The Evolution of China A Share Market Microstructure
Gene Reilly, Greenwich Quantitative Research's Chief Investment Officer, speaks with Leyla Gulen about the evolution of China A Share market microstructure.
Leyla Gulen (00:00):
Hello and welcome to Quantitative Investment Insights, presented by Greenwich Quantitative Research. Greenwich Quantitative Research is a hedge fund based in Greenwich, Connecticut focused on market neutral quantitative investing in the Asia-Pacific region. I'm here with the company's founder and Chief Investment Officer, Gene Reilly. Gene has 30 years of experience in trading and investing, including 19 years living and working in Asia. And in terms of career highlights, Gene was a partner at Goldman Sachs and ran equity trading for them across the region. Gene also has substantial quantitative investing experience and more recently ran Global Quantitative Trading for Merrill Lynch in New York. Gene, it's good to see you.
Well, expanding on a theme we previously discussed, we provided a solid explanation for why China's onshore equity market is suitable for quantitative market neutral investing. We learned about many unique aspects of China's equity markets and explored the access channels open to foreign investors, namely QFI and Connect. Today we're going to discuss the significance of the new QFI rules announced in 2020 and we'll review the various practical options investors have for executing orders onshore, and we'll cover important areas such as domestic exchanges, and the broad range of share equity classes that are sometimes confusing for some investors.
Now before we get into the new QFI rules, let's talk about the success of the Connect program. Gene, starting with the 2014 Shanghai-Hong Kong Stock Connect Program, we saw a material increase in foreign flows into China and this accelerated even further after the 2016 Shenzhen-Hong Kong Stock Connect Launch. So why did Connect attract so much more investor interest and flow than QFII and RQFII?
Gene Reilly (01:55):
Thanks, Leyla. Connect launched in November 2014, well after QFII and RQFII. But by the end of Q1 2020, QFII and RQFII represented only a third of A-Share holdings by foreign investors, while Stock Connect investors represented two thirds. So, really significant growth in that channel as the preferred channel for investors investing in onshore China. And the main reasons are investor access, ease of FX management, simplicity and helping to fill product gaps, including the addition of China to the global index benchmarks.
Leyla Gulen (02:33):
Can you give us more background on these reasons? How was investor access different under Connect versus QFII and RQFII?
Gene Reilly (02:44):
Well Connect is a channel that's available to all investors and investor strategies and for anyone who can open an account in Hong Kong. QFII and RQFII had strict qualification criteria which meant most investors weren't actually eligible to use the program. The QFII and RQFII programs stated that long term strategic investments were preferred, China’s stance dissuaded eligible firms who had short and medium term trading strategies like hedge funds, or even retail investors. So to satisfy the QFII and RQFII requirements, investors needed to fully invest their QFII. And it wasn't strictly enforced, but it created some regulatory friction and also repatriation was an issue. So investors were holding Renminbi balances even if they did not have an investible stock position at the time.
Leyla Gulen (03:37):
You mentioned managing FX exposure.
Gene Reilly (03:40):
Sure. Under QFII and RQFII, investors needed to be comfortable managing and hedging RMB. So RMB's a restricted currency, you had to hold a balance of RMB onshore. The only way to hedge that RMB exposure was using the NDF or non deliverable forward market which can be very technical for some investors. Under Connect, investors can execute orders and settle with either US Dollars or offshore Renminbi the same way they would transact with any other markets. So it really created an easier way to transact from an FX perspective relative to the cumbersome FX requirements and potential FX hedging requirements to transact via the old
QFII and RQFII system.
Leyla Gulen (04:30):
And now I can see why the FX management issues would be a major hurdle for most investors and why solving FX management attracted more foreign flows. How was Connect simpler compared with QFII and RQFII?
Gene Reilly (04:46):
It was simple and more flexible. Investors could use their existing brokerage accounts for Connect. QFII required QFII-specific accounts. The cross border flow was handled by the Hong Kong Stock Exchange so brokerage firms would only need to connect to the Hong Kong Stock Exchange that they already did business with. QFII investors had to establish their own onshore and offshore appointed custodians as well as well as specific onshore brokers. So Connect just remains significantly similar.
In terms of attaining the QFII license, the old program took three to six months to just get the license. The new QFI program has been simplified but is still a lot more time consuming and requires specific documentation and approval compared to Stock Connect which is open to anyone who has an account in Hong Kong to trade equities.
Leyla Gulen (05:46):
What products or features did Connect offer that wasn't available in QFII and RQFII?
Gene Reilly (05:52):
Specifically from a regulatory change, the ability to utilize broker swap inventory to short became permissible under the Connect rules. That was specifically prohibited under the QFII rules.
