Increasing Integration of the Funds Market with mainland China
Hong Kong maintains its place as a global financial centre. Market links to mainland China are enhanced.
In the last eighteen months there have been two significant areas in which access between Hong Kong and mainland China’s markets has been opened up.
A recent fund management survey by Hong Kong’s Securities and Futures Commission (SFC) showed that overseas investors accounted for 71% of Hong Kong’s fund management business in 2014. Hong Kong’s increasing links to mainland China markets are expected to enhance its attractiveness to international investors, and increase participation in its markets by mainland institutions. This is a long term trend which will outlast recent periods of market turbulence. In this issue we provide an overview of the Mutual Recognition of Funds scheme (MRF) between mainland China and the Hong Kong SAR, introduced in the middle of last year, and take another look at the Hong Kong Stock Connect Initiative introduced at the end of 2014, in the context of the funds market.
Mutual Recognition of Funds
Since 1 July 2015, a fund that is authorised by the SFC in Hong Kong, or the China Securities and Regulatory Commission (CSRC) in mainland China, has been able to apply for authorisation for retail distribution in the corresponding host jurisdiction provided that certain requirements can be satisfied.
In general, the relevant fund must be (a) authorised by the home regulator for sale to the public and (b) managed in accordance with the laws and regulations in the home jurisdiction and its constitutive documents. After obtaining authorisation in the host jurisdiction, the relevant fund must be offered and marketed in accordance with local laws and regulations. The host jurisdictions have published rules and regulations concerning the authorisation, post-authorisation and on-going compliance of funds under MRF, as well as in relation to sales and distribution. The CSRC and the SFC treat investors from both the home jurisdiction and the host jurisdiction in the same manner.
Hong Kong domiciled unit trusts that are authorised by the SFC and seeking authorisation in mainland China need to comply with the Code on Unit Trusts and Mutual Funds (UT Code) (which form s part of the SFC’s Handbook). Funds from mainland China seeking to be authorised by the SFC for sale to the public in Hong Kong need to comply with the relevant laws and regulations in mainland China and are deemed to have substantially complied with the relevant SFC requirements.
The first batch of funds under MRF were approved by the CSRC and SFC respectively on 18 December 2015 (three for distribution in mainland China and four for distribution in Hong Kong). The second batch, comprising nine Southbound funds, were authorised by the SFC on 30 December 2015 and a third batch of ten mainland funds received approval on 5 January 2016.
Recognised Mainland Funds Coming to Hong Kong – ‘Southbound’
At present, only plain vanilla equity funds, bond funds, mixed funds, unlisted index funds and physical ETFs from mainland China are eligible to apply for Hong Kong authorisation under MRF.
Mainland funds seeking SFC authorisation must:
Managers of eligible mainland funds must be registered and operate in mainland China in accordance with local laws and regulations and licensed by the CSRC to manage public funds and have a clean regulatory history in the past three years or since its establishment (if established for less than three years). For the time being, management delegation outside of mainland China is not allowed.The custodian of mainland funds must be qualified to act as such in accordance with the laws and regulations in mainland China.
Mainland funds under MRF need to appoint a Hong Kong representative as required under Chapter 9 of the UT Code. Other operational and on-going compliance requirements under the UT Code (e.g. suspension in dealing, pricing errors, the inspection of the fund’s constitutive documents, and the absence of provisions which seek to exclude the jurisdiction of Hong Kong courts) also apply to eligible mainland funds.
Scheme changes for mainland funds under MRF follow the requirements in the home jurisdiction and are required to be filed with the SFC and notified to Hong Kong investors. When issuing advertisements for mainland funds under MRF, the SFC’s Advertising Guidelines apply. The SFC’s MRF circular dated 22 May 2015 also sets out various Hong Kong disclosures which the SFC would expect. The Chinese version of the offering documents of mainland funds to be sold to the public in Hong Kong should be prepared in traditional Chinese. As with all other SFC authorised funds, mainland issuers will need to prepare Key Fact Statements.
The SFC has published FAQs on MRF which offer guidance on some of the requirements for authorisation of mainland China funds in Hong Kong and include sample risk factors that should be included in the Hong Kong offering documents for southbound funds. These cover such risks as: quota restrictions; eligibility requirements; mainland China tax risk; different market practices; concentration risk; RMB currency risk and conversion risks; risks relating to A-shares; and mainland debt securities risks.
Recognised Hong Kong funds going to the Mainland – ‘Northbound’
The CSRC issued Interim Provisions on Administration of Hong Kong Mutually Recognised Funds (Interim Provisions) on 22 May 2015, which establish the requirements for Hong Kong funds seeking registration with the CSRC.
