EU reg­u­la­tory fears blamed for thin Stock Con­nect vol­umes

China Daily (Canada) - - BUSINESS - By REUTERS

Con­cerns by Europe’s top funds watch­dog that the land­mark Hong Kong-Chi­nese main­land trad­ing link may not ad­e­quately pro­tect in­vestors are pre­vent­ing thou­sands of funds from buy­ing Shang­hai stocks, threat­en­ing the suc­cess of the project, mar­ket par­tic­i­pants told Reuters.

The Stock Con­nect scheme, launched on Nov 17, al­lows for­eign in­vestors to trade Shang­hai-listed shares via the Hong Kong stock ex­change, and main­land in­vestors to invest in Hong Kong shares via the Shang­hai bourse.

But within a week of its launch, trad­ing vol­umes had dwin­dled to less than 20 per­cent of the max­i­mum al­lowance.

Banks, fund man­agers and lawyers told Reuters that was be­cause many large EU-reg­u­lated funds are un­able to par­tic­i­pate un­til Europe’s main funds reg­u­la­tor, Lux­em­bourg’s Com­mis­sion de Surveil­lance du Secteur Fi­nancier, is sat­is­fied that the scheme pro­tects in­vestors.

About 13,000 global mu­tual funds, or twothirds of Europe’s funds in­dus­try, are domi­ciled in low-tax Lux­em­bourg and reg­u­lated by the CSSF. Th­ese in­clude heavy­weights such as Black­rock, Tem­ple­ton and Fidelity, part of Lux­em­bourg’s 3 tril­lion euro ($3.7 tril­lion) as­set man­age­ment in­dus­try.

The CSSF, mar­ket par­tic­i­pants say, wants to be sure that the Chi­nese shares EU savers buy through the link-up can be ad­e­quately re­cov­ered should the bank that guards the stocks— the cus­to­dian bank— or one of the ex­changes, go bust.

The col­lapse of Lehman Brothers in 2008, which saw bil­lions of dol­lars in fund as­sets sucked into the in­sol­vent Lehmans es­tate, has made in­vestors and reg­u­la­tors highly sen­si­tive over cus­tody ar­range­ments.

Sev­eral mar­ket par­tic­i­pants said the CSSF has ques­tioned whether Stock Con­nect’s ar­range­mentsmeet Europe’s strict rules gov­ern­ing the safe-keep­ing of as­sets man­aged by mu­tual funds for re­tail in­vestors, popular in­vest­ment prod­ucts known as UCITS.

“The Lux­em­bourg reg­u­la­tor is ask­ing the custodians to clar­ify that the cus­tody ar­range­ments com­ply with UCITS rules,” said Jeremy Lam, a part­ner at law firm Dea­cons in­Hong Kong.

But some custodians feel un­able to pro­vide that re­as­sur­ance, lawyers and in­dus­try par­tic­i­pants said. The CSSF said it had had “con­tacts with some custodians (over Stock Con­nect) and the dis­cus­sions were re­lated at this stage to gen­eral points”.

It de­clined to give fur­ther de­tails on th­ese dis­cus­sions, but said that it had yet to re­ceive any for­mal ap­pli­ca­tion by a UCITS fund to par­tic­i­pate in the Hong Kong-Chi­nese main­land scheme.

Sal­lyWong, chief ex­ec­u­tive of the Hong Kong In­vest­ment Funds As­so­ci­a­tion, said funds have been work­ing around the clock with Euro­pean reg­u­la­tors to re­solve the is­sue.

Some mar­ket par­tic­i­pants said it could take six months to find a so­lu­tion to sat­isfy the CSSF, or longer if China is re­quired to make changes to its se­cu­ri­ties law.

Shares and bonds bought by mu­tual funds are typ­i­cally held by custodians on be­half of the in­vestor, a con­cept known as ben­e­fi­cial own­er­ship. Un­der EU rules for mu­tual funds, the cus­to­dian must be able to iden­tify and mon­i­tor the client funds at all time.

But the Chi­nese main­land trad­ing scheme makes it tough for custodians to ful­fil th­ese obli­ga­tions, be­cause Shang­hai shares are phys­i­cally held in the main­land through an un­usu­ally com­plex three-tiered struc­ture in­volv­ing the cus­to­dian, theHong Kong clear­ing house, and the Shang­hai clear­ing house.

To make mat­ters worse, some lawyers say Chi­nese law does not ex­plic­itly rec­og­nize the con­cept of ben­e­fi­cial own­er­ship, mean­ing for­eign in­vestors may not be able to prove they own the shares if some­thing goes wrong.

“Ul­ti­mately, fund man­agers have fidu­ciary re­spon­si­bil­i­ties to the clients,” saidWong.

In re­ply to a re­quest by Reuters, the Hong Kong stock ex­change said in a writ­ten re­sponse that the scheme’s cus­tody ar­range­ments are clearly stated on its web­site. The ex­change has said it will pro­vide custodians with cer­tifi­cates as proof of own­er­ship.

But it is un­clear if this will sat­isfy CSSF’s re­quire­ments, custodians said.

The Shang­hai Stock Ex­change told Reuters low trad­ing vol­umes were caused by a va­ri­ety of fac­tors, with­out giv­ing de­tails.

Mu­tual funds ex­pe­ri­enced a sim­i­lar prob­lem when at­tempt­ing to invest in Chi­nese main­land through a quota-based cross-bor­der scheme known as RQFII first launched in 2011. In this in­stance, the UCITS funds had to wait nine months for a green light from CSSF.

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