Asia
24 February 2015
The opening of the Shanghai-Hong Kong Stock Connect programme has securities borrowing and lending brimming with optimism
Image: Shutterstock
There are indications that the margin financing and securities lending markets in China are growing—is this what you’re seeing? What would you attribute this growth to?
Dane Fannin: Since the inception of the onshore pilot scheme for margin trading and securities borrowing and lending in 2012, the centralised programme has subsequently been made easier and available to a wider set of domestic participants. The recent increase in margin financing activity, thought to have been spurred by a lowering of interest rates and tighter controls on the property market (thus making stocks more appealing), has helped increase the retail margin pool of lendable assets, which has helped to boost securities borrowing and lending as a result.
However, we understand that onshore participants continue to lobby regulators to liberalise the programme further, since a bilateral arrangement is considered more conducive rather than the current model, which is centralised.
Paul Solway: While access is growing, we are still seeing foreign investors waiting to see how the market develops. The Shanghai-Hong Kong Stock Connect programme is open and has a dynamic approach to its expansion; global, equal and transparent participation are key aspects to its success.
A potential route into China could be the creation of a rule-driven model similar to other ID markets such as South Korea, whereby offshore participants could replicate and leverage from existing infrastructure and investment. This could creating the fastest route to market.
David Raccat: The emergence of China as the world’s second largest economy and the gradual opening of the country’s capital account have seen capital controls evolve for the securities lending market.
Regulation still prevents long-only fund managers from fully committing and participating in securities lending of their portfolios within the offshore and mainland markets, and the timing of regulatory change is unknown.
The market has generally been pleasantly surprised by the pace of developments, with the speed at which Stock Connect was implemented a good example. However, as we clearly found with the delayed go-live and operational challenges at the time, this uncertainty has meant that different types of participants will enter the market at different stages of development. For example, the split cash/stock settlement process that was implemented for the initial model kept many US pension funds away simply because of the non-delivery versus payment (DVP) settlement rule.
This will be addressed in the second phase with the launch of an enhanced pre-checking model, which may attract new investors. We expect the ensuing increase in activity and the diversified investment strategies coming into the mainland market to drive securities lending opportunities.
Paul Wilson: There has been an eightfold increase in the domestic securities lending market over the last two years, but this has been predominantly for domestic brokers using the China Íø±¬³Ô¹Ï Finance Corporation securities borrowing and lending facilities.
Of more interest for international asset managers and banks is the opening up of the domestic equity market via the Stock Connect mechanism that started in November 2014. The current rules are still evolving, but associations have been working with local regulators and exchanges to help with that process.
Business is conducted through the Shanghai Stock Exchange and Shenzhen Stock Exchange—how permissive are rules around trading?
Wilson: Only the Shanghai Stock Exchange is live for equities trading on Stock Connect, but the Shenzhen Stock Exchange is expected in 2015. As already noted, associations have made recommendations to the interested local entities that include the participation of non-exchange participants and rights around collateral, but it is still in the consultative stage.
Raccat: The trading rules need to be made accessible to everyone—similar to the US and European models, with straightforward regulation, and the removal of ‘unique’ lending structures. This will take time, of course. It is clear the regulators are looking for a progressive, step-by-step opening up of their markets to open international investment (and vice versa). Not forgetting, the Shanghai and Shenzhen stock exchanges were founded in the 1990s, which is not that long ago in context of other markets.
In my view, the market is expecting the rules to relax over time. This includes expanding the limited access to listings and asset types, which is currently limited, and an easing of trading in line with international peers in two to three years. What we do not want to see is overly complex collateral requirements or unique settlement or operational complexities.
We are all trying to balance trade profitability with IT and operational efficiencies. If operational structures are developed and may only be required for three or four months until a next phase of model is introduced, this poses costs and risk burdens on market participants. The Stock Connect settlement and funding model was a good example, with many choosing to wait until the initial model was revised. In this example, the rules around settlement and liquidity concerns dictated trading appetite rather than the trading rules themselves.
With Stock Connect up and running, how will the programme contribute to interest in A shares?
Solway: Market liquidity is enhanced with access to an efficient and workable lending platform, either for short-term settlement purposes or supporting ongoing investment strategies. Usually, buy and hold strategies only work well in a rising market.
