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The Shanghai Hong Kong Stock Connect Scheme

Sponsored by China Offshore
15 May, 2015

The Shanghai Hong Kong Stock Connect (SHKSC) scheme, launched last year, represents another milestone on the path towards liberalization of the Chinese economy. The program is summarized in this feature.

What Is The SHKSC?

In brief, the SHKSC is a mutual market access program that allows investors in mainland China to trade stocks listed on the Stock Exchange of Hong Kong (SEHK) directly through the Shanghai Stock Exchange (SSE). At the same time, it also allows Hong Kong and overseas investors to trade stocks listed on the SSE directly through the SEHK, also for the first time. At the moment, it is operating on a pilot basis.

For China, it is hoped that the SHKSC will help increase the participation of institutional investors in the Shanghai securities market, enable investors in mainland China to invest in overseas markets in an orderly way, enhance the opening up of China’s capital market and promote internationalization the Chinese renminbi (RMB).

In Hong Kong, it is hoped that the SHKSC will strengthen the co-operation and interaction between Hong Kong and the markets in mainland China, increase the two-way RMB funds flow between the onshore and offshore markets, and further increasing the liquidity of the offshore RMB market in Hong Kong.

History of the SHKSC

The SHKSC has had a short life so far. But quiet a successful one, as is described later in this piece.

The development of the SHKSC was approved in principle by the China Securities Regulatory Commission (CRSC) and the Hong Kong Securities and Futures Commission (SFC) in April 2014.

A six-month preparation period was then envisaged, with the expectation that actual trading would commence in mid-October 2014, after all possible problems in adapting the two different systems on the Mainland and in Hong Kong had been ironed out.

A significant step forward in the scheme’s development took place in August 2014, when the exchanges in both cities began trading tests.

An agreement towards establishing the Stock Connect scheme was then signed on September 4, 2014, by the SEHK and Hong Kong Securities Clearing Company Limited, wholly-owned subsidiaries of Hong Kong Exchanges and Clearing Limited (HKEx), the SSE, and China Securities Depository and Clearing Corporation Limited (ChinaClear), which are jointly developing the program.

According to HKEx Chief Executive Charles Li, the agreement represents the master document for the cooperation of the four parties, clearly spelling out the obligations and responsibilities of each party based on the principles set out in the joint announcement by the regulators.

SSE Chairman Gui Minjie said: "With this agreement, we have built up a complete framework for the SHKSC business that clarifies all rights and responsibilities of the four related parties in terms of trading, clearing, custody, and market surveillance. It is a milestone marking that the two exchanges and the two clearing houses have had consensus about the market mechanism and business arrangement. Our next step is to consolidate the technical preparations, release business rules, and further conduct system testing for the launch of the program."

The project was subject to some uncertainty in late October, when, having missed its anticipated mid-October start date, the SHKSC scheme had yet to receive the appropriate regulatory approvals, despite being technically ready to launch.

Investors and market participants had only a relatively minor delay to endure however, with the Stock Connect scheme finally commencing trading on November 17, 2014.

"This is the first time that investors in Shanghai and Hong Kong markets, whether individuals or institutions, are able to trade listed shares in the other market, through their own local brokers and exchange," HKEx Chairman C K Chow said of the historic moment, marked by a ceremony at the Hong Kong exchange. "It is a breakthrough in the opening up of China's financial markets and a great milestone in the development of Hong Kong as a unique gateway between mainland and international investors."

SHKSC Rules And Requirements

While all Hong Kong and overseas investors are allowed to trade SSE Securities through Shanghai-Hong Kong Stock Connect, only China-based institutional investors and those individual investors who satisfy the eligibility criteria (i.e. individual investors who hold an aggregate balance of not less than RMB500,000 in their securities and cash accounts) will be accepted to trade SEHK Securities through Shanghai-Hong Kong Stock Connect.

Among the different types of SSE-listed securities, only A shares will be included in the Stock Connect scheme in the initial stage. Other product types such as B shares, Exchange Traded Funds (ETFs), bonds, and other securities will not be included.

In the initial phase, Hong Kong and overseas investors will be able to trade all the constituent stocks from time to time of the SSE 180 Index and SSE 380 Index, and all the SSE-listed A shares that are not included as constituent stocks of the relevant indices but which have corresponding H shares listed on SEHK, except SSE-listed shares which are not traded in RMB in addition to SSE-listed shares which are included in the “risk alert board.”

