A look at the difference in settlement systems between Shanghai and
Hong Kong ahead of the launch of the Shanghai-Hong Kong Stock
Connect
Yang Xia, Head of China Equities, UBS Securities Co., Ltd
Since the pilot programme was announced in April this year, all parties involved have paid
much attention to the Shanghai-Hong Kong Stock Connect. All kinds of analyses and
assessments have been covered at length in the media, dissecting every possible angle of
the Shanghai-Hong Kong Stock Connect – from the meaning behind the reform to the
attitude of the industry, from market trends to individual stock analyses. But in the face of
so much great foresight, I believe that what is most direly needed at this stage is investor
education. Taking a cue from the Chinese philosopher, essayist and diplomat Hu Shi – who
stated that the aim must be "to spend less time discussing theories and more time
researching issues" – I am going to try here to discuss the differences between Shanghai
and Hong Kong in terms of their trading and settlement systems, in the hope of offering
something that can be used as a reference by investors and brokers in the soon-to-depart
Shanghai-Hong Kong Stock Connect.
When mentioning that Hong Kong is different from the A-share market, what comes to
most people's mind first is the difference between Hong Kong's "T+0" and China's "T+1".
As everybody knows, back in the 1990's when the A-share market first got going, it also
adopted the "T+0" same-day turnaround trading model. But because speculative
behaviour was rampant and got out of hand, a halt was called in early 1995 and since then
the "T+1" model has been in use. In those 20 years, some have credited the "T+1" system
with controlling excessive speculation. Others have complained that the system kills market
liquidity. But does the praise or blame actually hit the point? Let's take a look at the Hong
Kong stock market.
The Hong Kong market - the trading mechanism promotes the development of
service
Investors who trade in HK market may feel that buying and selling one stock on the same
day is nothing out of ordinary, because the Hong Kong trading rules have implemented the
same-day turnaround trading model.
When you check the website of the Hong Kong exchange, you may also discover that it
stipulates that the cash and stock settlement both take place on T+2. For this reason, Hong
Kong market investors can, before the settlement on T+2, fully utilize their available cash
and stock to enter repeat trades.
As members of the Hong Kong exchange, brokers offer investors proxy trading service, and
need to enter into a proxy services agreement with investors. The same-day turnaround
trading mechanism currently in place at the Hong Kong market allows brokers to offer
investors, as far as possible, a plethora of custom-made trading services – provided they
mitigate the risk. On one hand, this develops the number of different services; while on the
other hand this promotes an increase in liquidity in the market.
Naturally, Hong Kong's T+2 settlement system has a lot of fine print which this article is
not going to discuss, for fear of becoming a dissertation.
The A- share market - regulators emphasize more on the safety of trading
mechanism
Let's put Hong Kong aside for a moment and turn our attention to the trading and
settlement system of mainland China's A-share market. Simply put, the settlement system
for stocks traded on the A-share market is a T+0 model, while its funds settlement system
has adopted a T+1 model. For example, when during regular trading hours an investor
successfully buys 100 shares of a certain company for RMB 1000, he may find that 100
shares immediately show up in his stock account and that RMB 1000 has been deducted
from his cash account (if we temporarily do not consider the trading fees). In reality, these
100 shares have not yet entered his stock account (they will do so in the evening of the
day they were traded, so on T+0). The payment too has not yet entered the seller's
account (it will be done at 4pm on T+1). The investor can see the result of the transaction
immediately, only because the brokers offer corresponding account services. Conversely, if
this investor originally held 100 shares, and gained RMB1000 after selling these, then he
might have discovered that he could use the RMB1000 to buy other shares on the same
day, even though he would be unable to withdraw this amount. This RMB1000 in funds
can be used for re-investment without physically entering the account (only do so at 4pm
on T+1). It is because the domestic trading mechanism allows the rolling use of the funds,
so that the investor can immediately invest the funds he has gained through selling stock.
Compared with major markets around the globe, this A-share market model where shares
and funds are settled at different times may well be unique, containing inherent risks.
