Expectations are high about the potential for the Shanghai-Hong Kong Stock Connect scheme, but there are issues to be tackled – such as insider dealing, or ‘rat trading’ as it’s known in China.

Some in the market are worried that the scheme, due to go live in October, could make it easier for mainland investors to front-run in Hong Kong’s stock market.

It is not yet fully clear how market abuse will be dealt with, and may well not be until the Stock Connect launches and a case emerges. But there is some optimism that Hong Kong will bring its influence to bear to encourage best practice.

The practice – typically involving a portfolio manager buying a stock ahead of a trade by his/her own fund – is endemic in China. Wu Dong, a Shanghai-based lawyer at Hui Ye Law Firm, recalled that one group of money managers did not realise the practice was illegal until his colleague gave a presentation in 2012 on the subject at their firm.

Certainly, the Chinese government has got tougher on such abuses since February 2009, when the National People’s Congress for the first time prescribed jail terms of up to 10 years for market misconduct.

It recently caught its largest rat so far, when Ma Le, a former employee of Shenzhen-based Bosera Asset Management, was found to have made Rmb18.83 million ($3.02 million) from front-running between March 2011 and May 2013. He was sentenced to three years in prison in March, fined Rmb18.84 million and made to return his gains.

Under Stock Connect, the China Securities and Regulatory Commission (CSRC) and Hong Kong’s Securities and Futures Commission (SFC) plan to strengthen cooperation on areas such as information exchange on market misconduct.

Operationally, mainland investors will be subject to CSRC rules when trading Hong Kong, and vice versa, said Tim Pagett, China financial services industry leader at Deloitte in Shanghai. But it is unclear what happens enforcement-wise when one of the exchanges flags a suspected market misconduct, said sources.

Yet the Hong Kong SFC and the CSRC are already parties to the International Organisation of Securities Commissions multilateral memorandum of understanding that allows for the sharing of information in cases relating to market abuse. China and Hong Kong have also had a cross-border enforcement agreement since 2007, whereby the SFC can request help from the CSRC on obtaining information.

However, according to Chinese legal practice, crimes such as rat trading committed outside its borders are usually not punishable by domestic law enforcement agencies, whereas they are in Hong Kong.

Another issue is China’s lack of transparency, says Pagett. “The principles of transparency, openness and consistency and determination of consequences exist in a lot of other markets, [but in China] you just don’t know.”

On the flip side, international investors can directly access the mainland stock market via a recognised international jurisdiction. Pagett said: “I can now rely on the SFC and Hong Kong’s exchange and their ability to influence and partner the Shanghai exchange and CSRC.”

Many in the market will be hoping such influence has a beneficial effect.

Note: The full version of this article first appeared in the July issue of AsianInvestor magazine.