China’s stock market has achieved many milestones in the past 12 months, including surpassing Japan as the second largest in the world, based upon market capitalisation. Despite this astounding growth, a fully scalable offshore securities lending model has yet to emerge. Whilst the long-term prospects look promising, recent market volatility and a shift in regulatory priorities away from further liberalization is likely to delay the emergence of a viable offshore securities lending model in the near term. We explore the state of play.
Does an offshore lending model exist?
A lending model for offshore holders of Shanghai listed A-Shares exists, but its use remains limited. As of 02 March 2015, short selling of certain eligible Shanghai listed securities has been allowed using the Shanghai-Hong Kong Connect Scheme (“the Connect Scheme”).
Participation in the Connect Scheme lending model remains limited due to various restrictions in place that curb both lending supply and end-user demand.
How does the HK-Shanghai Connect Model work?
Lending via the Connect Scheme can only be conducted via eligible Connect Participants. Lenders of securities via the Connect Scheme must either be exchange participants or designated as a “Qualified Institution.”
For the purpose of lending, designated Qualified Institutions are Funds, Unit Trusts and Collective Investment Schemes which are registered to carry out Type 9 (asset management) regulated activity. Further, Qualified Institutions are only permitted to lend assets they hold on a principal basis.
Securities lending volumes remain muted due to various regulatory restrictions surrounding lending via the Connect Scheme. In its current state, the model is not viewed as being scalable enough to realize the significant potential returns of the Chinese market.
What is the current regulatory approach of the CSRC?
Regulatory momentum behind the development of a viable offshore model has stalled since the sharp decline in the mainland China equity markets in June. The Chinese Regulatory Securities Commission (CSRC) has increasingly focused on overall market stability versus further market liberalization.
Over the long term, however, we are optimistic that the CSRC will look to introduce reforms to the offshore securities lending market. The CSRC has historically taken a structured and measured approach to market liberalization. As offshore holdings of A-Share securities grow, the ability of lending to improve market liquidity and allow investors to manage risk will align with the CSRC’s broader objectives for market stability.
What is the timeframe for a lending model to emerge?
Inclusion of A-Shares into global benchmark indices is essential to the development of offshore lending. FTSE has already begun to add A-shares to some global benchmarks, while MSCI commented in a June review that further liberalization of Chinese capital markets will be needed to support the addition of A-Shares to the Emerging Markets benchmark.
Although index providers are currently taking a measured approach, A-Share securities financing is expected to grow significantly as both index providers and offshore investors increase their exposure to China’s capital markets.
We expect that a scalable offshore lending model is likely to emerge in the next two to five years as overseas institutions rapidly increase their A-Share holdings and China’s regulatory priorities shift back towards further market liberalization.