Shenzhen-Hong Kong Stock Connect Not Without Challenges

The recently announced approval of the Shenzhen-Hong Kong Stock Connect, which will allow non-mainland investors to trade in shares listed on the Shenzhen Stock Exchange, will likely come with its own challenges.

Some worry it might mirror the first link between Hong Kong Stock Exchange and the Shanghai Stock Exchange, the Shanghai-Hong Kong Stock Connect, which has been up and running since Nov. 17, 2014.

Matthew Chan, head of trade processing and middle office services for Asia-Pacific at the Depository Trust & Clearing Corporation (DTCC), says that while the move is positive, he expects there to be issues and challenges in the middle and back offices, particularly for firms trading into China through a Connect link for the first time.

"Operationally, as trade volumes rise over time, firms need to think about how scalable their existing systems are and whether their middle- and back-office processes can handle higher volumes through these links," he says. "We know that in the case of Shanghai-Hong Kong Stock Connect, some firms got by with workarounds and manual fixes. For these firms and others contemplating direct exposure to China through Shenzhen Connect, it is important they start thinking about whether they have systems in place that are robust and scalable to handle both the complexity and likely scale of future volumes."

He adds that the greatest challenges for companies using the new link will likely be due to a number of unique features of China's markets, which can restrict trading strategies, lead to operational complexity and, in some cases, pose additional risks compared to other markets.

Among them are the hybrid settlement cycles and a non-delivery-vs-payment ─ or ‘non-DVP' ─ system. "These are not insurmountable challenges, but if Shanghai-Hong Kong Connect taught us anything, they are nevertheless significant issues requiring much thought and planning by firms," he says.

According to Chan, for the Shanghai Stock Connect, investors can only sell shares held in their trading account the previous day (T-1). If the securities are held by a custodian or multiple brokers, this means those firms need to transfer stocks a day prior to trading, which is unusual. "In addition, unlike most other markets, stocks settle the same day as they are traded (T+0); however, cash doesn't settle until T+1. This is a very unique, hybrid settlement cycle," he adds.

Although some workarounds have been implemented to address the impact of the pre-delivery requirement, uptake has not been universal and many firms still deal with the operational complexities and counterparty risk associated with a non-DVP system.

"We expect the investment community outside China to confront similar challenges with the Shenzhen-Hong Kong Stock Connect, and DTCC is already starting to work with the industry to see how specific challenges can be met," Chan says.

New Avenues, New Questions

For UK-based network and communications provider Colt, the link will encourage vendors to test the appetite for the Shenzhen market before deciding whether to invest directly in the mainland to offer services such as co-location.

Ralph Achkar, director at Colt Capital Markets, says many market participants will be looking to their vendors to make this market available to them. Vendors will need time to size up the level of appetite from their clients, get the right paperwork and infrastructure in place, and set project plans to mobilize their technical teams for testing and implementation.

"Vendors need to investigate and understand the following: services available on the new link (data feeds, etc.), the potential business models available, and the commercial value they can give to the end user, as well as the infrastructure needed to make services available," Achkar says. "Customers can always go to the exchanges directly, so vendors need to decide if they can add value versus the direct model. Provided that they can add value, vendors could help attract more users to the Connect by making it easier for users to take advantage of it."

In a joint announcement in mid-August, the China Securities Regulatory Commission (CSRC) and the Securities and Futures Commission (SFC) approved the establishment of the Shenzhen-Hong Kong Stock Connect after months of anticipation.

Previous complaints of the Shanghai-Hong Kong Stock Connect include the aggregate quota placed on cross-boundary investments between the two cities. The aggregate quota for Northbound trades from Hong Kong to Shanghai was capped at a maximum of RMB300 billion ($45 billion) while the maximum for Southbound trades was RMB250 billion ($37.6 billion).

However, in the announcement of the Shenzhen-Hong Kong Stock Connect, the CSRC and SFC said there will be no aggregate quota under Shenzhen-Hong Kong Stock Connect, and the quota under the Shanghai-Hong Kong Stock Connect will be abolished, effective immediately.

That said, there is still a daily quota ─ which mimics the daily quotas of the Shanghai-Hong Kong Stock Connect ─ that is RMB13 billion ($1.95 billion) for Northbound trades and RMB10.5 billion ($1.58 billion) for Southbound trades.

"The Shenzhen-Hong Kong Stock Connect opens up new opportunities for direct exposure to Chinese equities, this time for stocks listed on Shenzhen, which is weighted more towards technology and new economy stocks than the Shanghai bourse," says the DTTC's Chan.

The plan is for the trading link to go live before Jan. 1, 2017. 
 

The Bottom Line

• In mid-August, the CSRC and SFC approved the establishment of the Shenzhen-Hong Kong Stock Connect, similar to the Shanghai-Hong Kong Stock Connect, which launched in 2014.
• The link will allow investors from around the globe to have access to Shenzhen Stock Exchange, and it will allow vendors to have a better idea if they want to establish a presence for services like co-location in the region. 
• The Shanghai link experienced several problems that will, hopefully, be addressed before Shenzhen Connect goes live.