HK-Shanghai Stock Connect: a slow burner

Brokers see a slow ramp up in Hong Kong-Shanghai Stock Connect volumes and more products and markets eventually added. For now equity managers are trying to keep a lid on costs.

Brokers say they are not expecting an explosion in volumes when the Shanghai-Hong Kong Stock Connect mutual market access programme launches in October but they want to make sure they have the infrastructure in place as China gradually opens up.

Senior equity traders see this latest pilot programme as an incremental move in cranking open mainland China’s capital markets and internationalising the renminbi. More products and markets will continue to be added to the pilot scheme also known as the Through Train.

“We don’t think there will be a big bang; large funds won’t come in and trade in big volumes right from the start. It will be a slow ramp up,” said Ali Naqvi, head of equities across the Asia-Pacific region at Credit Suisse in an interview with FinanceAsia.

Larger, risk-averse institutional funds will want to see proof that trading systems work smoothly before dealing in size, while many tracker funds will sit on the sidelines until MSCI includes A-shares in its benchmark indices. MSCI said in June that China A-shares will not be included in the MSCI EM index given the restraints of the current QFII and RQFII programmes but the decision will be reviewed in 2015.

Some funds will also be put off because Shanghai’s stock market has been among the worst performing markets globally in recent years and the benchmark SSE Composite Index is still well below its 2007 peak.

The HSCEI and CSI300 have generated returns of 15% and 10% a year since 2003, trailing nominal GDP growth of 18% and underperforming global peers in terms of converting economic growth into equity returns, according to Goldman Sachs research.

While cash equities is a very competitive, low-margin business, market participants say China will in time also loosen restrictions on other key financial areas such as commodities, prime brokerage and possibly derivatives.

For brokers, this means more ways to make money.

Chow Chung-kong, chairman of the Hong Kong bourse, has said he does not rule out the inclusion of Shenzhen’s stock exchange if all goes well with Stock Connect, making another 15% of the total market cap of A-shares readily available to foreign funds.

“Over time we’ll think whether or not Hong Kong-Shanghai Stock Connect gives us any imagination to potentially extend that into commodities and fixed income,” Hong Kong Exchanges and Clearing chief executive Charles Li said in May.

HKEx took over the London Metal Exchange in 2012 and will launch LME Clear this month. Some analysts and investors say HKEx was targeting cooperation with onshore
commodity exchanges to benefit from China’s status as the biggest global commodity buyer. 

Goldman Sachs researchers said in a note that Stock Connect may even extend to other exchanges including bourses in Taiwan and Singapore given cultural proximity and the rising renminbi circulation in both cities, although negotiations could be challenging given potential political considerations.

“We’re only talking about cash agency access right now but that’s the first step. When China’s markets become fully accessible with the whole plethora of products, then it will become very interesting,” Rakesh Patel, HSBC’s co-head of equities for the Asia-Pacific region, told FinanceAsia.


Source: FactSet, MSCI, CEIC, Goldman Sachs
Earnings growth in China has been tracking GDP growth quite well but not for stock returns

Door opening
Premier Li Keqiang announced Stock Connect in April, following other recent reforms such as the widening of the QFII quota for trading in China A shares and a broader trading band for the renminbi.

China’s new leaders said last year that allowing private investors to play a bigger role in determining market prices was a key plank in its reform agenda.

“Its relevance is beyond the initial size,” Ian Cohen, chief operating officer in equities for HSBC, told FinanceAsia. Cohen is also chairman of the equities committee of the Asia Securities Industry & Financial Markets Association, which lobbies on behalf of the region’s brokers.

Stock Connect in isolation is small. China will limit the value of trading northbound into Shanghai to Rmb300 billion ($49.1 billion) — about half the value of QFII and RQFII (another trading access scheme) combined — and Rmb250 billion ($40.7 billion) to Hong Kong.

Eye on costs
Brokers need to be careful not to ramp up costs too quickly in case revenues take time to materialise.

Brokers are hiring sales traders and research analysts as well as developing IT systems to cope with the idiosyncrasies of both markets.

“Implementing this link successfully involves additional technology infrastructure, as well as new tools and processes right across the front, middle and back office", said David Jenkins, head of product marketing at trading systems firm Fidessa in Asia Pacific. 

Brokers have to design the algorithms to cater for the wider spreads, transient liquidity and volatility associated with trading the Shanghai market.

Source: Bloomberg & Goldman
Brokers may look to up coverage of China A shares

A war for talent is already brewing as brokers hunt for China market experts with language skills, from traders through to back office workers. Global brokers will face pressure to localize in China and the strongest mainland brokers will continue to internationalise. 

For global brokers a greater local focus will make it harder to have scale efficiencies across borders, so the classic ‘hub and spoke’ model will become difficult to deploy. This will also make it harder for financial firms to manage through market cycles, Goldman Sachs analysts said in a note. 

“It’s just like starting a new market. Previously investors could not execute in the domestic [China] market with all its peculiarities,” Credit Suisse’s Naqvi said, whose business is scaling up in line with the revenue opportunity.

In an August report on the impact of Stock Connect, brokerage analysts at Morgan Stanley sounded a note of caution: “We expect Mutual Market Access to add less than 5% to A-share volume with even lower additions to [mainland] securities firms’ revenue, even if the quota is enlarged by five times in two years.”

Many smaller brokers will struggle with this substantial outlay at a time of low volatility and low agency volumes.

To begin with some brokers plan to offer basic broking services which are scalable, even so the initial development of IT systems for trading desks is generally the most expensive part of a build out.

Source: HKMA, PBOC, CSRC, SFC, SSE, Goldman Sachs
Big picture: Stock Connect is part of China's capital market reforms
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