Leyla Gulen (06:08):
How did these changes impact the thinking of global index providers such as FTSE and MSCI on China markets?
Gene Reilly (06:17):
MSCI specifically cited the market opening measures introduced through the Connect program as one of the major reasons they added China to the MSCI Emerging Market Benchmark. That provided a push for investors that were significantly underweight China to allocate to the market and they had a much easier way to execute via Connect. So, significant inflow into the market and it gave investors a benchmark that was much more representative of global market capitalization.
Leyla Gulen (06:46):
What about the recent changes to the QFI program? Given the great success of the Stock Connect Program and the modest appetite to even among eligible investors for QFII and RQFII, why do you think China decided to make changes to the QFII and RQFII programs instead of concentrating its efforts on getting one program right?
Gene Reilly (07:09):
It's not clear why China decided to close the gap between the QFII program and the Connect program by revamping some of the QFII rules instead of just focusing on improving Connect. It's likely that in the long term, China anticipates that investors will be able to invest directly into China without going through an intermediary such as the Hong Kong Stock Exchange. At that point, potentially the Renminbi would be a freely convertible currency and the difficulties in terms of international investors accessing the exchanges on shore in China might be eliminated. So from that perspective, they could see that evolution in the market.
Leyla Gulen (07:48):
I see. Can you discuss the changes made to QFII and RQFII and their relevance?
Gene Reilly (07:55):
Sure. They, they've merged the QFII and RQFII programs and they now collectively refer to them as QFI, with one I. In January of 2019, the CSRC, SAFE and the PBOC circulated a consultation paper on the proposed changes to the programs and they requested market feedback. In September of 2020, they published the new regulations, which became effective on November 1, 2020. The changes included merging the two programs, QFII and RQFII, into QFI and are significant and represent another major market opening step by China. The changes address many of the issues investors faced with the old program.
Leyla Gulen (08:38):
Over the years, investors called for a number of changes to address QFII and RQFII program limitations and inflexible rules. We have already discussed the issues surrounding FX repatriation. Was FX management improved over the past few years by China's reforms?
Gene Reilly (08:57):
Sure. In 2018, China's regulators made capital repatriation more flexible by removing the lock-up period and permitting investors to repatriate their proceeds at any time. There previously had been strict limits on the amount foreign investors could take out of China at a time and it took multiple years to potentially fully repatriate your QFII balance. In 2020, they continued to address the process by allowing QFIs to repatriate proceeds shortly after they submit a tax commitment letter signed by the QFIs and the custodians. Previously, the process was time consuming, QFIs had to submit a special audit report on investments issued by a Chinese Certified Public Accountant and tax clearance certificates.
Leyla Gulen (09:46):
You mentioned QFII and RQFII are quota-based programs. There are quota limits at the individual investor level and an overall limit for the whole program. Did China address quotas in the 2020 QFI reforms?
Gene Reilly (10:00):
Absolutely. In September of 2019, People's Bank of China and SAFE announced that QFII and RQFII investors would no longer need to have SAFE approve a quota for them. QFIs can simply request their custodian to make registration with SAFE. The $300 billion overall cap on the program was also removed and that quota removal became effective in June of 2020. So this was a, a pretty big change. Going back more than a decade, there wasn't enough quota in the market for the international demand for Chinese securities. And as a result of that there were sometimes significant premiums to access the the Chinese market. And as a result of that, sometimes the Chinese ETF traded at significant premiums as well. So this should lead to a more level playing field so to speak in terms of international investors being able to access the the Chinese market in the quantities that they would like to do so.
Leyla Gulen (11:12):
How about investor access? Is QFI open to a wider range of investors?
Gene Reilly (11:19):
Sure, they've relaxed that significantly. Previously there was a minimum period which a firm needed to be operating before they would be eligible for a QFII. The applicants can now be all types of asset managers. There previously had been a strong preference for purely long only investors to receive their own QFIIs. That's now opened the door for hedge funds to establish QFIs. Also, the language has been removed that gave preference to long-term holders. So that is no longer an explicit requirement. And the application procedure and, and the approval process has been cut down to 10 days from, from what was potentially a multi-month process previously.
Leyla Gulen (12:05):
These changes are pretty significant. Was the limited product scope addressed?
Gene Reilly (12:11):
The investment scope's been expanded to equity investors. Margin trading and securities lending on stock exchanges has been approved. Stocks listed on the NEEQ are now approved for QFI investors as the third national equity trading venue after the Shenzhen and Shanghai Stock Exchanges. It's an over-the-counter system that was established back in 2012 for trading stocks that weren't listed on the two major exchanges. Also, options that are listed and traded on the futures exchange are approved by the State Council or the CSRC.
