shanghai©yuliufu.jpgThe Shanghai-Hong Kong Stock Connect link has made significant in-roads in the opening of China’s capital markets to international trading but barriers to participation, including restricted trading strategies, introduce risk and create operational complexity.

The long-term success of the venture hinges on removing these barriers, according to a study by Celent on behalf of the Depository Trust & Clearing Corporation.

SHSC is the result of a deal last year between China’s Hong Kong and Shanghai stock exchanges that allows non-resident investors to invest in Chinese companies whose shares are listed on the SSE and denominated in renminbi only – so-called China A-shares – without having to apply for to be a Qualified Foreign Institutional Investor or Renminbi Qualified Foreign Institutional Investor.

“What’s driving demand for SHSC is the fact that it opens up a market previously difficult to access. Links providing access to other relatively new or untapped markets are likely to be the most successful ones,” said Matthew Chan, head of strategy at DTCC’s post-trade processing subsidiary Omgeo. “We look forward to today’s challenges being resolved, and to SHSC achieving its potential. Over the next few years, as China becomes a core market for mainstream institutional investors, participants need to ensure their post-trade systems and operations can scale up to meet increased volumes and that best practice is employed to minimise operational risk.”

According to the paper, institutional investors continue to cite issues such as limited support for short selling, using Renminbi as the sole settlement currency and the hybrid (T+0/T+1) settlement cycle as obstacles to increased usage of SHSC. This hesitancy is compounded by remaining uncertainty over asset fungibility, shareholder rights and reporting.

Regulators and the Hong Kong and Shanghai exchanges are working to resolve these issues as well as to address a unique requirement to ‘pre-deliver’ shares for all sell orders. The paper says that improvements in these areas should “enable greater participation; pave the way to more A share representation in global equity benchmark indices (maintained by MSCI and FTSE Russell), which will in turn unleash substantial further investment in A shares longer term; and ultimately open up this significant market to more trading strategies and investors globally”.

Neil Katkov, senior vice president in Celent’s Global Asian Financial Services Group, said: “We estimate these ‘workarounds’ will drive international holdings of A shares to $428 billion by 2017. Because they are committed to opening China’s capital account, regulators can be expected to expand quotas to meet investor demand. The success of the SHSC, despite the challenges, is inspiring a wave of cross-border exchange initiatives involving China, Asia and beyond. Already, a Shenzhen-Hong Kong Stock Connect is slated to start later this year. Observers debate the extent to which this will be followed by links between Shanghai or Shenzhen and Taiwan, Singapore, Tokyo, New York and London. SHSC has also inspired a number of proposals for links between Asian markets outside of China.”

Last month, Shanghai Stock Exchange, China Financial Futures Exchange and Deutsche Börse AG agreed on a strategic cooperation to launch a joint venture. It has the objective to develop and to market financial instruments based on Chinese underlyings to international investors outside mainland China, therefore, products will be offered in RMB.

The whitepaper is available for download.