Stock Connect Awaits Possible Salvation From European UCITS

Luxembourg may hold the key to future improvement in volumes in the Shanghai-Hong Kong Stock Connect, the access mechanism whose charms have been largely neglected by investors in the fortnight since inception.
By Editorial
According to law firm Arendt& Medernach, Luxembourg’s securities regulator, the Commission de Surveillance du Secteur Financier (CSSF), has no objections to UCITS funds investing in China A shares via the Shanghai-Hong Kong Stock Connect Platform.

As a result, UCITS managers now have three ways to gain direct exposure to China A-Shares, subject to conditions and the prior approval of the CSSF, through the qualified foreign institutional investor scheme (QFII), the RMB qualified foreign institutional investor scheme (R-QFII) and now Stock Connect.

The addition of UCITS funds could be the key to future improvement in volumes in Stock Connect, the access mechanism whose charms have been largely neglected by investors in the fortnight since inception.

The Stock Connect trade on the first day of launch was rebalancing the premium and discount between the two markets, and once that was accomplished, the next big trade had to conceptualized. It is not clear what that big idea is yet, although last Monday did see more Stock Connect activity after the previous Friday’s 40 basis point cut in lending rates.

The outstanding issue of tax had been solved, for now at least, when it was announced that taxes would be waived until further notice on A share trades across all access schemes.

Until now, UCITS funds were unable to invest in Stock Connect, as Luxembourg, home to majority of European UCITS, has a law that says funds are not allowed to buy funds where they are not recognized as the beneficial owner of the securities, which until now has been deemed to conflict with the legal framework of the Stock Connect, where beneficial ownership is less equivocal.

Irish and Cyprus UCITS funds have been able to use the Stock Connect platform, but in terms of potential flows they are small compared to Luxembourg funds, which account for approximately 80-85% of European UCITS assets under management

The UCITS funds on the sidelines are not necessarily China-focused. If they were China-themed, then they logically would already have some operating arrangement in place, such as a QFII program.

“Most UCITS funds have a 5% discretionary exposure that they can take to anything to they want,” says Barnaby Nelson, regional head for Northeast Asia and Greater China transaction banking at Standard Chartered. “There are a lot of global and Asian funds saying they’d be happy to rack up exposure to Stock Connect A shares without having to rewrite their prospectuses.”

Funds could express a China view in another way, such as via P notes or red chips.

Nelson says that in his firm’s experience the P Notes desk was busy during the Stock Connect launch period, which is the reverse of what one might expect if P Note users were thinking about possibly getting into direct stock investment.

His interpretation of that activity is that P notes have no ambiguity regulatory-wise about how they can be used, although such derivatives cannot be used in the portfolio of long only funds and UCITS funds in Europe, only for institutions doing it for their own money.

“There is a huge volume of Luxembourg managers keen to take on some basic China exposure. They’re the first injection of quota consumption,” predicts Nelson. “There should be some moment in Q2/2015 when those managers will jump in, individually in a small way, but forming cumulatively a much larger amount.”