Only funds that are established and operating in accordance with Hong Kong law, authorised by the SFC for public offering and regulated by the SFC are eligible to apply for CSRC registration under MRF. These are also limited to plain vanilla equity funds, mixed assets funds, bond funds and index funds (including ETFs).
Hong Kong domiciled funds seeking CSRC registration must:
Managers of eligible Hong Kong funds must be incorporated and operating in Hong Kong, hold an SFC licence for Type 9 (Asset Management) regulated activities and not be subject to any material disciplinary actions in the past three years or since establishment (if established for less than three years). Again, management delegation is not allowed. The requirements for trustees and custodians follow the requirements imposed by the SFC.
Hong Kong funds under MRF need to appoint a CSRC-approved public fund manager or custodian as their mainland local agent for handling mainland-related matters including product registration, information disclosure, distribution arrangements, information exchange, clearing, regulatory reporting, communication, investors services and monitoring. The Interim Provisions also set out various mainland related disclosures which the CSRC would expect. Managers should ensure that mainland and Hong Kong investors are treated fairly and receive the same level of investor protection and disclosures.
Matters relating to investment transactions, safekeeping of assets, valuation, dealings, fee arrangement, taxation, unitholders meetings, changes to constitutive documents, termination and merger and withdrawal of authorisation, continue to follow the requirements under the fund’s constitutive documents and the requirements imposed by the SFC.
Mainland distributors of Hong Kong funds should obtain the relevant mainland business licences. Advertisements and promotional materials are subject to local filing requirements. If the manager is aware that the eligibility requirements may cease to be satisfied (e.g. there is a drop in fund size), the same should be reported to the CSRC immediately.
Shanghai – Hong Kong Stock Connect
The Shanghai-Hong Kong Stock Connect programme (Stock Connect), a scheme that permits (within certain parameters) investors with access to one market to buy and sell eligible shares listed on the other market, commenced trading on 17 November 2014. A similar cross-border stock link programme covering Shenzhen and Hong Kong is anticipated in 2016. It’s fair to say that market expectation is that the parameters of these arrangements will gradually be broadened.
Stock Connect has been of great interest to fund managers globally, with product issuers exploring how they can make use of the programme, especially those without Qualified Foreign Institutional Investors (QFII) or RMB Qualified Foreign Institutional Investor (RQFII) quotas. The PRC Government originally earmarked RMB 270 billion RQFII quotas for Hong Kong-based asset management companies. However, the Hong Kong quotas have been fully allocated to RQFII licence holders. As a result, industry participants have turned their focus to Stock Connect in order to invest in China A-shares.
The PRC Government has been inclined to promote Stock Connect rather than issuing further RQFII quotas. Apart from the RQFII ETFs listed on the Hong Kong Stock Exchange, the majority of the RQFII funds in Hong Kong have been RMB fixed income funds. Stock Connect has stimulated interest in funds investing in PRC equities.
Following the launch of Stock Connect, industry participants and associations have been actively discussing new product ideas for Hong Kong with the SFC. At the same time, European counterparts are making use of Stock Connect for their UCITS funds, subject to the agreement of the relevant regulators. Regulators in Luxembourg and Ireland have thus far been prepared to approve their authorised funds for access to Stock Connect on a case by case basis.
The planned level of investments in China A-shares via Stock Connect varies from one fund house to another. Some portfolio managers only invest 5% to 10% of a fund’s total net assets using Stock Connect. Others like to make full use of Stock Connect together with RQFII. The majority invest around 10% to 30% of a China-related or RMB-related fund’s total net asset value in China A-shares via Stock Connect.
One area of concern to fund management companies had been beneficial ownership of the China A-shares acquired via Stock Connect. On 15 May 2015, the CSRC issued FAQs on Beneficial Ownership under Stock Connect confirming the validity of the nominee shareholding. Ultimate investors are therefore recognised as having beneficial ownership in A-shares. According to a survey of Hong Kong Investment Funds Association (HKIFA) members conducted in November and December 2015, the CSRC’s FAQs went a long way in addressing the industry’s concerns although a formal adoption of the concept into law would be welcome. From Hong Kong’s perspective, the Central Clearing and Settlement System rules and operational procedures have been updated to set out the rights and obligations of Hong Kong Securities Clearing Company Limited as the “nominee holder”.
The authorisation of funds by the SFC and the CSRC for public sale under the landmark MRF scheme is a major breakthrough in developing access between Hong Kong and mainland China’s fund markets. There is optimism that when the scheme proves successful, it could be extended to other Asian markets and form the basis of a regulatory standard in the region, similar to the UCITS scheme in Europe.
For Stock Connect, the recent HKIFA survey reflects that adding Shenzhen-listed stocks to the scheme would significantly boost its attractiveness. Meanwhile, the programme remains a key milestone in the mainland’s capital account opening and RMB internationalization.