A string of alliances and acquisitions among Asian exchanges shows the competition and the lengths venues are willing to go to attract liquidity. Nicholas Pratt investigates whether this approach guarantees success.
Chinese premier Li Keqiang in April announced a pilot programme to link the respective equity exchanges of Hong Kong and Shanghai.
The Shanghai-Hong Kong Stock Exchanges Connectivity Mechanism, or Stock Connect, will allow cross-market stock investment by China and Hong Kong investors.
It is part of a wider effort to liberalise capital flows between the two markets, and open China to more international market forces after many years of government control.
The Stock Connect project also comes shortly after the announcement of possible mutual fund recognition between China and Hong Kong, a project that will aim to allow funds to be marketed in both Hong Kong and China.
This is motivated by the same regulatory forces that are pushing hard for the gradual opening of the country’s investment account to international investors.
It is also welcome news in Hong Kong, which is ambitious to become the international gateway to China.
“The programme is not only a major breakthrough for the opening up of China’s capital markets but also a great milestone for the development of Hong Kong as an international financial centre,” says Chung-kong Chow, chairman at Hong Kong Exchanges and Clearing.
“Hong Kong will again act as a bridge connecting the Chinese economy and the rest of the world,” he adds.
Since the initial announcement, more details have emerged as to how the project will work. This includes the all-important quotas, which will be now set at the exchange level.
Hong Kong-based investors will be permitted to buy up to 13 billion renminbi ($2.1 billion) of Shanghai-listed stocks per day while mainland Chinese investors will be able to buy up to $13.2 billion Hong Kong dollars ($1.7 billion) of Hong Kong shares.
The combined market capitalisation of the stocks listed on the two exchanges will exceed $5 trillion, according to research undertaken by the World Federation of Exchanges.
Short selling and margin trading will be prohibited. Brokers will also be prevented from engaging in large block trading or dark pool trading where shares are traded off-exchange.
Anthony Skriba, manager, client services, at Shanghai-based consultant Z-Ben Advisors, says the introduction of the platform is a “watershed moment”, given that it provides a means for other cross-border programmes to be wound down, while simultaneously increasing the flexibility in the cross-border space in the short-term.
“While we do not expect major inflows overnight, the infrastructure for a transition to a more open investment account for Greater China now appears
to be coming into place,” comments Skriba.
Foreign investors have been required to register under the qualified foreign institutional investor (QFII) scheme and Skriba says the Shanghai-Hong Kong Connect Program is best seen as complementary to QFII.
“This simply will open up the possibility to a much wider range of investors, those that do not have the $50 million generally required to commit to QFII, and will also be better suited for smaller investors since it will not force the capital to remain onshore, as QFII does.”
Skriba says that northbound demand – international investors buying Chinese A-shares – will likely outstrip southbound demand – Chinese investors buying Hong Kong Stocks – given that Chinese investors will be required to have 500,000 renminbi in their trading accounts. Those that do so will likely already have a Hong Kong trading account.
Similarly, Chinese institutions already have relatively easy access to offshore channels. “So this is not adding as much flexibility for them as it is international buyers,” Skriba says.
The aforementioned quotas will also be an important factor in how the project progresses.
One concern among economists is that the necessary preconditions for liberalising China’s capital markets are not evident – a sound banking system, a healthy property market and an array of retail investors well versed in the risk of international investment.
Should the cross-border flows become volatile or should there be an excessive flow of capital out of China, this could potentially be detrimental to both the domestic property and wealth management markets.
On the other hand, China’s ambition to make its currency fully convertible will be somewhat dependent on the level of interest in Shanghai stocks shown by foreign or Hong Kong-based institutions and investors.
Mainland regulators tend to roll out these types of programmes gradually, says Skriba, adding that it is likely that quotas will be gradually increased over time.
“That said, the amount of quota offered does appear relatively generous, at least when compared to historic norms for new programmes.”
Should all quota be used up, inflows from the Stock Connect programme could amount to between 5% and 10% of volume on the Shanghai exchange, depending on how active domestic investors are on any given month.
Exchange alliances have not been limited to the Stock Connect project. The first major initiative came back in 2012 when the Asean Trading link was launched between seven exchanges in six Asian countries: Thailand, Malaysia, Singapore, Philippines, Indonesia and Vietnam. This created a combined market capitalisation of more than $2 trillion, as at the end of 2012.
There have been further collaborations between exchanges since then, most of which are designed to allow the mutual clearing of trades in different locations thereby offsetting the fractured liquidity across the region.
For example, in December last year the Hong Kong Stock Exchange and the Singapore Exchange agreed a deal to jointly develop renminbi-denominated products as well as forging closer technology and regulatory ties.
There are also numerous plans from western exchanges to link up with Asian counterparts, especially when it comes to derivatives and commodities.
