China boasts the world’s second largest and most liquid equity market; the second largest bond market and three of the largest five commodity exchanges, as measured by turnover. And these markets are growing. For instance, the number of public companies has more than doubled over the past decade to nearly 4,000 listed on China’s Shanghai and Shenzhen exchanges, and there are another 8,000 OTC listed companies. In contrast, the number of public companies in the US has declined from about 8,000 in the mid-1990s to just over 4,000 today.
For over a decade, hedge fund managers have been accessing Chinese markets in various ways for strategies such as CTAs and managed futures, long/short equity, corporate credit and distressed debt such as non-performing loans. The first were often running managed futures, because commodity futures had no restrictions on short selling, though there are also ways to short equities for speculative purposes through swaps, onshore entities, stock connect programs, and possibly eventually also under new QFII rules. A few hedge fund strategies remain difficult to apply in China: “for example some equities quant strategies would find it difficult to implement due to the lack of an intraday equity trading mechanisms,” says Melody Yang, a partner in Simmons & Simmons’ Beijing office, who featured in The Hedge Fund Journal’s 50 Leading Women in Hedge Funds 2020 report published in association with EY.
Capital requirements are generally at least USD 1.5 million, though not all of this needs to be paid up. The highest cost is human resources.
Melody Yang, Partner, Simmons & Simmons, Beijing
Yang focuses her practice on a broad range of areas, including fund formation, fund regulatory issues, fund investments by institutional investors and high net worth individuals/companies, managed account arrangements and private equity investment. She has advised multiple leading global asset management groups in connection with their China market entry strategies through the PFM regime, QDLP, QFLP/QDIE, QDII and RQFII/QFII, and a number of Chinese asset managers in connection with launching their USD funds overseas.
This article highlights some factors that could be considered by western hedge fund managers who want to initiate, or expand, their access to Chinese markets in light of the recent reforms, which make it easier for some hedge funds to trade a wider range of markets in China, including initial offerings of equity and debt.
For the first time, hedge fund managers can apply for their own direct QFII (Qualified Foreign Institutional Investor) market access, rather than relying on brokers, while QFII’s market coverage has expanded, particularly for equities – and quotas have been lifted. Managers have been able to set up their own wholly owned PFM management company since 2016, which also benefits from the expanded QFII investment scope. “Institutional asset managers who wanted QFII or PFM already have it. Most of those queuing up for a license now are hedge fund managers. Now there are nearly 90 managers who are applying for licenses,” says Yang.
The way in which hedge fund managers choose to access the Chinese market depends on variables including their strategy and asset class coverage, appetite for regulatory reporting obligations, assessment of regulatory risks and costs of setting up onshore entities.
Presuming that overseas listings, Stock Connect and Bond Connect schemes do not provide sufficient coverage, managers need to decide whether to apply for QFII directly or access it via broker swaps.
Though there is no longer any minimum level of assets for QFII, some managers may prefer to avoid getting their own direct QFII for several reasons.
Brokers can provide equity swaps for shorting or leverage or both, which may be more convenient than navigating the operational complexities of onshore shorting and leverage, which we touch on later.
“QFII is a licensing regime, with a higher level of reporting, disclosure and other regulatory obligations and not all hedge fund managers would want this burden,” says Yang.
“To the extent that CFTC rules do not recognize some Chinese futures as eligible, some managers may prefer to use swaps rather than directly access the market,” says Yang. The CFTC has had a memorandum of understanding with China’s CSRC on “Futures Regulatory Cooperation” since January 2002, but this has not yet led to recognition. CFTC officials have made speeches praising internationalization of financial markets, so we could surmise that China is making steps in the right direction towards eventual CFTC recognition for futures.
“Prospectuses need to explicitly flag up risks on repatriation restrictions per se, and effective restrictions that might arise due to uncertainty over tax status,” says Yang. “We do not advise on tax planning but point out repatriation requires that a tax undertaking letter confirming that taxes due are paid or will be in future. There is no withholding tax on exchange listed shares, but the tax position on futures, OTC shares and PFM funds is not yet clear – so it is not clear if a QFII holder can give this undertaking”.
If managers feel comfortable with these issues, they might look at direct QFII or onshore entities. “The origin of China’s alphabet soup of programmes for foreign investment is that the capital account for foreign exchange is still somewhat controlled, so a cross border programme is needed to get access,” explains Yang.
Merging QFII and RQFII creates one regime for trading both foreign currency and Renminbi assets in China, with one streamlined application process replacing two.