Francesco Squillacioti: The launch of Stock Connect and the ability to lend through that platform opens some interesting opportunities. It will allow offshore investors/beneficial owners to trade eligible China A shares directly through Hong Kong brokers, effectively giving greater flexibility and access to that market. The securities lending component of this is a further aspect of that and, likewise, will bring the benefits of securities lending to beneficial owners and to the market itself in terms
of liquidity.
Of course, it is a new programme and, as with other markets in the region, how it works will likely evolve over time. We look to be front and centre in the process, as well as in further development of the market.
Raccat: Stock Connect will enable margin financing, securities lending and other features to develop. The major issue as explained to the Hong Stock Exchange by multiple associations is that the scheme currently only works with Hong Kong broker-dealer entities (as exchange participants and principal lenders).
The participation of international agent lenders is key to enhancing the process and providing liquidity to the market.
Fannin: End user demand to gain exposure to China continues to remain robust, and so unsurprisingly, Stock Connect has attracted a great deal of attention within securities borrowing and lending. In its current form, however, the programme is not conducive for offshore participants to transact securities borrowing and lending arrangements, although various industry bodies have sought to suggest practical changes to address this.
Ultimately, there will be two catalysts that will drive the monetisation of the scheme for securities borrowing and lending participants. The first relates to mechanism, to the extent that the securities borrowing and lending framework should align with those models considered robust and feasible for securities borrowing and lending elsewhere, such as Hong Kong.
The second relates to supply, which realistically speaking, will only be bolstered as and when the prominent indices include A shares purchased through the scheme as part of a tracking index. This in itself will require liberalisation of the programme, particularly around quotas.
Despite these short-term considerations, this initiative will clearly be a significant opportunity for the securities borrowing and lending market in the long term.
Outside of China, where in Asia are you seeing interest in securities lending business, and what are the prevailing strategies?
Raccat: We still see Hong Kong as the focus market, because of its accessibility and straightforward lending market regulations. Japan and Australia are second and third In terms of seamless securities lending frameworks that create supply and liquidity in the market.
Fannin: Íø±¬³Ô¹Ï lending demand continues to gravitate towards the deep and liquid markets in Asia, particularly Hong Kong and Japan, and away from Taiwan given the geopolitical and regulatory issues that persist in that market. Long-term directional strategies dominate activity in Hong Kong, particularly for those sectors perceived to be facing headwinds in mainland China, particularly commodity, property and retail.
Furthermore, appetite for A/H share arbitrage strategies has been robust, particularly ahead of the Stock Connect launch given a view that spreads would return to parity as a function of increased volumes. In Japan, aggressive monetary easing hasn’t necessarily benefitted securities lending volumes, although there has been noticeable interest for fundamental-based stock picking strategies, particularly within the online gaming sector amid heightened competition, as well as consumer electronics despite a weaker yen.
On the peripheral, the industry is anticipating the imminent launch of Indonesia, which should be a valuable addition to the region’s emerging market suite particularly as participants continue facing headwinds in markets such as Taiwan, where a short sale quota is perceived to be constraining demand.
Wilson: We are seeing new lenders come to market with attractive in-demand portfolios and flexibility on collateral. There is particularly strong interest and participation by index funds to add alpha, as a relatively risk-free overlay to their passive investment strategies.
From a markets perspective, consistent with other regions demand remains constrained across the region, with Hong Kong continuing to have the most vibrant market. There is a more supply coming to the market in Taiwan, where spreads continue to be high. We continue to monitor the evolution of markets with interest in India, Indonesia, the Philippines and Vietnam.
Solway: A theme that has carried forward from 2014 is the mature markets of Japan and Hong Kong. Large-cap liquidity themes are prevailing over the opportunistic smaller markets of South Korea, Taiwan and Malaysia.
Related to this theme could be the rule-driven models of the securities borrowing and lending platforms of each of these emerging markets: short-sell rules/quotas change the daily dynamics of trading, especially for investors who are outside of the time zone. Leaving orders that have additional execution constraints cause investors to look to other markets for alternative opportunities, where possible.