For example, an investor buys shares on day T. The same day the shares are settled and
entered into that investor's account. But the settlement of the funds occurs on T+1. If at
that point in time there is a lack of funds in the relevant account, there may be a breach of
contract that affects normal trading and, in an extreme case, disturbs the market order. To
prevent this kind of situation from happening, when signing a services agreement, the
Chinese mainland brokers and investors need to spell out clearly in the agreement that the
investor may only enter into a trade of buying (or selling) a certain amount when he has in
his account at least an equal amount of funds (or shares). This is what is called the pretrade "verification of funds and stock".
Having gone through the funds and stock verification, and a same-day turnaround of stock
being prohibited, mainland brokers, at the expense of lowered flexibility of service, have
successfully eliminated the risk that could result from a discrepancy at the time of settling
the shares and funds.
Investors must adapt to the new regulations of the new market
To the Stock Connect mainland Chinese investor, Hong Kong is an open and flexible
market. A same-day turnaround market brings with it fluctuations more obvious than in
the A-share market. Even though current regulations still require to go through a funds
and stock verification, and the financing trading manners, such as margin trading (SBL),
will not be used in the early stage of the Stock Connect, I believe that – as the Stock
Connect business gradually matures and expands – these methods that can help control
funding efficiency will open the door for the Stock Connect mainland investors.
To the Stock Connect Hong Kong investor, the Chinese mainland A-share market is
without doubt a much more tightly regulated market. As the saying goes, "It is easy to go
from frugality to extravagance, but difficult to go from extravagance to frugality". Foreign
investors and dealers used to same-day turnarounds and the ability to have funds available
for investing right before T+2 are advised to diligently study the regulations of the A-share
market.
Especially worth mentioning is the difference between Hong Kong's system where one can
open an account with several brokers and several custody accounts, whereas in mainland
China there is a designated broker and a single custody account. This makes the funds and
stock verification harder for the Stock Connect Hong Kong investor. If an investor uses
multiple brokers, he must ascertain before day T how much in funds and stock he has with
each broker and must make the required transfers of funds in time in preparation of the
trade on day T. On the day of trading, that investor still has to pass on to all his brokers
buying and selling orders. Under certain circumstances, he has to be bear responsibility for
price differences resulting from how various brokers have executed their orders. In addition,
the funds and stock verification requirement may force the investor to use non-deal
transfers before the trade really takes place in order to transfer funds or stocks into the
broker's account. Overseas funds may want to tread carefully about the inherent
confidentiality and counterparty risks.
In order to reduce the hassle that multiple brokers and custody accounts carry with them,
the Stock Connect Hong Kong investor might as well resort to a single broker to execute
trades. After adapting for many years, the QFII investor that entered the A-share market
earlier has now accepted the modus operandi of the mainland Chinese market. Although
regulations allow QFII investors to open accounts with a maximum of three brokers, they
often only have one broker at any given time in order to simplify the trade flow and to
avoid situations where stock bought exceeds funds held – a situation more likely to occur
in the case of multiple brokers. Large dealers with a greater financial prowess can still
provide clients with prime brokerage services at the same time as they execute Stock
Connect trades for the client or provide stock custodial services. Such model not only can
effectively guarantee that the client before day T has prepared sufficient stock and funds
required for the funds and stock verification, it also facilitates the broker's overview of the
client's position, thereby avoiding an overbuy or oversell. Brokers may consider negotiating
designated custodians with clients unwilling to sign prime brokerage service contracts and
in so doing reduce as far as possible the inconvenience of reconciling many positions.
Of course, the above are just superficial suggestions based on my own experience. The
most ideal method would still be if the supervisory authorities took the lead and devised a
uniform solution for the entire industry so that standardization is reached at the early
stages.
Trading in the Shanghai-Hong Kong Stock Connect will formally commence in October.
The most pressing matter at the moment is that the investor becomes familiar with the
new system and adapts to a new market. Brokers, custodians and other institutions need
to provide clients with new solutions. The supervisory authorities need to more effectively
protect market order and market efficiency. Even if this article only helps a little in
educating the Shanghai-Hong Kong Stock Connect investor, it will have been worth it.