The sleeping giant stirs
02 February 2021
China has amended its QFII scheme to allow foreign investors to lend and borrow securities directly in the mainland market. As the world鈥檚 second-largest securities market opens, SFT examines what it means for securities finance participants globally
Image: Elena Schweitzer/stock.adobe.com
China鈥檚 equity and fixed income markets are the second largest in the world in terms of capitalisation, after the US. The question of when this vast sea of assets will become easily accessible to international investors has been the multi-billion dollar question for decades.
Since 2014, the Shanghai-Hong Kong Stock Connect has offered exchange participants a way to engage in China-A shares securities lending, but, even though engagement on the stock connect has increased, securities financing volumes remain muted, relative to the size of the market.
However, in December 2020, after a lengthy consultation between regional regulators and Asia Pacific market players, the scope of products available to those who had a Qualified Foreign Institutional Investor (QFII) licence was expanded to include securities lending and short selling, among other amendments.
The potential for what this could mean for China鈥檚 underdeveloped securities financing market, and the rest of the world, cannot be overstated.
The QFII relaxations including quota abolishment, a simplification of the application process and the removal of the eligibility criteria for applications, along with investment scope expansion, and multiple channels opening up including Stock Connect and Bond Connect have all contributed to an increase of inflow to the onshore market, explains Patrick Wong, head of China business development and client management, securities services at HSBC.
The index inclusions also act as a catalyst for demand, he notes. Major index providers including MSCI, FTSE, and S&P all include China A-shares in their benchmark indices, which create demand for global passive flows into China A-shares.
鈥淕iven the scale of the market and the pace of progress, it would be reasonable to expect that China will become one of the biggest securities lending markets globally,鈥� says the Pan Asia 色花堂Lending Association鈥檚 (PASLA) chair, Stuart Jones. 鈥淭he real question is how long this will take, and whether last year鈥檚 reforms will make possible a vibrant securities lending market for foreign participants within the next five years.鈥�
International custodians, with hubs in Hong Kong or nearby, including HSBC, Deutsche Bank, and Standard Chartered have also welcomed the move and were quick to facilitate the first domestic securities lending transactions on the day the rules changed late last year.
Standard Chartered鈥檚 executive director, sales, China Access, financing and securities services, Susan Yu, says the move is 鈥渁 remarkable step forward opening up the domestic securities lending and borrowing market to global participants鈥�.
Meanwhile, Deutsche Bank expects China鈥檚 markets to continue growing, corresponding to the country鈥檚 economy. Tony Chao, head of securities services Greater China and head of securities services sales in North Asia at Deutsche Bank, says China will soon become 鈥渢oo big to ignore鈥� for global investors, not only in terms of portfolio allocation and risk diversification but also for absolute returns.
With this barrier to international involvement in China now removed, market observers are unanimous that the Asian giant will become a major player in the global securities finance market; the only question is when. A feeling-out process is inevitable as domestic and international firms get comfortable with each other鈥檚 needs and wants, but further integration is widely believed to be in the best interests of everyone.
China today
Since Mao Zedong declared the creation of the People鈥檚 Republic of China in 1949, the Chinese Communist Party has ensured the country鈥檚 financial markets remained insular. As a result, the domestic market is dominated by retail investors, who account for around 80 per cent of the average daily trading volume, according to Standard Chartered data, which Yu notes is 鈥渋n general opposite to other international markets鈥�.
In contrast, foreign institutional investors make up a mere 3 per cent of the market. Margin loan and short selling participation in the domestic market is also low, around 2 per cent to 3 per cent, compared to overseas markets where it is closer to 10 per cent, according to HSBC, although, the bank predicts these volumes will now grow in the near term.
Wong notes this market dynamic is 鈥渘ot healthy on a longer-term as volatility is comparatively high鈥�. Yu further notes that retail investors are more focused on short-term gain and seem to worry less about company fundamentals. This partly explains why volatility in China A-shares is much higher than other developed markets, where institutional and sophisticated investors are the major players.
Both Wong and Yu hope that the predicted influx of foreign institutional investors will bring some much-need stability by improving price discovery and reducing volatility.
Deutsche Bank鈥檚 Chao also highlights that a large body of research now exists to suggest an activity securities lending and short selling market positivity contributes to a healthy and transparent market and will likewise benefit China.
Wong says the demand is there from long term investors and exchange-traded funds who entered the Chinese market and the growing securities lending market 鈥渨ill definitely enhance their yield onshore鈥�.
