Stock Connect tipped to squeeze prime brokers

As China opens its capital account, the country's foreign investor quota system is being seen as declining in importance. In a two-part series, AsianInvestor examines how prime brokers are responding.
Stock Connect tipped to squeeze prime brokers

Prime brokers offering hedge fund clients A-share execution via qualified foreign institutional investor (QFII) quota are bracing for lower commissions once the Shanghai-Hong Kong Stock Connect launches, as is expected in October.

The prospect of declining business has prompted some prime brokers to re-evaluate how they use their QFII quota.

Investment banks have earned lucrative commissions by offering clients access to China’s A-share market using their quota. But that revenue stream is tipped to shrink with the advent of the Stock connect trading link, which will allow investors to trade A-shares on the Hong Kong stock exchange and H-shares on the Shanghai Stock Exchange.

They were incentivised to allocate quota to their prime broking divisions because, until recently, QFII was the only avenue through which dollar-based investors could trade A-shares, whose total market capitalisation is Rmb16.1 trillion ($2.6 trillion).

Since the launch of QFII in 2002, prime brokers have been recycling their quota and helping hedge fund managers that do not have quota. They do this by issuing managers with participatory notes (P-notes) and swaps that mirror the performance of the underlying shares.

With the launch of Stock Connect, hedge funds will be able to directly buy A-shares with no need for a quota.

The first challenge prime brokers could face is a drop in QFII broking commission, industry players said.

Brokers are earning 80 to 100 basis points on P-note and swap trades under the QFII scheme, said Andy Maynard, global head of trading and execution in Hong Kong, at equity brokerage CLSA. When Stock Connect goes live, that will drop to between 20 and 60bp, he added.

Stock Connect will for the first time allow managers to shop around for prime brokers with whom to trade A-shares, as they will not be restricted to trading with counterparties able to provide QFII quota. 

One Hong Kong-based prime broking head estimates that, on average, most broker-dealers have been earning an annualised return of 3-7% from QFII-related broking business. He bases that calculation on an average quota of $1 billion-$1.5 billion at current market values.

“With Stock Connect, banks that used to have a large portion of quota allocated to access products would probably be left with a hole in their budget and will earn less from QFII going forward,” said the prime broker.

A daily quota of Rmb13 billion ($2.1 billion) will be in force for northbound trades – that is, for offshore investors to trade the eligible 568 A-shares on the Shanghai Stock Exchange. Southbound trades – mainland investors trading 266 eligible H-shares – will be subject to a quota of Rmb10.5 billion. The quotas, which apply only to buy orders, are applied at the exchanges.

Since the QFII scheme launched in 2002, Beijing has awarded a total of $57.9 billion in quotas to foreign financial institutions as of the end of July.

On Monday, AsianInvestor reveals how global broker-dealers are restructuring their QFII operations amid the loosening of their grip on access to China’s capital markets.

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