Hong Kong: Bond Connect
Author: Etelka Bogardi
The Bond Connect scheme allows foreign fund managers to trade in Mainland China’s government, agency and corporate debt markets without, for the first time, having to set up onshore accounts.
Introduction
In July 2017, a new mutual market access scheme went live that allows investors from Mainland China and overseas to trade in each other’s bond markets through a connection between the related Mainland and Hong Kong financial infrastructure institutions. The new scheme is called Bond Connect.
To support Bond Connect related trading services a joint venture company, Bond Connect Company Limited (BCCL), has been established by the China Foreign Exchange Trade System (National Interbank Funding Centre) (CFETS) and Hong Kong Exchanges and Clearing Limited (HKEX). CFETS and its subsidiary company own 60 per cent. of BCCL, while 40 per cent. is owned by HKEX. CFETS is directly affiliated to the People’s Bank of China (PBoC).
Northbound and Southbound trading – two phases
The initial phase of Bond Connect, northbound trading, has commenced, allowing overseas investors from Hong Kong and other regions to invest in the China interbank bond market (CIBM) through mutual access arrangements in respect of trading, custody and settlement. Southbound trading is to be explored at a later stage. When Bond Connect was launched, an initial batch of about 20 large Mainland institutions had submitted applications to become participating dealers to provide quotations to the first offshore participants through the trading system of CFETS.
Nominee holding arrangement
When Bond Connect was launched, the Chief Executive of the Hong Kong Monetary Authority (HKMA), Norman T.L. Chan described the new scheme as follows:
“Bond Connect is a new financial infrastructure established through the connection between HKMA’s CMU and the relevant central securities depositories (CSDs) on the Mainland. Under Bond Connect, eligible overseas investors can settle and hold their Mainland bonds through CMU using nominee holding arrangement. Nominee holding arrangement is widely used by investors in international capital markets as it provides greater convenience and flexibility to investors and market participants. CMU also adopts nominee holding arrangement and provides nominee holding services for more than 200 local and international banks, trust companies and custodians through its linkages with Euroclear, Clearstream and other regional CSDs. The continued liberalisation of the Mainland’s capital account and RMB internationalisation will progressively raise demand from overseas investors for RMB asset allocation, while the Mainland has been proactively rolling out measures to facilitate overseas investors’ access to its bond market. We believe that Bond Connect would enhance overseas investors’ participation in the Mainland bond market.”
Custody and settlement services
Prior to the launch of Bond Connect, the Shanghai Clearing House (SCH) and the Central Moneymarkets Unit of the HKMA (CMU) issued a joint announcement which provided further clarity as regards the provision of custody and settlement services for Bond Connect, as follows:
SCH is the bond market infrastructure institution authorised by the PBoC to provide the custody and settlement service for debt securities. CMU is the bond market infrastructure operated by the HKMA. SCH and CMU will jointly provide the custody and settlement service for Bond Connect through a connection between the two infrastructures.
Mutual access between SCH and CMU with respect to the custody and settlement service will cover northbound trading in the initial phase. Overseas investors will be able to invest in the CIBM through the mutual access arrangement between CMU and SCH. Relevant arrangements for southbound trading will be separately announced having regard to the directive of the Mainland and Hong Kong regulators.
Overseas investors investing in the CIBM through the Bond Connect shall hold their bonds using the nominee holding arrangement. SCH is the ultimate CSD and CMU will be the nominee holder of the bonds. A legal agreement will be signed between SCH and CMU to set out the respective rights and obligations of the two entities under such an arrangement.
The scope of eligible investors and bonds for overseas investors investing in the CIBM through Bond Connect shall be the same as that for overseas investors investing directly in the CIBM. All bonds registered and deposited in SCH are eligible for investment under Bond Connect.
SCH provides the settlement service on a Delivery-versus-Payment (DvP) and gross settlement basis for overseas investors investing in the CIBM through Bond Connect.
Information reporting in respect of SCH, CMU and overseas investors investing in the CIBM through the Bond Connect will be carried out according to the requirements of the Mainland and Hong Kong regulators.
SCH and CMU will prepare detailed operational rules specifying the requirements relating to custody and settlement for overseas investors participating in Bond Connect. The rules will be implemented upon approval by the Mainland and Hong Kong regulators.
Global bond indices
The development of Bond Connect is an important step, demonstrating the importance of Hong Kong as an international financial centre. In particular, the new scheme allows foreign fund managers to trade in Mainland China’s government, agency and corporate debt markets without, for the first time, having to set up onshore accounts. The new initiative, a sister scheme to the Stock Connect scheme already running between Hong Kong, Shanghai and Shenzhen, is thought likely by many in the market to help Mainland China win inclusion in global bond indices – a move that analysts expect the key bond index providers to make in the next year.
Rules and regulations
Investors can find further information on the Bond Connect website. Like any new scheme, working out the new rules for admission will be key and some analysts expect that trading flows will increase once investors become more familiar with them. Overseas investors who comply with the CIBM admission criteria prescribed in the PBoC’s Public Notice No.3 [2016], PBoC Notice No. 220 [2015] and other relevant PBoC notices may apply to Bond Connect to conduct trading in the CIBM. Importantly, the criteria restricts admission to institutional investors and does not include hedge funds. In addition, it is also worth noting that there are additional requirements for investors from certain jurisdictions including Canada, France, Singapore, UAE, and the United States of America.