Since overseas listings of Chinese companies and Connect schemes with the Shanghai and Shenzhen exchanges mainly access larger companies, they overlook at least 2,300 of China’s 4,100 listed companies on these two exchanges, as of December 2020, according to Southmoney.com. “Connect does not cover most of the new STAR market for technology and innovation,” says Yang. The Shanghai Stock Exchange launched its Science and Technology Innovation Board (STAR) in 2019. Connect also ignores a third exchange: “QFII also covers stocks listed on China’s OTC boards such as National Equities Exchange and Quotations (NEEQ),” says Yang. The NEEQ market or “Third Board”, launched in 2013 has 8,209 listed companies as of December 2020.
A direct QFII gives managers more freedom to trade a wider variety of exchange traded and some OTC assets that may not all be covered by their existing broker relationships; relaxing the cap on the number of brokers is a related move that lets managers forage more widely. Allowing more brokers per exchange should give managers access to a wider variety of local research, which is not yet “unbundled” from trading commissions. “The Chinese regulators are closely watching the MiFID II rules, but they do not apply in China. Research is part of brokers’ overall services,” says Yang.
QFII also gives managers access to onshore equity IPOs and primary bond and ABS issuance for the first time.
“By way of comparison, in fixed income markets QFII does not offer much wider coverage than Bond Connect and CIBM Direct – covering currency, interest rate and fixed income trading in the bond markets,” points out Yang.
Whether QFII permits unfettered shorting of financial futures, for speculation as well as hedging, remains to be seen. The regulations open up the possibility, but exchanges have some discretion over the matter and need to determine the rules for each futures contract. So far, one exchange has indicated that stock index futures can still only be used for hedging under QFII.
QFII also provides access to dozens of commodity futures listed on five exchanges, including many markets unique to China, a specified list of those commodities futures is yet to be unveiled. Only six commodity futures have been internationalized so far as of December 2020.
The number of public companies has more than doubled over the past decade to nearly 4,000 listed on China’s Shanghai and Shenzhen exchanges.
There are hopes that the ability to lend QFII inventory could increase market breadth – the universe of stocks that can be shorted, and increase market depth, or the volume, not only for equities but also in other assets. For instance, a more active corporate bond repo market might stimulate the development of credit default swaps (CDS). Sovereign CDS exists in China and there were unattributed reports in April 2019 that the Chinese regulator is encouraging companies to match bond issuance with CDS.
Yang adopts a wait and see attitude here, having observed hedge funds did not find it easy to pursue short selling in the past. She points out that, “brokers need to route securities lending and borrowing for short selling via a centralised repository – China Securities Finance Corporation – and not directly between QFII and the broker. Other features of shorting cash equities in China include T+1 settlement, and the inability to carry out naked shorting”. There is also some risk that the government might halt shorting activity, as it did so very clearly after the 2015 crash. The government also reportedly uses “moral suasion” to try and restrict short selling, for instance by asking brokers to be more cautious on margin trading.
Leaving aside research offices in China, which do not require regulation, going beyond QFII and setting up a regulated onshore entity would provide maximum potential for long investment, and short selling across a variety of markets without the possibly continued need for proof of hedging for financial futures under QFII, or broker swaps.
Though QFII’s coverage has been expanded, an onshore entity still provides even wider market access. For instance, “QFII is generally focused on liquid markets but does not cover all OTC products such as total return swaps, various OTC products that are not listed on the China Interbank Bond Market, non-exchange traded repoes and some time deposits. It also omits some products from trust companies, wealth management subsidiaries of banks, and insurance products,” says Yang.
An onshore entity is also needed for trading non-performing loans (NPLs), which have their own structures: managers can set up an asset management company (AMC) or can set up a closed end fund (CEF) to buy NPLs from an AMC. “These products are regulated similarly to private equity funds,” says Yang.
Indeed, there are multiple onshore structures: “Other onshore entities include PFM; QFLP for closed end funds; QDLP feeder funds into overseas master funds; and FMC fund management companies for retail funds,” explains Yang.
There are at least 30 Chinese equities ETFs listed on western exchanges
“A PRC law firm gives an opinion on licensing, while international law firms such as us advise on fund and trading documents independently. Most of the regulators speak English, but the working language is Mandarin. We first draft in English and then prepare the Chinese version so it is smooth and natural. Both language versions are of equal effect,” says Yang.
Yet the onshore entity could be too costly for some smaller managers. “Capital requirements are generally at least USD 1.5 million, though not all of this needs to be paid up. The highest cost is human resources, since five full time employees are required, including one full time chief compliance officer (CCO). Senior management need to pass an exam, which can be taken in English if they meet thresholds of experience, or otherwise needs to be taken in Chinese. Some senior managers such as the CCO need to be based in China; trading and investment decisions also need to be made within China, whilst some trading ideas can be generated outside China, with traceable data,” Yang explains.