PASLA鈥檚 Jones also believes the QFII reforms should reduce the volatility risk around index rebalancing events, which he says will become increasingly valuable as China grows within various index-tracking products. 鈥淗owever, there are commercial, credit, legal and collateral factors that will need clarification for offshore participants at some point,鈥� he adds.
Elsewhere, Jones notes that changes to the QFII scheme are also an example of the healthy relationship between Chinese regulators and their regional counterparts, along with other stakeholders that are pushing for the country to open to the world.
The reforms are 鈥渁n important part of this progressive approach, coming on the back of an industry-wide consultation in which they listened to views on how they could respond to market needs,鈥� Jones says, noting that domestic development has also been ongoing for a while before the rule change. 鈥淚t鈥檚 very encouraging to see that domestic investors, retail and institutional, are embracing the expansion in product choices available to them,鈥� he says, adding 鈥渨e see this as a growth story for the market as a whole, not one that is exclusive to offshore investors鈥�.
Hello world!
Deutsche Bank鈥檚 Chao believes there is 鈥渢remendous pent-up demand鈥� for international assets from Chinese investors for the same reasons international investors want to invest in China. Moreover, he argues, the continued growth of the China wealth management and fund industries is also expected to 鈥渓ead to demand for value-added products and services that currently can鈥檛 be offered by domestic service providers鈥�.
A common opinion voiced by international banks active in China is that domestic assets can add diversification to global investors. Standard Chartered, Yu, explains that global investors can 鈥渆njoy the dividends brought by qualitative economic growth鈥�.
However, he adds, global investors, must adapt to differing rules in China, similar to the rest of Asia Pacific. PASLA鈥檚 Jones explains that over time 鈥淐hina has become a very investible and accessible market and is engaged with the full spectrum of portfolio risk management products and the importance of different investor types to the ecosystem鈥�.
鈥淓mbracing and understanding these factors is important to all global investors as they look to increase their exposure to such a large market,鈥� he states. 鈥淎ny evolution takes time and today鈥檚 reformed QFII scheme is a result of an ongoing dialogue and engagement by a regulator that is both forward-looking and collaborative.鈥�
Despite the market demand, gatekeeper not affected by possible profits remain and Chao predicts China will likely remain a standalone market for some time. Like Yu, Chao suggests China will maintain its regulations and market practices. International investors must adapt to these rules of engagement and manage their investments in China in a somewhat segregated manner, he says.
Although the QFII reforms present a new gateway for foreign investors to enter China, regulatory walls that have stood for half a century around the country鈥檚 markets are not quite ready to come down altogether.
Since 2014, the Shanghai-Hong Kong Stock Connect has offered exchange participants a way to engage in China-A shares securities lending, but, even though engagement on the stock connect has increased, securities financing volumes remain muted, relative to the size of the market.
However, in December 2020, after a lengthy consultation between regional regulators and Asia Pacific market players, the scope of products available to those who had a Qualified Foreign Institutional Investor (QFII) licence was expanded to include securities lending and short selling, among other amendments.
The potential for what this could mean for China鈥檚 underdeveloped securities financing market, and the rest of the world, cannot be overstated.
The QFII relaxations including quota abolishment, a simplification of the application process and the removal of the eligibility criteria for applications, along with investment scope expansion, and multiple channels opening up including Stock Connect and Bond Connect have all contributed to an increase of inflow to the onshore market, explains Patrick Wong, head of China business development and client management, securities services at HSBC.
The index inclusions also act as a catalyst for demand, he notes. Major index providers including MSCI, FTSE, and S&P all include China A-shares in their benchmark indices, which create demand for global passive flows into China A-shares.
鈥淕iven the scale of the market and the pace of progress, it would be reasonable to expect that China will become one of the biggest securities lending markets globally,鈥� says the Pan Asia 色花堂Lending Association鈥檚 (PASLA) chair, Stuart Jones. 鈥淭he real question is how long this will take, and whether last year鈥檚 reforms will make possible a vibrant securities lending market for foreign participants within the next five years.鈥�
International custodians, with hubs in Hong Kong or nearby, including HSBC, Deutsche Bank, and Standard Chartered have also welcomed the move and were quick to facilitate the first domestic securities lending transactions on the day the rules changed late last year.
Standard Chartered鈥檚 executive director, sales, China Access, financing and securities services, Susan Yu, says the move is 鈥渁 remarkable step forward opening up the domestic securities lending and borrowing market to global participants鈥�.
