’s Bank of China before you could trade.  With Stock Connect, these requirements are all removed and you can still use all the same service providers in Hong Kong and plug straight into China.  Currently, if you want to distribute a fund to Chinese investors, you need to set up a joint venture with a domestic player that will be the majority owner. And few of those have been successful. But with all the other passport or stock connect schemes, are those markets difficult to access? Any international managers interested in those markets are probably already there. They don’t need a passport. So I think the likelihood of an inter-regional market in Asia will depend on how China expands its MRF programme. Right now, there is just a tiny outflow of Chinese investors’ money, although it is expected to grow quickly, so this is a tremendous opportunity for these funds to offer global asset classes and other products that Chinese investors may not have access to. Li: Fragmented passport initiatives will run faster because compromise on the framework of fund passport among different member countries is still one of the challenges. Concerning MRF, we shall soon see it in action. With the experience of other past policies, China may further expand them when they are starting to run smoothly. Funds Global: What opinions does the panel have on possible disruptive developments like online distribution of funds and blockchain technology? Murray: There a number of different markets in Asia trying to encourage online distribution. There is a Mutual Fund Utility in India and Indonesia has tried for a number of years to introduce online distribution. We’ve seen a consortium in Korea and even in Hong Kong, the SFC has embraced it. Previously there was uncertainty about creating an uneven playing field between online and over-the-counter sales. The focus was more investor protection, disclosure and suitability testing but now it seems it is embracing the introduction of online channels. This should lead to reduced sales costs and create more choice.  This has been talked about for a number of years but so far, online channels in Hong Kong have not made their mark. It is not something that can be ignored. Once you have data in a transferable format, it will be helpful for everybody. Durand: My understanding of the blockchain is that it allows disintermediated trust. Is it what the industry needs? I don’t think so. Is it what could disrupt the industry? Yes, maybe in five or ten years’ time, once the technology has proved itself and the various actors in the industry have found where it can be applied. But I don’t think it will go through the funds industry first.  One way that Alibaba could be disruptive is in its use of big data. The funds industry has struggled for years to consolidate the data on its investors and use that for marketing but Alibaba has managed to create a whole new market by using big data and finding individuals who would be ready to invest in the funds they were launching despite not being existing investors. That is completely disruptive.  We have seen disruptions happening in other domains for the last 15 years and it could happen in our industry. It is a real threat to traditional asset managers. Yes, the industry is highly regulated but so is the taxi industry and look what has happened with the likes of Uber. There may be some legal issues and governments may be offering the taxi industry protection but consumers are asking for more liberalisation. So I don’t think we as the funds industry can hide behind regulation. Chaker: I don’t see initiatives such as Alibaba’s Yuebao online platform as disruption because, as you describe it, they just aim to provide financial advisory and portfolio management to a much wider base of investors at a lower cost. It is actually a big opportunity for the fund management industry. Mutual fund penetration rate in Asia is currently well below 10% and initiatives such as Alibaba are simply helping to increase that rate by targeting a brand new range of investors. The high net worth individuals will still be served by the bank-based distributors.  The danger is that mutual funds will be in competition with much cheaper products like ETFs. If you look at all the platforms – the so-called robo-advisers – that have been launched in the US and in the UK, it is all based on ETFs. The mutual funds are not there because they are still seen as too expensive, not just because of the fees paid for active management but also because the processes are so archaic.   A lot of these ‘fintechs’ that are launching new products have no legacy technology. They are starting with a blank-sheet of paper and they are allergic to any manual processes because they design low-cost services with low margins, so everything has to be super-efficient. So if mutual fund managers want to take what is a massive opportunity, they have to find a way to modernise the distribution process of their products and make them easily and efficiently accessible to their investors and distributors. Wong: Korea has also launched an online fund supermarket where investors can buy funds directly at a cheap rate, but it has not taken off yet. It is not down to the technology, it is investor behaviour. These funds need to be sold to them by advisers, they will not search for them online. ETFs are a different story, though, because investors can buy them just like stocks through their existing brokerage accounts. They are low-cost and the investors are used to them. But for funds distribution in Asia, you still usually see an intermediary sitting between the investors and the investment products. Li: We are in the digital age and the younger generation may be more prepared to buy funds online, but Alibaba is still a unique case. We have not seen anyone else replicate that success yet but my inclination is that the new digitalisation will come sooner and faster than everyone expects. Chaker: No, but the example of Alibaba Group holding a controlling stake in Tianhong Asset Management via its affiliate Ant Financial Services could easily be replicated by other large financial technology groups such as Google, Amazon or Facebook. They would then control the end-to-end points from production to distribution. That would be truly disruptive. Chen: People obviously welcome more choice and a lighter cost model but regulation also has to be supportive. In Hong Kong, the current KYC requirement means that to open a bank account, you have to be present in the branch. There are also rigorous suitability tests imposed on sales teams, to ensure that investors understand what they are buying, that can take hours. If the market is going to move to a lighter-cost, online model, regulations have to support that move. Funds Global: In the coming year, what does the panel see as the main item on their action list?
We are market-driven, so there will never be a specific goal. Investors follow the money. With the US market recovering, the market’s focus may shift there. And if the Asian markets go very well, maybe the fund passport could be successful. As a service provider, we have to be flexible and keep up to date so that we can react and adapt immediately to market changes and trends. In 2015, we have invested significantly and updated some of our core systems in order to meet the fast-evolving markets and client demand. Some of this work is completed but some of it will continue in 2016. Chaker: Our first priority is to help our Hong Kong-based clients to smoothly connect to China. In parallel, there are the two other Asian passports that will also impact distribution flows in Asia and thereby our clients’ operations. We are working to connect these markets to allow fund distributors to easily access any funds they wish to invest in and for fund managers and transfer agents to connect to distributors wherever they are. Wong: Our first task is to adapt our existing infrastructures to cope with the demands of the wider Asian investors communities and facilitate Asians investing into international funds. In the future we are going to see more intra-regional flows, so that is where we will try and modify our systems. The second task is the MRF. We need to provide service to our clients and to launch it in the coming months while at the same time keeping an eye on the Asia Regional Fund Passport and all the post-trade developments that will bring. Durand: I’m a bit concerned about what’s going to happen on the markets next year, be it the stock market or the bond market. It can be really nasty on our business, so I will focus on my clients instead and try to give my best to them. Chen: My three priorities are China, China and China again. Shenzhen has to be included in Stock Connect because it represents a big part of the Chinese economy. There are already over 30 Luxembourg-based funds and 20 Dublin-based funds approved for Stock Connect and all those managers need to be prepared for Shenzhen.  The first batch of MRFs will go this year and the second batch will follow next year, so we will continue to build our service and improve the efficiency because, with the renminbi depreciating, we are expecting more outflow.  And finally, there is the China interbank bond market. With the renminbi set to be included in the IMF’s Special Drawing Right as a reserve currency, over 100 central banks will need to have access to the Chinese interbank bond market and asset managers will have to position themselves over the next year to service these institutions and sovereign wealth funds. Murray: As a service provider, it’s difficult to see beyond China, but something we will also be focusing on next year is the Mandatory Provident Fund business.  Sponsors will look to include a low-cost product in 2017 and that will create more interest in passive product strategies. Together with increased member choice and open-architecture platforms, we are seeing new fund managers entering this space. These Hong Kong-domiciled funds will also be eligible for MRF and those structured as Hong Kong-domiciled ETF’s are likely to be included in Stock Connect.  So we are seeing more interest than ever before from international managers seeking to set up local domestic funds, many for the first time. ©2015 funds global asia

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