While the “enhanced pre-trade checking model” for the Shanghai-Hong Kong Stock Connect programme (Stock Connect) addresses some of the limitations of existing pre-trade and post-trade processes, it remains to be seen whether it will meet the risk management standards of asset managers and overseas regulators.

 

The new model, which the Hong Kong Exchange (HKEx) expects to be available in March 2015, allows institutional investors to comply with mainland China’s pre-trade checking requirement without transferring their shares to brokers before execution.

 

Known as the pre-trade delivery, this requirement has been a major sticking point with institutional investors and other users of the Stock Connect because this leaves them open to counter-party risk. Also, pre-trade delivery is not in line with the practice of institutional investors and regulatory standards in other markets outside China where the shares are moved to brokers only on settlement day on a delivery versus payment (DVP) protocol.

 

In the existing model, the institutional investors basically have one account in the central clearing and settlement system (CCASS), the securities settlement system of the HKEx. This is opened under an institutional investor’s custodian bank, with the latter usually having all of its institutional investor clients in the account. This means the CCASS only sees the custodian bank’s omnibus account and not the individual accounts of the investors.

 

“When the enhanced pre-trade system is introduced, the institutional investors will be allowed to open their own special segregated account (SPSA) under CCASS, which will report this position to the HKEx so they’ll know whether you actually have a position or not when you’re trading. HKEX will have the visibility of individual investor’s balance so you don’t need to do the pre-trade delivery of the stock,” says Carrie Cheung, head of electronic trading, Asia-Pacific, BNP Paribas.

 

Lawrence Au, head of BNP Paribas Securities Services in Asia-Pacific, however explains that while the new model reduces counter-party risks, it does not completely eliminate it.

 

“That’s what we are arguing because under the new model, you still have to move your securities before you actually receive the cash. There will be a couple of hours that you actually are out of your stock before you receive your cash. It’s not 24 hours, so it’s no longer an overnight risk. It becomes an intraday risk, but on the other hand it is not true DVP and does not completely eliminate the counterparty risk,” Au says.

 

This means that the institutional investors and asset managers will have to evaluate this risk carefully before using the new model.

 

Overseas regulators responsible for supervising institutional investors and asset managers using the Stock Connect will also have to consider whether the new model will meet their respective risk management standards.

 

“Moreover, there is only a three-hour window for sorting out all trades on settlement day which will be especially challenging for investors with no presence in Hong Kong, Au adds. “Failure to settle a sale transaction will result in all the transactions for the same stock being blocked for settlement.”

 

According to the HKEx, the limitations of existing pre-trade checking model are: it requires pre-trade delivery of shares by investors from custodians to broker; it involves frequent movement of shares between custodians and brokers which may cause operational burden and costs; and inconvenience for investors to trade via multiple brokers.

 

The enhanced pre-trade checking model allows investors to trade with multiple brokers (maximum of 20) by opening a special segregated account (SPSA) at the central securities depository (CSD) level, through their custodians, which links to a unique investor ID to hold, sell and settle A-shares, according to BNP Paribas.

 

The CSD then provides a snapshot of all SPSA accounts to the China stock connect system (CSC) to comply with the pre-trade check requirement. Investors will need their unique investor IDs for sell orders only (any buy order containing an investor ID will be rejected by the HKEx), the bank adds.