In the latest of our regular primer articles, IFLR explains Bond Connect, the challenges it faces and the technical issues arising from its unique structure.
What is the Bond Connect?
Launched on July 3, it is a mutual market access (MMA) programme and is the third scheme of such kind established by Hong Kong and PRC regulators since the Shanghai-Hong Kong Stock Connect was introduced in 2014.
The Bond Connect scheme is chiefly co-operated by the Hong Kong Monetary Authority (HKMA) and the People’s Bank of China (PBOC). It also sees the collaboration of five different parties: the PBOC-run China Foreign Exchange Trade System (CFETs), China Central Depository & Clearing (CCDC); the Shanghai Clearing House (SHCH), the Hong Kong Stock Exchange (HKEx) as well as the Central Moneymarkets Unit (CMU).
All bonds registered and deposited in the SHCH, such as government bonds and corporate bonds, are eligible for investment without any quotas imposed under the Bond Connect. This has dispelled any pre-launch uncertainty over what types of onshore products overseas investors could access.
How does it work?
Unlike the Stock Connect, which is mediated by exchanges, bonds have long been traded over the counter in China’s Interbank Bond Market (CIBM). The onshore bond market is now valued at RMB65 trillion ($9.57 trillion) but only 1.3% of RMB800 billion of the total is held by foreign investors.
Trading on the Bond Connect, which is currently restricted to the northbound channel of the scheme, is executed via a Tradeweb Markets-operated trading platform and run by the HKEx and CFETs. The settlement is conducted by the Central Moneymarkets Unit in Hong Kong via special accounts set up at the CCDC and the SHCH.
The cash settlement for the northbound link of the Bond Connect is processed via RMB Cross-border Interbank Payment System (CIPS), which was launched in 2015 by PBOC to improve the efficiency of cross-border RMB settlement. The CIPS is constructed in two phases – the completed CIPS Phase I adopts real-time gross settlement and acts as a fast track of RMB cross-border cash settlement; and the second phase of the CIPS, which is currently under construction, will further extend the operating time and offer flexible business modes to make the settlement services to cross-border bond trading more convenient.
Why does it matter?
The Bond Connect is a boon for foreign investors, enabling them to buy onshore RMB-denominated instruments traded on the CIBM directly through their offshore accounts. This sets the new scheme apart from the CIBM Direct Access regime, which, while also being free of quota or repatriation restrictions, require qualified foreign investors to open an onshore account with the onshore settlement agent.
The PBOC has also recently announced that it will allow foreign credit-rating agencies to start operating on their own. This is expected to address decade-long market concerns about the lack of credibility of domestic ratings. But the international rating agencies will be required to qualify for certain conditions, such as having established a branch in China which has filed with a local PBOC branch.
Chin Chong Liew
, partner at Linklaters in Hong Kong, believes that all these developments could create more scope for product development outside China under the Bond Connect. While only foreign institutional investors (FIIs) such as investment bank and securities firms can offer fixed-income products in the CIBM, non-FIIs based overseas can now enter the onshore market and purchase these products.
“An FII in Hong Kong – Bank of China, for instance – can create a product which can get into the Bond Connect market and non-FIIs can then buy this product offered by BOC,” said Liew. He believes that there will be a lot more development in that area, whether in bonds, funds, structured notes and wealth management products.
How can it be improved?
Tax remains a problem, with little clarity over the Connect’s position. Uncertainty also surrounds the impact a default would have, as well the practical matter of foreign investors’ ability to file a lawsuit against the PRC issuer. “There are no precedents or real cases in that area, and it may take a real case to test out how well the rules and the procedures would work,” said Yin Ge, head of China financial services practice at Clifford Chance in Shanghai.
Foreign investors have also been asking law firms whether they could issue structured products offshore to hedge their risk from their bond position, for example, through the use of credit default swaps (CDS). Technically speaking, structured products transactions on a purely offshore basis may be out of PRC regulators’ jurisdiction, but in reality they could pique their interest if they have material impact on the onshore bond market.
International investors are also looking for clarification over the feasibility of offshore financing or the ability to take security over their bonds to finance offshore. “This relates to how PRC laws would come into play, especially over whether a pledge over a bond would be recognised or be valid under PRC laws,” said Ge.
How does payment work?
It’s not completely clear, with the onshore Chinese payment system yet to be fully explored. The system, while being robust, does not guarantee 100% finality of transfers due to insolvency jurisdictions such as the EU, Hong Kong and Singapore. Crucially, if the transferor is insolvent, its liquidator cannot claw back the payment already made in the settlement system. This would cause huge disruptions.
Ge points out that, while there is finality prescribed in the central bank’s regulations, there is a residual doubt if this will prevail over the Bankruptcy Law, which is higher in hierarchy.
For both the stock connect and the CIBM Direct Access regime, two of the key areas of focus among European regulators are beneficial ownership and custody arrangements. Specifically they look at whether a custody arrangement is robust enough ensure that the beneficial ownership is clear and the underlying investors are recognised as the beneficial owner. One of the key features of the Bond Connect is the multi-tier custody arrangements, so that European regulators will look at whether the custody chain is complete and the ownership can be traced relatively easily and clearly. “But I hear from market that they still need some time to obtain certain overseas regulators’ clearance on that,” said Ge.
Other, shorter-term issues need to be addressed, one of them being the settlement risk with the CCDC which is not the true Delivery-versus-payment (DVP) that foreign investors are familiar with. A buyer has to pay money to their seller first before they are assured of the security transfer into their account.
If investors want to buy the bond from the market maker in China, they will have to pay money into the seller’s account first and then both parties give instructions to CCDC to transfer the bonds into CMU’s nominee account for you. But according to one lawyer, problems arise if the market maker doesn’t give instructions to transfer the bond upon receiving payment.
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