Among the different types of SEHK-listed securities, only equities listed on the Main Board will be included in Stock Connect. Other products such as stocks listed on the Growth and Enterprise Market, Nasdaq Pilot Program stocks, ETFs, Real Estate Investment Trusts, structured products, bonds, and other securities will not be included.

Through Shanghai-Hong Kong Stock Connect, Mainland investors will be able to trade the constituent stocks of the Hang Seng Composite LargeCap Index and Hang Seng Composite MidCap Index, and all H shares that are not included as constituent stocks of the relevant indices but which have corresponding shares in the form of SSE-listed Shares, except the following: Hong Kong shares that are not traded in Hong Kong dollars; H shares which have corresponding shares listed and traded on an exchange in Mainland China other than SSE; and H shares with corresponding A shares put under “risk alert.”

Trading under Shanghai-Hong Kong Stock Connect will, initially, be subject to a maximum cross-boundary investment quota (aggregate quota), together with a daily quota.

The “northbound” (from Hong Kong to Shanghai) aggregate quota is set at RMB300bn. The southbound (from Shanghai to Hong Kong) aggregate quota is set at RMB250bn. The northbound daily quota is set at RMB13bn, and the southbound daily quota is set at RMB10.5bn.

Since March 2, 2015, the short selling of certain Shanghai-listed A shares has been permitted under the SHKSC. The list of Eligible SSE Securities for short selling is maintained on the HKEx website.

Trading On the SHKSC

As had been expected, on the first day of trading, northbound trading exceeded southbound trading, as international investors took the advantage of the new way of purchasing Chinese shares. Sentiment was also said to have been helped by the confirmation last year that trading in Chinese shares would be eligible for China’s capital gains tax exemption.

In fact, Hong Kong used up its entire daily net quota with total stock trading reaching over RMB12bn (USD2bn), while trading over the program in Shanghai took up only 12.8 percent of its quota at RMB2.3bn.

Hong Kong's Acting Secretary for Financial Services and the Treasury, James Lau, observed on December 3, 2014, during a Legislative Council debate, that the SHKSC's investment quota is used as a risk management tool rather than "a volume target or an indicator," and that, with the Southbound Trading Link's quota utilization at that point lagging far behind the Northbound Trading Link, investors were generally seen "to take a cautious approach when entering a new market." Institutional investors "may need to conduct due diligence and risk assessment" before joining, he said.

Later that month, data confirmed that the program had seen a greater uptake from Hong Kong-based and foreign investors than mainland China investors in the first few weeks of trading.

During SHKSC's first 20 trading days to December 12, 2014, the average daily turnover in northbound trading totaled RMB5.8bn. In the same period, the average daily turnover in southbound trading was RMB757m.

Full-day buy turnover value exceeded sell turnover in both directions throughout SHKSC's first four weeks, and 91 out of 97 eligible SEHK market participants had already engaged in northbound trading, with 547 out of the 568 eligible securities in that direction having been traded.

Commenting on the figures, Chalres Li said: "The launch of SHKSC has been a great success because it is a very important breakthrough, beginning a new era of the world's last major capital market opening. It also reinforces Hong Kong's position as a leading international financial center."

"Since its launch, SHKSC has been running smoothly with complete operational stability, giving both international and Chinese investors convenient and sustainable access," he added. "Like any new market infrastructure, we anticipate utilization will increase gradually as investors gain better understanding of the program and assess the investment opportunities that are available to them for the first time."

And so it has proved. On April 8, 2015, HKEx announced that total daily trading through SHKSC surged to RMB29.9bn, its best level since its launch. This contributed to record market turnover on HKEx that day of HKD252.4bn (USD29bn) far exceeding the previous daily record of HKD211bn set on October 3, 2007.

"Stock Connect was one of the catalysts for today's record high securities market turnover," said HKEx Chairman C K Chow. "The program has given us another source of market liquidity that was enhanced by the Mainland authorities' recent clarification of policies regarding institutional investor participation in Stock Connect."

Tax Treaty Changes Boost Stock Connect

The recent signing of the fourth Protocol to the China-Hong Kong double taxation agreement (DTA) is expected to further boost trading activity through the SHKSC program.