“Virtually a supermajority of PFMs have historically been based in Shanghai, which is also the home to exchanges and brokers, and free trade zones, with steady and consistent policies,” says Yang. Various regional regulators are offering fiscal and other incentives to set up firms in areas such as Hengqin.
Wider market access might be the only reason for some managers to set up onshore, but others are also looking to raise assets domestically. “The regulator does not publish data on how much assets have been raised domestically by WFOEs, but we understand that it is not very easy to raise capital domestically. Institutional investors are only just starting with pension fund reforms, so asset raising is more likely to come from high net worth individuals and corporates. Foreign PFMs in China need a brand and strategy to be known. The high-net-worth thresholds in China are lower than in the US, but suitability tests on matching product risk with investor needs also need to be considered,” says Yang. “When using third party marketers, managers need to assess KYC and AML risks,” she adds.
Joint ventures are no longer required for managing money in China, but partnerships with local companies could be needed for distribution: “Most assets in China are run by banks, insurance companies, and trust companies, who may wrap a strategy into a wealth management product or set up a fund of funds multi-manager product. It is also easier to work with a trust or bank on KYC,” says Yang.
However, some of the largest global asset managers are confident enough to obtain FMC licenses to become local retail fund managers, authorized to set up retail funds. “This structure has stricter registration requirements and paid in capital of 100 million RMB,” says Yang.
It could soon be easier to raise assets from overseas: “The new regime should internationalize asset raising by letting managers grow assets by investing into a PFM, which can be seeded by an affiliate and sold to other QFIIs, once pending rules are finalized,” says Yang.
A Hong Kong retail fund already offers one way to raise money inside and outside China. Provided that a Hong Kong retail fund satisfies the eligibility requirements, it can be distributed in mainland China under mutual recognition of fund regime. A Hong Kong retail fund has the flexibility to run some types of alternative strategies that involve a limited amount of shorting. Says Eva Chan, partner in Simmons’ Hong Kong office: “An SFC authorized fund is allowed to engage in short selling, provided that it will not result in the fund’s liability to deliver securities exceeding 10% of its total net asset value, there is no naked or uncovered short sale of securities, and the security which is to be sold short is actively traded on a market where short selling activity is permitted”.
Yang currently acts as an advisor to the International Partners Committee of the Asset Management Association of China (AMAC), China’s de facto private fund regulator, and contributed to the consultation process that helped to shape the recent reforms. She was pleased to see that regulators heeded industry feedback in many areas: for instance: “It is now clear that PFMs nearly have the same investment scope as QFII and RQFII,” but she does have a “wish list” of items to be clarified within the current reforms or added to later reforms. Here are three examples on investment scope, custodial rules, and the overall regime.
“The first drafts of QFII/RQFII only allowed financial futures to be used for hedging purposes. Now there is potential for exchanges to allow them to be used for speculation,” says Yang. However, exchanges need to provide guidance on this for each and every instrument.
“Sub-custodian rules should be reformed to follow international practice. Those using QFII still need to form a relationship with a local custodian, of which 19 exist, including some Chinese subsidiaries of international banks. For now, it is not possible for global custodians to appoint a local sub-custodian, but the regulator is aware of this and might at some stage adopt the sub-custodian model,” says Yang.
Time to market could be expedited by shifting from a licensing to a registration scheme. “This distinction is specific to Chinese law. Licensing authorities have some element of discretion to reject applications but under a registration regime, applications that ticked boxes would have to proceed,” Yang adds
The November 2020 reforms can be seen in the context of growing internationalization of China’s financial markets. Hong Kong and the US are the largest interfaces but there are other access routes. Some smaller and early-stage managers who may not want to apply for QFII – and might not even yet have any prime broker – may want to use overseas dual listings and reciprocal listings such as ADRs, GDRs, various Connects and recently introduced programs for mutual recognition of ETFs. Even some of the largest asset managers running more traditional plain vanilla and less esoteric strategies find that overseas listings, Stock Connect and Bond Connect are sufficient. In equities, the Connects generally offer adequate coverage of mega caps, blue chips, large caps and many mid-caps for investors who do not want to participate in IPOs. In bonds, the Connect regime offers coverage comparable to QFII.
The China Interbank Bond Market, which started in February 2016, covers around 90% in value of China’s fixed income markets, and can be accessed directly through CIBM Direct or indirectly through the Bond Connect scheme for mutual recognition of credit markets launched in 2017, between the Peoples’ Bank of China and the Hong Kong Monetary Authority. Bond Connect allows overseas access through electronic platforms.