Synthetic structures also offer more timely solutions that have contributed to lower securities borrowing and lending volumes as a result. The dominant long/short strategies across Asia require timely executions, in order to position portfolios quickly and effectively, especially as quantitative/algorithmic trading continues to evolve across the region.
In the Asia Pacific, compared to a few years back, the fixed income market has certainly taken off in terms of securities lending. Many sell-side firms have brought together their equity and fixed income functions, for many reasons, but the emergence of collateral transformation following the US Dodd-Frank Act and the birth of the central clearinghouses have been a clear trend as well as a requirement. As the demand for high-quality assets continues for over-the-counter securities through central counterparties, fixed income upgrade trades are growing within the securities lending arena.
This is certainly an area to watch in the Asia Pacific as we continue to see demand from clients in Asia seeking to upgrade into higher quality assets in lieu of lower grade assets on hand. This trend has carried forward from 2014 as we saw increased demand for fixed income securities, given our 24/5 global trading and support capabilities in this area.
What are the general trends around collateral and how does this differ to Europe and the US?
Squillacioti: As I see it, collateral is really more of a global consideration than a regional one. While the concept of greater collateral flexibility is certainly one that is becoming increasingly prevalent, so too are the demands for greater transparency and granularity of detail. Again, these are really global trends, and there is probably no discernable difference regionally.
Wilson: In general terms, Asia-based lenders have always had a fairly balanced approached to collateral eligibility. While the US is dominated by cash collateral and Europe, the Middle East and Africa has a bias towards non-cash collateral as a region, Asia-based lenders tend to be a hybrid between the two, perhaps with a slight skew towards cash. For non-cash collateral, there is a good mix of bonds and equities.
Asia-based lenders are very thoughtful and are very open to discussions around collateral expansion and really take time to understand the risk/reward dynamics. We have seen a gradual increase in them taking additional equity indices and some re-assessment of cash investment guidelines given the quality of issuers and rates available in the more term space.
Fannin: The manner in which the business is thinking about collateral is largely consistent across all regions given that balance sheets are managed from a global perspective rather than regionally. Undoubtedly, regulation remains the prominent driver for collateral trends as borrowers gear their businesses ahead of Basel III requirements, manifesting in two key areas of focus.
Borrowers continue to seek longer termed wrappers for financing transactions that allow for alignment with the liquidity coverage and net stable funding ratios. The boundaries of acceptable collateral types also continue to be stretched as borrowers seek to maximise returns on assets by pledging the cheapest forms of collateral on their balance sheets. Lenders will be challenged in balancing demand for such requirements against their respective risk profiles and capital capacity.
Raccat: Collateral flexibility and optimisation are key as market conditions and internal/external requirements can force you to adapt and change your collateral profile very quickly. The issue is not with the five or six major indices in Asia but with the second tier, which are usually not recognised to be eligible.
The reuse of collateral is another hot topic from a regulatory perspective. Some new constraints may limit reuse, which is seen as a systemic risk by regulators, which in turn may limit access to liquidity in the market.
What would you like to see happen in terms of infrastructure and regulatory developments this year?
Fannin: Ideally, the industry in Asia would primarily like to see the Stock Connect securities borrowing and lending framework liberalised in a way that allows for the feasible launch of an offshore product. The robust potential opportunity with this will continue to draw significant attention from the market so long as China remains closed to offshore providers.
Outside of this, there is anticipation for a potential relaxation (ideally complete removal) of the short sale quota rule in Taiwan, which many believe will be the catalyst for increased demand and greater securities borrowing and lending volumes.
Raccat: I would like to see a convergence of regulations for the onshore and offshore renminbi capital markets to enable foreign investors to participate in securities lending within China. Allowing transactions to take place with local institutions without an intermediary or complex local transfer process involving several entities would increase the success of securities lending and margin financing.
Solway: Collateral flexibility, commercial margins, dynamic quotas and short selling rules all have a direct correlation to securities lending volumes. Having securities borrowing and lending models take into account the ever-changing regulations will ultimately allow investors to successfully navigate the market landscape in terms of opportunity and due diligence. No two markets have exactly the same rules, which ultimately drives up costs and reduces participation in some cases.
