Bond Connect and the First 90 Days

The early signs in the latest “Connect” undertaking appear promising with RMB 7 billion of mainland bonds traded on the first day alone¹, and around 140 investors registered to use the access channel. These are unprecedented transactional volumes in comparison to previous market openings in China, and while trading activity has fallen slightly since, it remains stable.

It is anticipated that the number of Bond Connect registered investors will rise to between 400 and 500 by year-end. If these numbers are reached, the Bond Connect programme will have surpassed the number of registered investors under each of the established Qualified Foreign Institutional Investor (QFII), RMB Qualified Foreign Institutional Investor (RQFII) and the CIBM Direct schemes within 6 months. But what have been the core drivers for this interest, and what improvements and remedies need to be made? We assess how Bond Connect has fared over its first 90 days and look ahead to the future of China’s latest market access scheme, as it continues on its voyage of RMB internationalisation.

Bond Connect: Investors jump at the Opportunity

China’s $9 trillion bond market has long been underweight by foreign institutional investors² but this is likely to change amid Bond Connect interest from a broad spectrum of asset allocators including fund management houses, insurance companies and pension plans globally who are looking to take advantage of this latest quota-free access channel.

Standard Chartered Bank, for example, has helped support a number of clients with Bond Connect trading including China Merchants Securities, GF Global Capital, Manulife Asset Management and Taikang Asset Management in Hong Kong.³ Following day one, Standard Chartered has held market briefings in every leading global RMB investment centre during the first two weeks of trading, revealing unprecedented interest in this new mechanism. This is down to several factors.

First, the launch was well-handled by the People’s Bank of China (PBOC) and Hong Kong Monetary Authority (HKMA) who proactively engaged with the industry in the eight-week lead up to the go-live date. This proactivity and transparency created predictability, which allowed financial institutions such as Standard Chartered, to fully support Bond Connect’s implementation seamlessly.

The regulators have aimed to use Hong Kong as an “adaptor” to CIBM under Bond Connect – striving to find areas which can be adjusted to assist with integrating international investors into a historically domestic market. The option to settle on a T+2 cycle was introduced in time for launch and was used by 80% of the market on day one. This demonstrates the lessons learnt from Stock Connect where the mandatory T+0/T+1 settlement cycle caused significant challenges for international investors.

Second, registration for Bond Connect is also straightforward, with authorisation usually granted within two weeks. Whilst the time it takes to apply to trade directly onshore through the CIBM has improved, Bond Connect offers an offshore, fairly frictionless solution which is appealing to international investors.

“Many institutions simply prefer to access China’s bond market through Hong Kong, where they have established custodian and banking relationships and understand the Common Law legal system. I anticipate flows through Bond Connect will jump significantly as passive funds increase their exposures off the back of China’s probable inclusion into major bond indices such as Bloomberg Barclays, Citi, and J.P. Morgan. These passive providers will want quick entry into the market through Bond Connect as opposed to CIBM, at least initially,” said Julia McKenny, Head, Market Advocacy, Securities Services at Standard Chartered.

Lastly, end investor demand for returns has played a major role in driving fund managers into the Chinese onshore bond market. Yields in onshore corporate debt are more attractive than US Treasury Bills or European sovereign debt instruments, which pay out limited or even negative interest.

The development continues….

Bond Connect is still in its initial pilot phase, and industry experts are working closely with clients and regulators to ensure that the platform evolves quickly to meet with a range of international regulatory standards.

“Standard Chartered has played a unique role in working with the industry and key regulators to ensure that the Bond Connect is quickly recognised as an investment mechanism for European-domiciled funds, under the terms of UCITS V and the Alternative Investment Fund Managers Directive (AIFMD) and we continue to lead the industry and regulatory discussions to facilitate resolution,” said McKenny.

Following the publication of the “Bond Connect and UCITS V” position paper, Standard Chartered has facilitated briefings in London, Luxembourg and Dublin to ensure that the mechanism and its development were fully understood by key regulators and industry leaders. These discussions have highlighted a small number of high priority development requirements, which are now being worked on.

In particular, a short-term concern raised is settlement risk, and the absence of true delivery-versus-payment (DVP) for one of the two bond depositories in China, although industry experts are confident this shortfall will be resolved during 2017. A system enabling true DVP for depositories is a core requirement for key regulatory approvals, as it will minimise counterparty risk for managers of UCITS and AIFs, and their depositary service providers, who take on liability for assets held in custody.

Also ongoing is confirmation of how beneficial ownership rights will be enforced and whether the HKMA’s Central Money-Markets Unit (CMU) will be recognised as a Central Securities Depository (CSD) under UCITS’ definitions. As with Stock Connect, these issues depend largely on legal validation of existing processes and clarification by the HKMA on this matter is expected imminently.

Taxation has also been an area rife with equivocality. Investors using QFII and RQFII have long questioned whether they need to accrue for withholding taxation or if they are required to unwind previous accruals. While Stock Connect provides an exemption on the issue, there is still limited understanding about how withholding tax is treated.

“As with all new mechanisms, other smaller operational challenges remain, such as the ability to block trade using the electronic RFQ platform, for example. But the strong performance of trading on Day 1 of the Bond Connect is strong evidence that even today’s pilot model is robust and usable for international investors,” commented James O’ Sullivan, Head of Securities Services Hong Kong & Head of C&C Product, Greater China and North Asia at Standard Chartered.

Conclusion: A good start and much more to come

Initial interest in Bond Connect has been strong and we have seen a number of financial institutions (most notably hedge funds and banks) begin to build up significant volumes on this new channel already. With more key developments still to come in 2017, we expect interest to convert into significant volume growth very quickly as the leading international fund domiciles begin to endorse the Bond Connect. Leveraging the invaluable experience of the Stock Connect, this project has begun with an unprecedented level of regulatory clarity and engagement. With leading players in both Europe and China entirely clear on what needs to be done, we should expect UCITS regulators to be able to move quickly towards approval of the Bond Connect for funds under their supervision.

Three months into trading now, we have indeed witnessed the successful launch of a unique access mechanism for China; the global investment community has warmly embraced this development, and Standard Chartered remains front and centre in continuing to contribute to its success.