Leyla Gulen (12:47):
Okay. Are there any other relevant changes to mention?
Gene Reilly (12:51):
QFI's can appoint an unlimited number of onshore securities brokers. Previously that was restricted to three onshore brokers. Additionally, QFIs could appoint only one custodian, now they can appoint three. QFIs can invest using any currency and convert into an Renminbi via their offshore custodian. There's still a requirement that funds must come from offshore, there has to be an FX conversion. They can't access it using onshore Renminbi. The new rules have also enhanced regulatory oversight of QFIs but at the same time reduce the required daily data submissions.
Leyla Gulen (13:33):
A number of announced changes to QFI are still pending approvals and additional reforms necessary to make them viable. I have heard that while changes have been officially announced, many of the new features cannot be implemented at this time. Is that correct?
Gene Reilly (13:49):
That's correct. The wording the new rules are sometimes vague and regulators need to provide detail on specific investment products. In addition, some of the activities permitted under the new rules can’t be carried out unless other existing rules and processes are changed. Stock borrow and loan is example, there are existing rules and processes to prevent that being transacted even though technically it's permitted. China market participants have seen this before with other market opening measures. Sometimes it takes a long period of time, maybe even a few years, before all the newly permitted activities can be carried out. For example, stock borrowing and lending is permitted under Stock Connect for a number of years already but further changes are required before the activity can be actually transacted effectively. There continues to be a dialogue with Chinese regulators as to how this can be more relevant to the international investor. If the announced changes to the QFI program are implemented as investors hope, it would solve all these problems.
Leyla Gulen (14:51):
And since the QFI rules came out though have any of the announced rules and features been clarified so that investors can actually benefit from the market opening measures?
Gene Reilly (15:00):
Yes. To date, clarity has been provided on commodity futures, commodity options and stock index options. In October, they announced that QFI investors will be able to trade commodity futures, commodity options, stock index options and trade on futures venues that have been approved by the CSRC. Trading in stock index options will be limited to the sole purpose of hedging. So there will be further rules clarifying what investors are going to be able to do on that front.
Leyla Gulen (15:30):
If we compare the QFI and Connect channels now, post the QFI rule changes, which program offers clients better access to China from an equity investor perspective?
Gene Reilly (15:42):
The changes that have been made to the QFI program over the past three years have now made QFI a better channel than Stock Connect for investors that have the infrastructure and staffing to manage the additional complexities of QFI compared with a simpler Stock Connect Channel. For stock access, QFI investors can access all the stocks listed on the Shanghai and Shenzhen exchanges. So 4,200 stocks and on the NEEQ which has over 10,000 stocks. Stock Connect has a smaller universe of securities, about 1,400. QFI's can also access onshore ETFs, IPOs, whereas Connect cannot.
I would note that the QFI and Connect programs are not mutually exclusive so investors that qualify can use both. If investors use Swap, they can transact through their brokers, they have access to both QFI and Connect so they'll have all the access available through both programs.
Leyla Gulen (16:38):
Connect has certainly been a very successful program in terms of opening China's equity markets to foreign investors. The new QFI rules sound like they will provide even greater market access. But there are still market restrictions that impact investor access to China in a meaningful way. Currently, what are the remaining major areas that investors would like to see improved?
Gene Reilly (17:04):
As a result of these market reforms MSCI, FTSE, and S&P added A-shares to their benchmarks, at an inclusion factor of 20 to 25%. That means they are not fully representing their market capitalization weight in those indices. So there are additional measures that the index providers would like to see implemented moving closer to international standards and that would actually result in an increased inclusion factor. In terms of Connect the introduction of block trading to increase liquidity in the market is something that is sought. Harmonization of the Hong Kong and China trading calendars to avoid days when the Chinese A-share market is open but Stock Connect investors can't trade because the Hong Kong stock exchange is closed. And an increase in the eligible securities. So there's really no reason why the Connect channel couldn't have all the securities available that the QFI channel currently has.
So for both, QFI and Stock Connect, order cancellation and the flexibility to cancel orders in the open and closing auction. Aligning the settlement cycle. The short settlement cycle onshore creates challenges for global investors. It doesn't support settlement on trade dated shares purchased on trade day. Leveraging the Stock Connect platform can resolve that issue. Also for stock borrowing and lending, programs have been officially announced for both Stock Connect and QFI but neither program can be yet used at this time because there needs to be different rules and clarification as to how exactly it's going to work.