Equities – Connect
The Shanghai Connect was launched in November 2014, and Shenzhen Connect in December 2016, operating via Hong Kong Exchange and Clearing Accounts. Shanghai Connect includes SSE 180 (the largest 180 companies) and SSE 380 constituents (mid-caps), and some other Shanghai A shares that have H shares. These are mainly mid, large caps and mega caps. The Shenzhen Connect includes companies in the main board Shenzhen component index, and the Small/Mid Cap Innovation index, with market capitalisations above RMB 6 billion, as well as Shenzhen A shares of A and H companies, adding up to 884 companies as of December 2020.
Equities – Overseas Listings
Overseas listings of Chinese firms also illustrate the competitive global market in company law, since Chinese companies and related entities can incorporate in China’s special administrative regions, namely Hong Kong and Macau; Cayman; Bermuda; BVI, Singapore and elsewhere, and might be listed on exchanges in the same or other domiciles. The nuances of different corporate governance systems – and exchange rules – can be of particular interest to merger arbitrage, event driven and activist managers.
There are 220 ‘H’ shares – Hong Kong listings of Chinese companies, traded in HKD.
There are 233 ‘N’-shares (listed on the Nasdaq or NYSE) or US listed China ADRs as of June 2020, according to BNP Paribas Wealth Management, and an index – The Nasdaq Golden Dragon China Index – is tracking some of them. It remains to be seen if companies will need to furnish their audits to the Public Company Accounting Oversight Board (PCAOB) to maintain a US listing if the Holding Foreign Companies Accountable bill, binding them to Sarbanes Oxley, is passed, which would anyway allow three years to comply. A separate SEC proposal could shift US-listed Chinese companies to OTC trading if they do not have a US overseen auditor. In January 2021, the NYSE announced it had started the process for delisting some ADRs of Chinese companies.
If various political, legal or regulatory considerations discourage or prevent some Chinese companies from listing in the US, relisting in China or Hong Kong is probably most likely. There are also other exchanges for those seeking a western listing.
There are GDRs listed on the London, Singapore, Luxembourg, and Frankfurt exchanges. For instance, the Shanghai-London Stock Connect launched in 2019 lets Shanghai Stock Exchange listed ‘A’ share companies with a market capitalization of at least RMB 20 billion (circa USD 3 billion) list fungible GDRs on the LSE, as part of a reciprocal deal whereby London listed firms can also list CDRs in Shanghai. Deutsche Borse is finalizing a feasibility study to adopt a similar scheme.
Separately, Deutsche Borse has set up the CEINEX D-Shares market joint venture with the Shanghai Stock Exchange, which lets Chinese companies list on Xetra and Borse Frankfurt, traded in Euros under European rules, with criteria including IFRS reporting. The minimum market capitalization is EUR 500 million for the GDRs listed in Frankfurt.
Singapore is home to both some GDRs and some primary listings of Chinese companies, known as “S-chips”, which have sometimes become spectacular corporate failures and had accounting and corporate governance scandals highlighted by short sellers.
ETFs and Indices
UCITS ETFs, non-ETF UCITS, and non-UCITS ETFs listed in various western markets can be used to gain exposure to Chinese equities. There are at least 30 Chinese equities ETFs listed on western exchanges. They are often based on indices, several of which have pre-emptively removed some constituents in response to President Trump’s ban on US investors owning stocks that the US Defense Department deems to be linked to the Chinese military.
CEINEX claims to have the largest AUM of any European exchange for China-related ETFs, which are mainly UCITS ETFs so far.
Nascent programmes for mutual recognition of mainland China ETFs include arrangements with Hong Kong and Japan. The China-Japan ETF Connectivity Scheme launched in June 2019, initially listing four Japanese ETFs on the Shanghai Stock Exchange and four China ETFs on the Tokyo stock exchange. ETF Connect secured regulatory approval in September 2020, initially for just two ETFs in Hong Kong and two in Shenzhen.
Six internationalized commodity contracts can now be directly accessed by foreigners and palm oil traded on the Dalian Exchange is set to become the seventh. Copper on the Shanghai International Energy Exchange was the sixth, which opened to overseas investors in November 2020, continuing a trend that started with Yuan denominated crude oil traded on another exchange in Shanghai: the Shanghai Futures Exchange. The other four internationalised commodity futures contracts are, iron ore, TSR 20 rubber, low-sulphur fuel oil and purified terephthalic acid (PTA). “It is possible that the commodity exchanges may further open up to foreign investors,” says Yang.