Fast emerging market growth poses opportunities and challenges for structural reform and innovation, finds Peter Guy.
The growth and liberalisation of China's capital markets have driven the expansion and development of financial products and custodial services. The two unique market characteristics that drive complexity for international investments into China are the several different accesses schemes and the fact that China continues to separate offshore and onshore currencies, namely its renminbi (RMB).
The evolution of custodial services parallels the level of international interest in its markets – interest fostered by a number of investment schemes.
In 2002 China launched the “QFII” (Qualified Foreign Institutional Investors) scheme. This was followed in 2010 by the CIBM (China Interbank Bond Market) Direct scheme. Then in 2011 came the RQFII – the Renminbi Qualified Foreign Institutional Investors Scheme. This then merged with the QFII in 2020 to create “QFI”, and it marked a major opening in China’s capital markets.
Along the way, these schemes were joined by two bilateral investment channels: the north-bound Stock Connect; and Bond Connect. Both went live in 2014 and 2017, respectively. Today, there are more options to invest in China. Each channel features unique characteristics with different rules and is regulated by separate authorities.
"This complexity drives investors to seek guidance from custodians on the differences and suitability of the various channels to enter the China market," Stanley Song, co-head of BNP Paribas Securities Services in China, says.
In China's evolving capital markets, investors need to make informed and timely decisions on their market entry strategy and through the ongoing management of their investment routes to ensure compliance with the latest regulatory and market developments. A key role of custodians is to serve as the bridge and advisor between foreign investors (who do not possess an onshore presence) and international and domestic regulators.
Custodial challenges in China
Magdalene Tay, Asia Pacific lead for global markets management at BNY Mellon, says that although rapid reforms have made it easier for global investors to access China equity and bond markets, there is still an “extensive web of applications, documentation and approvals that require a significant amount of time and dedication”.
“Current regulations permit foreign investors to participate in new instruments, but operational guidelines should move in tandem so that these foreign investors are able to realise the full potential of these new instruments in a timely manner,” says Tay. “The market also uses different local security codes for bonds dual-listed on the exchange and over-the-counter (OTC) markets. Investors must support different security codes.”
Investors need insights to help them make informed decisions on their entry strategy and in the ongoing management of their investments in order to ensure compliance.
Song says the China Securities Regulatory Commission (CSRC) has demonstrated its openness to accepting new types of investors with its easing of requirements. Broader and easier access is attracting more foreign investors.
“Take the QFI scheme as an example. Since November 2020 - when QFII and RQFII schemes were merged and simplified - there has been a 53% rise in new qualified investors, taking the total to 768, as of April 2023.
“It took almost 20 years to reach 500 QFI investors and only 30 months to add another 266," says Song.
Song has also observed a change in the profile of institutional investors. The vast majority of these new QFI investors are alternative asset managers, and two-thirds are based in Hong Kong or Singapore.
An increase in the number and diversity of investors, as well as a broadening investment scope, demands both specialised and customised services from custodians. A significant number of global and regional asset managers who already hold a Wholly Foreign Owned Enterprise (WFOE) license are applying for QFI investor status to inject or seed money in their local funds from offshore, Song says.
"Whilst regulators are looking at global standards, local nuances remain. The implementation of delivery versus payment (DVP) and the discussions on omnibus accounts are inching closer to standardisation. This is positive for investors who rely on their custodians to support multiple structures with the same market simultaneously," says Song.
Meeting future regulatory expectations
International investors prefer to defer to practices that are consistent across their invested markets. An ongoing topic is that of DVP, where the delivery of securities and payment are synchronised to minimise counterparty risk.
Sam Xu, country executive for China of BNY Mellon, says: “Since 2018, China has introduced many measures for global investors. This has resulted in the gradual adoption of more international practices in custodian and administrative services. However, China’s capital controls have yet to be relaxed; many new investment schemes with China’s unique characteristics - such as Greater Bay Area and Wealth Connect - require innovations to complement the inclusion of various indices and bring in more foreign capital inflows.”
Song adds: “In the China A-share market, for example, the delivery of securities happens on T+0 [the same day the trade is made] while cash is cleared on T+1 [a business day later]. The risk is not significant as the A-share market requires pre-funding, and the trade is forced to settle. However, the mismatch of the clearing and settlement cycles is inconsistent with the DVP standard seen in other markets.”
Regulators have committed to greater consistency and transparency on this topic, and in December 2022, the CSRC and China Securities Depository and Clearing Corporation (CSDC) announced a reform of DVP to address this concern.
Another product trend is the use of omnibus accounts, which is a common account structure in overseas markets. It refers to an account that holds multiple sub-accounts or investors. Globally, an investment manager normally opens an omnibus account for multiple investors with a custodian. Then, the global or local custodian uses their own name to open accounts with the local depository. This practice offers greater account opening efficiency and privacy if the end investor prefers anonymity.
China has enforced a high know-your-customer standard where “look through” is mandatory. Identification of the ultimate beneficiary owner is required. However, demonstrating their willingness to listen to investors, the Peoples’ Bank of China recently announced that it will explore a multi-layer custodian arrangement. Bonds purchased by foreign investors through a local custodian will be registered under the name of the local custodian, while foreign investors will hold the right to the securities.
“While we are seeking more clarity on the impact on account structures, for example, this move clearly shows the regulators’ intention to move towards an alignment with global practice,” remarked Song.
Attracting more foreign flows
Recent regulatory changes are likely to improve the market. For example, the long-awaited Swap Connect program, which is designed to attract more foreign capital inflows into China, started to trade in mid-May.
The Northbound trading of Swap Connect provides a secure channel for international investors to trade interest-rate swap products on the mainland via a connection between institutions in China and Hong Kong. The program is poised to facilitate global investors’ management of interest rate risks arising from their allocation to mainland bonds.
Xu says: “Further opening of the financial market requires a breakthrough in terms of liquidity. For example, how to allow foreign investors to hold Chinese government bonds as qualified collateral to support other financing needs.”
Another development happened on May 24, 2023, when the Shanghai Stock Exchange and Singapore Exchange announced a significant deepening of their relationship by signing a memorandum of understanding to launch an SSE-SGX exchange-traded fund (ETF) link.
Under this agreement, SSE and SGX will jointly develop and promote the ETF markets in both countries through a master-feeder fund model. The link also facilitates greater collaboration opportunities between issuers in both markets, enhancing investment options for investors.
China has also announced an ambitious ‘30/60 Plan’ (carbon peak by 2030 and carbon neutrality by 2060). It could be a boon to ESG investing. According to Wind, a market data provider, 263 ESG fund products existed by Q3 2022 in China with a market value of RMB 396 billion.
However, certain barriers remain that prevent higher growth.
Song says there is no consistent way of measuring ESG investments or disclosures. Participants are setting their own standards on data and reporting, which creates difficulties in comparing and identifying ESG products.
“Regulations and standardisation in ESG investments and reporting are required to achieve a unified framework,” says Song.
Tay, meanwhile, points to other changes that would facilitate more capital flows.
“There are a few areas that can encourage increased foreign participation. Firstly, the removal of CNY FX restrictions from single to multiple counterparties. Secondly, allowing foreign investors to participate in IPOs through Stock Connect and finally, harmonising the securities lending framework to international standards.”
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