The long-delayed Exchange-Traded Fund (ETF) Connect between mainland and Hong Kong could finally launch by the end 2018, after the Chinese and Hong Kong financial regulators introduce a regime in the third quarter that lets the former identify investors participating in the cross-border Connect programmes, say market experts.
Once implemented, ETF Connect could help given mainland institutional investors a new means to diversify into international assets, while simultaneously helping Hong Kong’s fledgling ETF market to flourish, added the experts, speaking at a Hong Kong Investment Funds Association (HKIFA) forum on Wednesday (January 3).
Currently Hong Kong has 179 tradable exchange-traded products (152 ETFs and 27 leveraged & inverse products) , but just four of them (all tracking Hong Kong and China equities) account for 60% of the combined assets under management (AUM).
Market experts had hoped ETF Connect would launch last year for cross-selling of ETFs between China and Hong Kong, following the introductions of Shanghai and Shenzhen Stock Connect in 2014 and late 2016 respectively, and Bond Connect in June 2017. But the idea failed to get off the ground, in large part due to an inability of the China Securities Regulatory Commission (CSRC) to effectively monitor which end investors are holders of mainland instruments.
However, this should be solved by the planned introduction of the investor identification (investor ID) model in the third quarter, in which asset managers in Hong Kong have to provide client identification data to mainland exchanges when placing orders for northbound trading.
The investor ID regime will enable more efficient cross-border market surveillance, Hong Kong Exchanges and Clearing (HKEX) said on November 30. Additionally, the government had said it would only consider ETF Connect after the investor ID scheme was implemented, said Sally Wong, chief executive of the HKIFA.
China's regulators want to harmonise the two markets as much as possible before rolling out any new mutual access schemes, Patrick Wong, head of China sales and business development at HSBC Securities Services, told AsianInvestor.
Extra information required
The introduction of the investor ID scheme has been touted by Beijing as a requirement ahead of ETF Connect.
In June 2017, the mainland and Hong Kong Closer Economic Partnership Arrangement (CEPA) stated that the ID mechanism would be required before ETFs could be included as eligible securities under the mutual market access scheme between China and Hong Kong.
The Securities and Future Commission's (SFC) introduction of the investor ID regime was encouraged by the CSRC, which wants to have better transparency as to who is behind the trade because China is a “see-through” market, Cindy Chen, country head of securities services in Hong Kong for Citi, told AsianInvestor.
“The importance of introducing investor ID is to provide the level of transparency that China is looking for to have proper surveillance of the market. That would give them enough comfort to allow the Connect [schemes] to further expand,” she added.
However, international investors are not heavily concerned about the additional information demands, as such transparency requirements are growing elsewhere too. Under the newly-introduced Markets in Financial Instruments Directive II (Mifid II) in the European Union, asset managers are required to have a legal entity indentifier (LEI) registration, Wong noted.
The introduction of ETF Connect would likely raise the appeal of international products listed in Hong Kong. These currently receive relatively little attention because investors in the city can invest directly into ETFs listed in the overseas markets.
In particular, institutional investors in China would likely be eager users of an ETF Connect scheme. They want to invest more overseas to diversify their heavily onshore-skewed investment portfolios, but it is uncertain when Beijing will authorise more Qualified Domestic Institutional Investor (QDII) quotas to let them do so, said Wong of HSBC.
However, ETF Connect is a separate channel, so these investors will be able to use Hong Kong listed products to diversify offshore. If domestic Chinese investors are allowed to do so it would likely drive up the trading volumes of ETFs tracking international indexes in the territory.
“Investors in the mainland do not have a choice,” said Wong. “Whenever they can invest overseas through QDII…the quotas are immediately used up when it is open. The demand is huge.”
Other market participants also expressed optimism about the potential launch of ETF Connect for end investors in China.
“We believe Chinese investors would benefit from an ETF Connect between Hong Kong and China … investment diversification is an important tool for any investor assessing the best options available to them,” Susan Chan, head of iShares and index investment for Asia Pacific at BlackRock Asset Management, told AsianInvestor in an emailed reply to questions.
HSBC's Wong added that the Hong Kong fund industry wants ETF Connect to launch as soon as possible. “The scale in the Hong Kong ETF market is relatively small [today],” he noted. “If this scale is maintained, the layer of ETF [in the investment universe] is difficult [business-wise] …as the expense ratio is higher.”
Hong Kong’s ETF market could do with the fillip. Currently it is dominated by four big ETFs, namely the Tracker Fund (with an AUM of HK$101 billion, or $12.92 billion, as of January 4), Hang Seng H-share (HK$43 billion AUM), iShares FTSE A50 (HK$32 billion), and the CSOP A50 (HK$24 billion). The four ETFs account for about 60% of value of the ETFs in the territory.
The value of Hong Kong's ETF market was HK$345 billion as of October 2017. That compares to the 86 Shanghai-listed ETFs, worth a combined Rmb176 billion as of January 4, or the 53 ETFs based in Shenzhen, which have a cumulative value of Rmb47 billion as of January 4, according to the latest information shown on the respective exchanges.
ETF Connect has been an idea in the planning for nearly 18 months. Its introduction was first mentioned by the securities regulators in Hong Kong and mainland in August 2016, before the launch of the Shenzhen-Hong Kong Stock Connect in December of that year.
Hong Kong SFC said at that time that a launch date would be revealed after the Stock Connect had been operating for an unspecified period and upon the satisfaction of relevant conditions, without elaborating on what these conditions would be.
Hong Kong Stock Exchange chief executive Charles Li said in a presentation in August 2016 that ETFs would be included in the Connect schemes in 2017. But in June of last year Li admitted in a media interview that ETF Connect was still the subject of talks between the respective regulators of China and Hong Kong, with both sides needing “to find terms they are comfortable [with]”.
There is also some disagreement over whether a unique form of mutual market access scheme and quotas should be established for ETF Connect, or whether it should fall under the auspices of the existing Stock Connect. Wong said she believed that a different quota should be set for ETFs.
The SFC declined to comment on the updates about the potential introduction of ETF Connect.