Harmonising these differing rules over time will certainly help improve connectivity—this could eventually lead to a multi-country model within a region that is both efficient and transparent. If that happens, it will mean exciting investment opportunities for all types of investors, large or small in the long run.
Dane Fannin: Since the inception of the onshore pilot scheme for margin trading and securities borrowing and lending in 2012, the centralised programme has subsequently been made easier and available to a wider set of domestic participants. The recent increase in margin financing activity, thought to have been spurred by a lowering of interest rates and tighter controls on the property market (thus making stocks more appealing), has helped increase the retail margin pool of lendable assets, which has helped to boost securities borrowing and lending as a result.
However, we understand that onshore participants continue to lobby regulators to liberalise the programme further, since a bilateral arrangement is considered more conducive rather than the current model, which is centralised.
Paul Solway: While access is growing, we are still seeing foreign investors waiting to see how the market develops. The Shanghai-Hong Kong Stock Connect programme is open and has a dynamic approach to its expansion; global, equal and transparent participation are key aspects to its success.
A potential route into China could be the creation of a rule-driven model similar to other ID markets such as South Korea, whereby offshore participants could replicate and leverage from existing infrastructure and investment. This could creating the fastest route to market.
David Raccat: The emergence of China as the world’s second largest economy and the gradual opening of the country’s capital account have seen capital controls evolve for the securities lending market.
Regulation still prevents long-only fund managers from fully committing and participating in securities lending of their portfolios within the offshore and mainland markets, and the timing of regulatory change is unknown.
The market has generally been pleasantly surprised by the pace of developments, with the speed at which Stock Connect was implemented a good example. However, as we clearly found with the delayed go-live and operational challenges at the time, this uncertainty has meant that different types of participants will enter the market at different stages of development. For example, the split cash/stock settlement process that was implemented for the initial model kept many US pension funds away simply because of the non-delivery versus payment (DVP) settlement rule.
This will be addressed in the second phase with the launch of an enhanced pre-checking model, which may attract new investors. We expect the ensuing increase in activity and the diversified investment strategies coming into the mainland market to drive securities lending opportunities.
Paul Wilson: There has been an eightfold increase in the domestic securities lending market over the last two years, but this has been predominantly for domestic brokers using the China Íø±¬³Ô¹Ï Finance Corporation securities borrowing and lending facilities.
Of more interest for international asset managers and banks is the opening up of the domestic equity market via the Stock Connect mechanism that started in November 2014. The current rules are still evolving, but associations have been working with local regulators and exchanges to help with that process.
Business is conducted through the Shanghai Stock Exchange and Shenzhen Stock Exchange—how permissive are rules around trading?
Wilson: Only the Shanghai Stock Exchange is live for equities trading on Stock Connect, but the Shenzhen Stock Exchange is expected in 2015. As already noted, associations have made recommendations to the interested local entities that include the participation of non-exchange participants and rights around collateral, but it is still in the consultative stage.
Raccat: The trading rules need to be made accessible to everyone—similar to the US and European models, with straightforward regulation, and the removal of ‘unique’ lending structures. This will take time, of course. It is clear the regulators are looking for a progressive, step-by-step opening up of their markets to open international investment (and vice versa). Not forgetting, the Shanghai and Shenzhen stock exchanges were founded in the 1990s, which is not that long ago in context of other markets.
In my view, the market is expecting the rules to relax over time. This includes expanding the limited access to listings and asset types, which is currently limited, and an easing of trading in line with international peers in two to three years. What we do not want to see is overly complex collateral requirements or unique settlement or operational complexities.
We are all trying to balance trade profitability with IT and operational efficiencies. If operational structures are developed and may only be required for three or four months until a next phase of model is introduced, this poses costs and risk burdens on market participants. The Stock Connect settlement and funding model was a good example, with many choosing to wait until the initial model was revised. In this example, the rules around settlement and liquidity concerns dictated trading appetite rather than the trading rules themselves.
With Stock Connect up and running, how will the programme contribute to interest in A shares?
Solway: Market liquidity is enhanced with access to an efficient and workable lending platform, either for short-term settlement purposes or supporting ongoing investment strategies. Usually, buy and hold strategies only work well in a rising market.
