QFII custodians seek a better deal

Custodians seek to reduce risk - and ultimately costs to clients - in China''s upcoming QFII scheme.

Global sub-custodians Citibank, HSBC and Standard Chartered, all of which have been granted permission by the People's Bank of China to act as custodians for China's emerging qualified foreign institutional investor (QFII) scheme, are lobbying hard for changes to the rules in order to mitigate risk.

Bankers want to create a matching and error-rectification process. Currently, custodians face principal risk, explains Richard Ernesti, regional head of global securities services at Citibank. Say a QFII licence holder orders a trade - say to buy a particular A share - and sends the information to the local broker/dealer. The broker/dealer confirms that the custodian has the cash to buy, and executes over the stock exchange. Then the trade goes to the China Securities Depository and Clearing Corporation (CSDCC). Trades in China must be settled on the trade day; cash settles on T+1.

Present QFII draft rules indicate that should there be a problem with the trade, then the custodians would be responsible, at least as far as the regulators are concerned. This presents a potential risk exposure to custodians, which never accept principal risk in any other market.

What the banks are proposing is the creation of an hour-long window starting at 3:00 or 3:30pm on trade day that would allow custodians to check the QFII licensee's order versus the CSDCC's report, and if there is a problem to push the trade back to the local broker.

Given the lack of a securities lending/borrowing market and the tight T+0 trade settlement environment, there is no other recourse for custodians to protect themselves, says Ernesti.

No one knows whether the custodians' wish will be granted. Local brokers are, understandably, hostile to the idea.

James Wong, senior vice president of custody and clearing at HSBC, says bankers are trying to find a middle ground. For example, custodians and brokers could agree on what constitutes an error, in order to facilitate the brokers' ability to handle fails.

Even if none of the custodians' wishes are listened to, QFII licensees can still go ahead and invest in the A-share market. But custodians would be forced to create risk-mitigating structures that would add to costs and headaches for QFII clients.

There are other, related issues custodians would like to resolve now. First, they want to have multiple cash clearing accounts at the China Securities Depository and Clearing Corporation (CSDCC), one for each QFII licensee they work for. Currently a custodian's various QFII clients will have their cash commingled in one account, which creates potential difficulties to the QFII licensees under their home regulations, as well as creates a risk for their clients - and extra work for custodians.

Second, they would like to move securities settlement from trade day to T+1, to match the existing T+1 environment for cash. This would achieve a real delivery-versus-payment structure, as well as provide banks with extra time to handle failed trades.

Third, they would like to establish sub-accounts for QFII licensees, many of which will be global brokers acting on behalf of a variety of clients. Custodian banks acknowledge this is unlikely to change for the time being, as the authorities want just one go-to organization if they have a question or problem. Sub-accounts would create too much of a headache for regulators. But this will become a priority later if the QFII system is to liberalize, and the CSRC has requested papers from banks to substantiate why sub-accounts are necessary and how they would work.

The custodians themselves are still awaiting final approval from the China Securities Regulatory Commission and the State Administration of Foreign Exchange to be licensed to handle QFII business. Once that is final, they can begin the process of guiding applications for QFII licenses through the regulatory system. There are also seven domestic banks that are licensed to act as QFII custodians.

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