Final word
Only time will tell as to whether or not Bond Connect will become a true gateway to the Chinese bonds market. There have been media reports that analysts believe that further catalysts are needed to attract new inflows from foreign investors. These include, in particular, clarified tax rules, the opening of access to hedging instruments and independent bond ratings from global credit rating agencies who have yet to set up onshore offices. However, it is likely that Chinese authorities will proceed cautiously to be able to closely monitor fund flows as Mainland China integrates its capital markets with the world.
Hong Kong: Securities and Futures Commission voices concern over asset management practices
Authors: Etelka Bogardi, Nicholas Wilson and Lillian Chau
The Securities and Futures Commission (SFC) recently issued two circulars to licensed corporations engaged in asset management business. The circulars were issued following routine inspection by the SFC of corporations licensed for such activity.
Irregularities identified relating to private funds and discretionary accounts
The first circular was issued by the SFC on 31 July 2017 (July Circular) in respect of concerns identified from inspections of licensed corporations engaged in managing private funds and discretionary accounts (PD asset managers).
The SFC noted that there were certain private funds and discretionary accounts with concentrated, illiquid and interconnected investments. These private funds and discretionary accounts were found to have the following irregularities:
- Discretionary account holders having large concentrated stock positions in their accounts and PD asset managers acting solely at the direction of their clients without exercising investment discretion;
- Related-party acquisition or disposal of shares in listed companies by bought and sold notes (e.g., a substantial shareholder of a listed company sells the company’s shares to a fund managed by a PD asset manager by bought and sold notes, and the substantial shareholder in turn invests in the fund through a discretionary account);
- Fund investors or discretionary account holders being related (e.g., as a substantial shareholder, director or affiliate) to the listed companies invested by the PD asset manager; and
- A director of a PD asset manager was also a director or chief executive officer of listed companies in which funds under the management of the PD asset manager were invested.
The nature and commercial substance of the above practices are regarded by the SFC as questionable as they may conceal the shareholding of the fund investors or discretionary account holders in the listed companies.
The SFC also identified situations which called into question whether the relevant PD asset managers were acting consistently with the Code of Conduct for Persons Licensed by or Registered with the SFC (Code of Conduct) general principles to act fairly and avoid conflicts of interest. These situations included:
- Where a fund was unable to meet margin calls on leveraged stock trading, accordingly, loans were arranged to be made by the PD asset manager’s other funds. This exposes the investors in the lending funds to risks, especially if the lending funds also needed cash to meet outstanding redemption requests and the borrowing fund was not able to repay uncollateralised loans. In this case, a party related to the PD asset manager made a loan to the borrowing fund with an extremely high one-off financing charge; and
- Where a fund investor related to a PD asset manager was given preferential treatment and was allowed to redeem his holdings before negative adjustment was applied to the fund, thereby minimising his own investment losses.
Other common instances of non-compliance in managing funds and discretionary accounts
Further to the July Circular, the SFC on 15 September 2017 issued a further circular (September Circular) which covers other regulatory issues noted from the SFC’s inspection of corporations licensed for asset management activity (asset management). These issues include:
- Inappropriate receipt of cash rebates giving rise to apparent conflicts of interest;
- Failure to ensure suitability of funds or discretionary account mandates when making solicitations or recommendations of funds under their management, or providing discretionary account management services, to clients;
- Failure to put in place a proper liquidity risk management process to ensure that liquidity risks of funds and discretionary accounts under management are adequately addressed;
- Deficiencies in setting up a proper governance structure and implementing comprehensive policies and procedures for fair valuation of assets;
- Deficiencies in systems and controls to ensure best execution;
- Failure to ensure fair order allocation;
- Inadequate systems and controls in relation to protection of client assets;
- Inadequate systems and controls for ensuring compliance with investment restrictions and guidance; and
- Inadequate systems and controls to address the risk of market misconduct.
What asset managers should do?
Asset managers with discretionary management authority are advised to perform their roles with due skill, care and diligence, in the best interests of their clients and the integrity of the market. The SFC warns that an asset manager should critically examine arrangements and transactions proposed by their clients and should not turn a blind eye to dubious arrangements, otherwise, they may risk being implicated in any associated market misconduct or other illicit activities. If an asset manager suspects that their clients have committed any market misconduct, they should report to the SFC in accordance with their obligation under the Code of Conduct.
Asset managers should have in place and maintain effective risk management policies and procedures in order to identify and manage risks to which their portfolios are exposed, especially liquidity risk, to ensure that investors’ redemption requests can be met in accordance with the terms set out in the relevant offering documents. Further, asset managers are advised to review their existing internal control procedures and operational capabilities, and enhance them as needed so as to ensure that standards of conduct and control procedures meet the expectations of the SFC.
It should be emphasised that the SFC expects the board and other senior management (including the managers-in-charge of core functions) of asset managers to maintain adequate oversight of their firm’s business activities. Senior management should have primary responsibility for ensuring the maintenance of appropriate standards of conduct (including, amongst other requirements, acting fairly and in the best interest of their clients and the integrity of the market) as well as ensuring adherence to proper procedures and the maintenance of proper risk management measures. The SFC recommends senior management review the areas of concern mentioned above and give priority to strengthening their supervisory and compliance programmes to ensure compliance with all applicable regulatory requirements.
