EU regulatory fears blamed for thin Stock Connect volumes
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.