Signed on April 1, 2015, the DTA's fourth Protocol clarifies the conditions under which an investment fund would qualify for Hong Kong resident status. This provides certainty to investment funds' application of their tax arrangements, and confirms that gains derived by a Hong Kong resident from the sale and purchase of shares in a Mainland-listed company will be taxable only in Hong Kong (where there is no such tax).

The latter confirmation is applicable, for example, to gains derived by a Hong Kong resident from the sale and purchase of A shares listed on the Shanghai Stock Exchange under SHKSC. It will therefore also be applicable to those investment funds qualifying for Hong Kong resident status.

Governance And Investor Protection

The SHKSC is founded on existing rules and regulations and operational models. Trading and clearing arrangements are subject to the regulations and operational rules of the market where trading and clearing take place.

Importantly, Hong Kong investors participating in the Shanghai-Hong Kong Stock Connect through SEHK Participants will continue to be protected by Hong Kong laws. Similarly for the trading and settlement activities, Hong Kong investors will continue to deal with SEHK Participants and be protected by the Securities and Futures Ordinance.

However, the CSRC and the SFC have confirmed that they will each take all necessary measures to establish, in the interests of investor protection, an effective regime under SHKSC to respond to all misconduct in either or both markets on a timely basis.

In May 2015, Professor K C Chan confirmed to the Legislative Council that the CSRC and the SFC would upgrade their bilateral agreement to strengthen enforcement co-operation in respect of the referral and information exchange mechanisms concerning: improper activities; and investigatory co-operation in relation to cross boundary illegal activities, including disclosure of false or misleading information, insider dealing, and market manipulation.

With regard to possible increased money laundering risks arising out of SHKSC transactions, Chan assured the Assembly that its cross-boundary trading will be conducted within closed settlement and clearing arrangements, and will be subject to comprehensive risk management measures.

He added that the existing Guideline on Anti-Money Laundering and Counter-Terrorist Financing provides specific guidance to assist licensed corporations, registered intermediaries, and their senior management in Hong Kong to formulate and implement their own anti-money laundering and counter-terrorist financing policies, procedures, and controls.

The requirements in the Guideline are the same for dealing in local shares or shares listed on markets outside Hong Kong (including A-shares to be traded via SHKSC), and the SFC can take enforcement actions against licensed corporations or registered intermediaries failing to comply with the customer due diligence and record-keeping requirements.

Furthermore, when brokers in China receive orders from clients to trade Hong Kong shares via SHKSC, they will be required to take appropriate measures to handle such clients' transactions in accordance with China’s laws and relevant regulations.

Hong Kong Shenzhen Stock Connect Next?

So it seems. On January 5, 2015, Chinese Premier Li Keqiang backed a stock link between Shenzhen and Hong Kong, to be established along similar lines to the SHKSC.

Situated in the Pearl River Delta region in Guangdong province and close to Hong Kong, Shenzhen is being seen as the next logical place from which to build greater links between stock exchanges on the Mainland and Hong Kong. It would also support the recently approved Guangdong free trade zone.

During an earlier visit to the Chinese city, Li confirmed that a Shenzhen-Hong Kong Stock Connect "should be next," while Hong Kong's Chief Executive CY Leung subsequently said that he will keep liaising with the Chinese authorities about its launch.

In February 2015, Professor K C Chan confirmed to the Hong Kong Legislative Council that the SEHK is in discussion with Shenzhen Stock Exchange regarding the proposed Shenzhen-Hong Kong Stock Connect (now abbreviated to Sz-HK Stock Connect), and that further details, including operational arrangements and an implementation timetable, will be available at a later stage when the discussion progresses further.

Song Liping, General Manager of the Shenzhen Stock Exchange, has since indicated that the proposed stock link could focus on the trading of shares in small and medium-sized enterprises.

Song confirmed that approval for the new stock link can be expected to be granted by the middle of this year, to enable the initiative's launch in the second half of 2015. Preparatory work is currently being undertaken by Hong Kong and Chinese regulatory authorities.

It has been confirmed that the design and development of the necessary technology systems has been completed and approved by the two regulators. They are now focusing on operational and technical considerations, which will enable an announcement on implementation.

Song pointed out that, given the concentration on the Shenzhen Stock Exchange of stocks in SMEs, high-technology companies, and start-up companies, it is expected that the link with the SEHK will be extended – depending on overseas investor demand – to include such stocks, as well as those of larger blue chip companies.


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