Brokerages have been able to offer de facto stock loan access via Swap for the Connect channel. It will now likely to be able to offer exposure for QFI since China has approved shorting for QFI. Additionally, there's a 30% foreign ownership limit. Foreign investors in Chinese companies are still subject to that cap. At certain times of the market that cap has become problematic in certain securities where the international community is at the cap and essentially getting access to the stock can be rationed or distorted in terms of a premium.
Leyla Gulen (19:21):
Well, now let's look at an actual order execution. What are the various execution options available for investors via the QFI and Connect channels?
Gene Reilly (19:31):
First it's important stress the same rules that govern the domestic investors in China are applied to foreign investors. So whilst it's a different market microstructure with its own compliance rules, generally those rules are the same for onshore investors as opposed to offshore investors utilizing the the Connect channel. In terms of what the relevant rules are, equity markets regulated are regulated by the CSRC. There's also the Securities and Futures Commission in Hong Kong. Other relevant regulators for QFI are the CSRC, the PBOC, and SAFE.
Leyla Gulen (20:08):
Okay, now let's hear about the different ways to execute orders in China to see how similar it is versus developed markets.
Gene Reilly (20:15):
Sure. In terms of QFI, cash stocks can be executed directly through the onshore broker and custodian. Swaps can be executed using the broker's QFI. Securities can't be purchased and sold on the same day, and that's true for all investors in the market. So if you buy a stock, you have to wait 24 hours. You have to wait until the next calendar trading day to sell the stock which has reduced the frequency of turnover in the market. Stock borrowing and lending are now permitted under the new 2020 QFI rules but they haven't clarified the details yet, there's some conflict around existing rules.
Consequently, shorting via QFI is not practical at this moment. And using brokers’ long positions to sell long on swap is the only way at present to gain short exposure to the market. Over time, China will work with market participants to change the rules, processes and infrastructure to support a more robust stock loan and stock shorting capability for QFIs.
For connect execution, it's very similar to QFI because the onshore rules apply, you can purchase both cash stocks as well as swaps. The same rules apply about being able to purchase and sell stock on the same day. Securities must be purchased the day prior to being sold. Investors can short on swap by using long inventory that their brokers may have but that inventory must have been purchased prior to the trade day.
Leyla Gulen (21:55):
Let's move on to exchanges. Can you give us an overview on the different stock exchanges in China? Shanghai and Shenzhen are the two exchanges most investors are familiar with.
Gene Reilly (22:08):
Sure, absolutely. And they're some of the biggest in the world now. The Shanghai Stock Exchange actually opened in 1990 and it operates two main boards. One is the main board where they have large, middle and small cap listings. And then there is the Star Market, which is a science and technology innovation segment of the markets. That launched in 2019 focused on tech stocks.
Then the Shenzhen Stock Exchange also launched in 1990. The Shenzhen Exchange has three major components. One the main board which has large cap listings. Then there is the SME, Small and Medium Cap venue. And they also have a program called ChiNext, which focuses on high growth and technology orientated startups. It is similar to NASDAQ in the States. And that was launched in 2009.
Leyla Gulen (23:07):
Okay. And I heard that China just launched a new stock exchange in Beijing on November 15. Can you tell us about the Beijing Stock Exchange and also when you discussed the new QFI rules you had mentioned the National Equities Exchange and Quotations.
Gene Reilly (23:23):
The National Equities Exchange and Quotations, NEEQ, established in 2012, is an over-the-counter system established in Beijing for trading stocks that aren't listed on the major exchanges, similar to how pink sheet work in the United States. It's approved for QFI investors via the new rules but not yet for Connect investors. The Beijing Stock Exchange just launched on November 15, 2021. The Beijing Stock Exchange has strong government sponsorship. The purpose of the Beijing Stock Exchange is that will complement the Shenzhen and Shanghai Exchanges by focusing on small and mid sized companies and provide an additional source of capital. Small businesses have had difficulty getting funding from banks and it's designed to be an equity funding option for those smaller businesses.
Policymakers would like to promote innovation and technology entrepreneurship domestically to grow China's tech sector specifically. The rules allow it to process listings more quickly than other exchanges. The first round of companies that are being listed are mainly software, pharmaceutical and high tech manufacturing. There's about 81 stocks listed. 10 were IPOs and 71 were "promoted" from the NEEQ. So it's really interesting to see how so many dynamic changes are taking place and, and that the market is becoming significantly more similar to the options that investors have on many of the international stock exchanges.
Leyla Gulen (25:04):
Absolutely. Well, this has been so informative. Thank you so much, Gene. That's all the time we have for now. I'd like to thank you, our listeners, and I look forward to covering more topics in the future. We'll see you next time.