Francesco Squillacioti: The launch of Stock Connect and the ability to lend through that platform opens some interesting opportunities. It will allow offshore investors/beneficial owners to trade eligible China A shares directly through Hong Kong brokers, effectively giving greater flexibility and access to that market. The securities lending component of this is a further aspect of that and, likewise, will bring the benefits of securities lending to beneficial owners and to the market itself in terms
of liquidity.
Of course, it is a new programme and, as with other markets in the region, how it works will likely evolve over time. We look to be front and centre in the process, as well as in further development of the market.
Raccat: Stock Connect will enable margin financing, securities lending and other features to develop. The major issue as explained to the Hong Stock Exchange by multiple associations is that the scheme currently only works with Hong Kong broker-dealer entities (as exchange participants and principal lenders).
The participation of international agent lenders is key to enhancing the process and providing liquidity to the market.
Fannin: End user demand to gain exposure to China continues to remain robust, and so unsurprisingly, Stock Connect has attracted a great deal of attention within securities borrowing and lending. In its current form, however, the programme is not conducive for offshore participants to transact securities borrowing and lending arrangements, although various industry bodies have sought to suggest practical changes to address this.
Ultimately, there will be two catalysts that will drive the monetisation of the scheme for securities borrowing and lending participants. The first relates to mechanism, to the extent that the securities borrowing and lending framework should align with those models considered robust and feasible for securities borrowing and lending elsewhere, such as Hong Kong.
The second relates to supply, which realistically speaking, will only be bolstered as and when the prominent indices include A shares purchased through the scheme as part of a tracking index. This in itself will require liberalisation of the programme, particularly around quotas.
Despite these short-term considerations, this initiative will clearly be a significant opportunity for the securities borrowing and lending market in the long term.
Outside of China, where in Asia are you seeing interest in securities lending business, and what are the prevailing strategies?
Raccat: We still see Hong Kong as the focus market, because of its accessibility and straightforward lending market regulations. Japan and Australia are second and third In terms of seamless securities lending frameworks that create supply and liquidity in the market.
Fannin: Íø±¬³Ô¹Ï lending demand continues to gravitate towards the deep and liquid markets in Asia, particularly Hong Kong and Japan, and away from Taiwan given the geopolitical and regulatory issues that persist in that market. Long-term directional strategies dominate activity in Hong Kong, particularly for those sectors perceived to be facing headwinds in mainland China, particularly commodity, property and retail.
Furthermore, appetite for A/H share arbitrage strategies has been robust, particularly ahead of the Stock Connect launch given a view that spreads would return to parity as a function of increased volumes. In Japan, aggressive monetary easing hasn’t necessarily benefitted securities lending volumes, although there has been noticeable interest for fundamental-based stock picking strategies, particularly within the online gaming sector amid heightened competition, as well as consumer electronics despite a weaker yen.
On the peripheral, the industry is anticipating the imminent launch of Indonesia, which should be a valuable addition to the region’s emerging market suite particularly as participants continue facing headwinds in markets such as Taiwan, where a short sale quota is perceived to be constraining demand.
Wilson: We are seeing new lenders come to market with attractive in-demand portfolios and flexibility on collateral. There is particularly strong interest and participation by index funds to add alpha, as a relatively risk-free overlay to their passive investment strategies.
From a markets perspective, consistent with other regions demand remains constrained across the region, with Hong Kong continuing to have the most vibrant market. There is a more supply coming to the market in Taiwan, where spreads continue to be high. We continue to monitor the evolution of markets with interest in India, Indonesia, the Philippines and Vietnam.
Solway: A theme that has carried forward from 2014 is the mature markets of Japan and Hong Kong. Large-cap liquidity themes are prevailing over the opportunistic smaller markets of South Korea, Taiwan and Malaysia.
Related to this theme could be the rule-driven models of the securities borrowing and lending platforms of each of these emerging markets: short-sell rules/quotas change the daily dynamics of trading, especially for investors who are outside of the time zone. Leaving orders that have additional execution constraints cause investors to look to other markets for alternative opportunities, where possible.
Synthetic structures also offer more timely solutions that have contributed to lower securities borrowing and lending volumes as a result. The dominant long/short strategies across Asia require timely executions, in order to position portfolios quickly and effectively, especially as quantitative/algorithmic trading continues to evolve across the region.
