One runs a risk combining the words 'custody' and 'nail-biter' in the same headline, but nonetheless global custodian banks are on tenterhooks as they await final details from several Chinese regulators about their role in the new scheme to open A shares to foreign portfolio investors.
Custody executives in Hong Kong say if the rules pile on too many risks, they will not participate. "These rules will determine our interest," says James Wong, senior vice president for Hong Kong custody and clearing at HSBC.
Scaring off global custodians would cripple China's plans to modernize its domestic capital markets. Foreign investors have already greeted news of the opening with a shrug.
The new law allowing Qualified Foreign Institutional Investment (QFII) licenses to global fund managers goes live on Sunday, December 1. But even now the regulators have yet to dot their i's and cross their t's. The People's Bank of China (PBoC), the State Administration for Foreign Exchange (SAFE), the China Securities Regulatory Commission (CSRC) and the China Securities Depository and Clearing Company (CSDCC) all have to finalize their rules.
Custodian banks are critical to the QFII process. Foreign fund managers must apply for their QFII license through foreign custodians, for starters, notes Richard Ernesti, Asia-Pacific head for global securities services at Citibank. The application to CSRC must stipulate the investor's choice of domestic broker to execute trades and outlines the manager's qualifications. Then the custodian must seek SAFE's approval for the actual amount that manager can bring in, with a maximum of $250 million per license.
Wong says an open question for the application process is whether regulators will allow separate accounts, and how ownership of those accounts will be recognized. Banks must have $10 billion in assets under custody to participate in QFII, but they want to ensure the clients' assets are segregated from the bank's. They also want the CSDCC to recognize that a QFII license holder will have multiple accounts as well, for different portfolios.
"Only the clearing house proves ownership," Wong explains. "It doubles as the registrar. We need the CSDCC to detail how to open an account at that level. If they only let each QFII license have one account, it will be hard to segregate portfolios. Even if they allow multiple accounts at the custody level, there is still an ownership issue. What happens if the investment manager is liquidated, or if there is a regulatory breach and the assets are frozen? In China these assets aren't recognized as belonging to the fund manager's clients, but as belonging to the QFII license holder."
Global custodians already have some experience dealing with this issue, which is similar in Taiwan, but the level of liability and the costs of operating in this environment will depend on the final regulations.
Ernesti says custodians need to know their exact role once investments begin. "In the West, the fund manager informs the broker and the custodian of the trade, and the custodian does a pre-match. But not in China, where the custodian only finds out after the fact. China has a T+0 settlement cycle so every trade must be pre-funded, probably at the depository level; that's how the A-share market works. But if the custodian isn't doing pre-matching, then what exactly are we doing? We still don't know what our job will be."
Wong adds that China's T+0 system means no trades can fail, so all parties must come up with a commercial arrangement about who must do what in the case of problems, and how to sort out mistakes once a faulty trade is executed.
The need to use a local broker is also worrying to both custodians and fund managers. Brokers will play a role in problems such as liquidations of portfolios, defaults and buy-ins. But the exact responsibilities for brokers, fund managers and custodians has yet to be spelt out. For example, Ernesti says it is unclear how often custodians must submit reports to managers or regulators, or what information is required, or even to whom reports must go.
"The custodian becomes a counterparty to the depository," says Wong. "We need to know what are our obligations, and whether we can swallow the exposure."
Citibank, HSBC, Standard Chartered Bank and Deutsche Bank are the four global custodians handling B shares, and are the ones considering doing A shares as well. Currently only HSBC operates onshore, so the others would probably have to set up operations on the mainland to handle QFII business.
The business of warehousing assets was never so harrowing.