Clearing links have been established between the Australia Securities Exchange and the Chicago Mercantile Exchange. The London Metal Exchange, owned by the Hong Kong Stock Exchange, is targeting cross-listing agreements with three China-based commodity exchanges in Shanghai, Dalian and Zhengzhou.
Furthermore, in November last year, the Atlanta-based Intercontinental Exchange acquired the Singapore Mercantile Exchange for $150 million – the biggest deal to date that has occurred between western and Asian exchanges.
Later that month Eurex, the derivatives arm of Deutsche Börse, acquired a 5% stake in the Taiwan Futures Exchange (Taifex). According to Eurex spokesman Heiner Seidel, the acquisition is both a strengthening of its strategic partnership with Taifex and a further milestone in Deutsche Börse’s Asia strategy.
“Taifex is excellently positioned, especially in Greater China, for the future internationalisation of the derivatives markets.”
The Eurex/Taifex Link will be officially launched on May 15 and will make Taifex options and futures available to traders outside of the normal Taiwanese trading hours.
The 24-hour trading and clearing of these instruments will be realised by listing a derivatives contract on Eurex for which the underlying asset is a position in the corresponding contract of the Taifex futures/options traded on Taifex.
“It will create an overnight market that enables international investors and traders to access liquid domestic benchmark derivatives,” says Seidel.
“The extension of trading hours and access via Eurex Exchange contributes to the further increase of the liquidity of these respective contracts.” The Eurex/Taifex Link provides existing market participants with hedging opportunities for Taifex positions and an opportunity to take advanced positions as and when the market fluctuates.
Such links have become a blueprint of a successful cooperation model as they are mutually beneficial, says Seidel.
“Our partners get access to Eurex’s global member base thereby extending the trading hours and increase the liquidity of the market while we can extend our product offering and complement our equity index derivative suite.”
The relatively low 5% stake taken by Eurex is not uncommon and is generally the limit allowed by many Asian countries, in terms of foreign ownership of domestic stock exchanges.
Deutsche Börse also holds a 5% stake in the Bombay Stock Exchange. For the western exchanges it is a chance to gain a foothold in Asian markets, but their growth ambitions may be tempered by the caution of national regulators.
Those regulators will not only want to preserve the national ownership of their own exchanges but also find a balance between encouraging competition between exchanges but avoiding the complexity of a deregulated, pan-continental exchange landscape, which has been the case in Europe.
In terms of offering investors greater access to international markets, one rival approach to the exchanges’ various linkages and alliances comes from the global asset servicing community, such as Citi aiming to offer brokers and investors access to international markets through its infrastructure. Citi’s Execution to Custody (E2C) service, as the name suggests, offers broker/dealers the opportunity to use Citi as an execution agent and also a custodian.
Citi has also approached a number of exchanges to offer the E2C service to their member brokers as a way of providing access to international markets. In such an arrangement, the exchange would act as an agency broker to its members.
“There are a lot of noteworthy linkages being proposed but each one is only solving a very small piece of the problem faced,” says Endre Markos, director and regional head of Citi’s markets and securities services, execution to custody service. “When two exchanges link they only link the traffic between the two venues. We offer execution capability on all exchanges and straight-through-processing services for the whole lifecycle of the trade.”
Part of the reason that these exchange links suffer, says Markos, is because they create more work in the short-term.
“The long-term benefits may materialise, but the short-term requirements for clearing counterparties and exchange membership are often very limiting for regional brokers,” Markos says. “And by introducing internal changes to their structure, the exchanges may end up passing the cost of integration and technology change.”
While the likes of E2C may offer access to global markets for an exchange’s clients, it will not provide the immediate and direct extra liquidity that exchanges are looking for through their cross-listings and regional alliances. So what is in it for the exchanges other than keeping their customers happy?
“This is not a solution that would drive extra liquidity directly to the exchanges, but they have to be careful that ... they still remain relevant to their clients. If you are a small emerging market exchange that is connected to global venues, it increases its relevance.”
While many of the exchange alliances in Asia are across multiple asset classes, including commodities and derivatives, the E2C service is primarily focused on equities as it relates to the offering for exchanges, says Markos. “It is simpler and the need is greater. There is also a custody aspect which is imperative for Citi.”
There are some regulatory issues that have to be resolved in terms of an exchange taking on an agency broker status which will add to the time taken to reach agreements but Markos is confident that regulators will see the benefit of the service.
“From a regulatory perspective they would have extra visibility on international flows through the E2C model than by reciprocal arrangements on a bilateral basis,” he adds.
Markos says that conversations with exchanges are ongoing and he is hopeful of successful deals in the near future. Citi was in discussion with the Osaka Stock Exchange until it was acquired by the Tokyo Stock Exchange. Discussions are now continuing with the new entity and several exchanges in the region and Markos is confident that agreements can be reached with some venues. “My hope is that one or two Asian exchanges will commit to implementation before the end of the year.”
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