In the Asia Pacific, compared to a few years back, the fixed income market has certainly taken off in terms of securities lending. Many sell-side firms have brought together their equity and fixed income functions, for many reasons, but the emergence of collateral transformation following the US Dodd-Frank Act and the birth of the central clearinghouses have been a clear trend as well as a requirement. As the demand for high-quality assets continues for over-the-counter securities through central counterparties, fixed income upgrade trades are growing within the securities lending arena.
This is certainly an area to watch in the Asia Pacific as we continue to see demand from clients in Asia seeking to upgrade into higher quality assets in lieu of lower grade assets on hand. This trend has carried forward from 2014 as we saw increased demand for fixed income securities, given our 24/5 global trading and support capabilities in this area.
What are the general trends around collateral and how does this differ to Europe and the US?
Squillacioti: As I see it, collateral is really more of a global consideration than a regional one. While the concept of greater collateral flexibility is certainly one that is becoming increasingly prevalent, so too are the demands for greater transparency and granularity of detail. Again, these are really global trends, and there is probably no discernable difference regionally.
Wilson: In general terms, Asia-based lenders have always had a fairly balanced approached to collateral eligibility. While the US is dominated by cash collateral and Europe, the Middle East and Africa has a bias towards non-cash collateral as a region, Asia-based lenders tend to be a hybrid between the two, perhaps with a slight skew towards cash. For non-cash collateral, there is a good mix of bonds and equities.
Asia-based lenders are very thoughtful and are very open to discussions around collateral expansion and really take time to understand the risk/reward dynamics. We have seen a gradual increase in them taking additional equity indices and some re-assessment of cash investment guidelines given the quality of issuers and rates available in the more term space.
Fannin: The manner in which the business is thinking about collateral is largely consistent across all regions given that balance sheets are managed from a global perspective rather than regionally. Undoubtedly, regulation remains the prominent driver for collateral trends as borrowers gear their businesses ahead of Basel III requirements, manifesting in two key areas of focus.
Borrowers continue to seek longer termed wrappers for financing transactions that allow for alignment with the liquidity coverage and net stable funding ratios. The boundaries of acceptable collateral types also continue to be stretched as borrowers seek to maximise returns on assets by pledging the cheapest forms of collateral on their balance sheets. Lenders will be challenged in balancing demand for such requirements against their respective risk profiles and capital capacity.
Raccat: Collateral flexibility and optimisation are key as market conditions and internal/external requirements can force you to adapt and change your collateral profile very quickly. The issue is not with the five or six major indices in Asia but with the second tier, which are usually not recognised to be eligible.
The reuse of collateral is another hot topic from a regulatory perspective. Some new constraints may limit reuse, which is seen as a systemic risk by regulators, which in turn may limit access to liquidity in the market.
What would you like to see happen in terms of infrastructure and regulatory developments this year?
Fannin: Ideally, the industry in Asia would primarily like to see the Stock Connect securities borrowing and lending framework liberalised in a way that allows for the feasible launch of an offshore product. The robust potential opportunity with this will continue to draw significant attention from the market so long as China remains closed to offshore providers.
Outside of this, there is anticipation for a potential relaxation (ideally complete removal) of the short sale quota rule in Taiwan, which many believe will be the catalyst for increased demand and greater securities borrowing and lending volumes.
Raccat: I would like to see a convergence of regulations for the onshore and offshore renminbi capital markets to enable foreign investors to participate in securities lending within China. Allowing transactions to take place with local institutions without an intermediary or complex local transfer process involving several entities would increase the success of securities lending and margin financing.
Solway: Collateral flexibility, commercial margins, dynamic quotas and short selling rules all have a direct correlation to securities lending volumes. Having securities borrowing and lending models take into account the ever-changing regulations will ultimately allow investors to successfully navigate the market landscape in terms of opportunity and due diligence. No two markets have exactly the same rules, which ultimately drives up costs and reduces participation in some cases.
Harmonising these differing rules over time will certainly help improve connectivity—this could eventually lead to a multi-country model within a region that is both efficient and transparent. If that happens, it will mean exciting investment opportunities for all types of investors, large or small in the long run.
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