Meanwhile, Deutsche Bank expects China鈥檚 markets to continue growing, corresponding to the country鈥檚 economy. Tony Chao, head of securities services Greater China and head of securities services sales in North Asia at Deutsche Bank, says China will soon become 鈥渢oo big to ignore鈥� for global investors, not only in terms of portfolio allocation and risk diversification but also for absolute returns.
With this barrier to international involvement in China now removed, market observers are unanimous that the Asian giant will become a major player in the global securities finance market; the only question is when. A feeling-out process is inevitable as domestic and international firms get comfortable with each other鈥檚 needs and wants, but further integration is widely believed to be in the best interests of everyone.
China today
Since Mao Zedong declared the creation of the People鈥檚 Republic of China in 1949, the Chinese Communist Party has ensured the country鈥檚 financial markets remained insular. As a result, the domestic market is dominated by retail investors, who account for around 80 per cent of the average daily trading volume, according to Standard Chartered data, which Yu notes is 鈥渋n general opposite to other international markets鈥�.
In contrast, foreign institutional investors make up a mere 3 per cent of the market. Margin loan and short selling participation in the domestic market is also low, around 2 per cent to 3 per cent, compared to overseas markets where it is closer to 10 per cent, according to HSBC, although, the bank predicts these volumes will now grow in the near term.
Wong notes this market dynamic is 鈥渘ot healthy on a longer-term as volatility is comparatively high鈥�. Yu further notes that retail investors are more focused on short-term gain and seem to worry less about company fundamentals. This partly explains why volatility in China A-shares is much higher than other developed markets, where institutional and sophisticated investors are the major players.
Both Wong and Yu hope that the predicted influx of foreign institutional investors will bring some much-need stability by improving price discovery and reducing volatility.
Deutsche Bank鈥檚 Chao also highlights that a large body of research now exists to suggest an activity securities lending and short selling market positivity contributes to a healthy and transparent market and will likewise benefit China.
Wong says the demand is there from long term investors and exchange-traded funds who entered the Chinese market and the growing securities lending market 鈥渨ill definitely enhance their yield onshore鈥�.
PASLA鈥檚 Jones also believes the QFII reforms should reduce the volatility risk around index rebalancing events, which he says will become increasingly valuable as China grows within various index-tracking products. 鈥淗owever, there are commercial, credit, legal and collateral factors that will need clarification for offshore participants at some point,鈥� he adds.
Elsewhere, Jones notes that changes to the QFII scheme are also an example of the healthy relationship between Chinese regulators and their regional counterparts, along with other stakeholders that are pushing for the country to open to the world.
The reforms are 鈥渁n important part of this progressive approach, coming on the back of an industry-wide consultation in which they listened to views on how they could respond to market needs,鈥� Jones says, noting that domestic development has also been ongoing for a while before the rule change. 鈥淚t鈥檚 very encouraging to see that domestic investors, retail and institutional, are embracing the expansion in product choices available to them,鈥� he says, adding 鈥渨e see this as a growth story for the market as a whole, not one that is exclusive to offshore investors鈥�.
Hello world!
Deutsche Bank鈥檚 Chao believes there is 鈥渢remendous pent-up demand鈥� for international assets from Chinese investors for the same reasons international investors want to invest in China. Moreover, he argues, the continued growth of the China wealth management and fund industries is also expected to 鈥渓ead to demand for value-added products and services that currently can鈥檛 be offered by domestic service providers鈥�.
A common opinion voiced by international banks active in China is that domestic assets can add diversification to global investors. Standard Chartered, Yu, explains that global investors can 鈥渆njoy the dividends brought by qualitative economic growth鈥�.
However, he adds, global investors, must adapt to differing rules in China, similar to the rest of Asia Pacific. PASLA鈥檚 Jones explains that over time 鈥淐hina has become a very investible and accessible market and is engaged with the full spectrum of portfolio risk management products and the importance of different investor types to the ecosystem鈥�.
鈥淓mbracing and understanding these factors is important to all global investors as they look to increase their exposure to such a large market,鈥� he states. 鈥淎ny evolution takes time and today鈥檚 reformed QFII scheme is a result of an ongoing dialogue and engagement by a regulator that is both forward-looking and collaborative.鈥�
Despite the market demand, gatekeeper not affected by possible profits remain and Chao predicts China will likely remain a standalone market for some time. Like Yu, Chao suggests China will maintain its regulations and market practices. International investors must adapt to these rules of engagement and manage their investments in China in a somewhat segregated manner, he says.
Although the QFII reforms present a new gateway for foreign investors to enter China, regulatory walls that have stood for half a century around the country鈥檚 markets are not quite ready to come down altogether.
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