George Jia, Country Manager Greater China, DTCC
Since the launch of the Shanghai-Hong Kong Stock Connect in November 2014, Chinese regulators have announced a number of significant market-access reform schemes to attract more capital inflows from global investors. While many global investors have embraced these strategies, some have been facing operational challenges brought about by the lack of consistency between China’s settlement arrangements and widely adopted global post-trade standards.
Domestically, in the Chinese equity market, shares are settled on T on a gross (trade-for-trade) basis while cash is settled on T+1 on a net basis, effectively a deliver-before-pay method whereby the delivery of securities happens before the corresponding transfer of funds. In the case of China’s interbank bond market, shares and cash are settled on a trade-for-trade basis on the settlement date agreed by the counterparties (T, T+1, T+2 or T+3) using the delivery-versus-payment (DVP) method, whereby each trade settles individually by simultaneously debiting and crediting the cash and securities positions of the counterparties.
The non-DVP settlement mode in the equities market results in potential counterparty and market risk for global investors outside Asia. Time zone differences and China’s tight settlement cycle create a further challenge, as market participants are only given 3.5 hours to settle their trades in the current settlement arrangement.
Over the past few years, to help the global investment community overcome these operational challenges, market infrastructures have worked with the industry to implement enhancements. For example, in time for the expansion of the Connect program to Shenzhen in 2016, Hong Kong Exchanges and Clearing Limited (HKEX) introduced the Special Segregated Account arrangement to allow the opening of a segregated account for pre-trade validation of share ownership, omitting the need for pre-delivery to the selling broker’s account. More recently, the Bond Connect Corp Limited (BCCL) extended settlement cycles for interbank bond market trades to as late as T+3, making it more favorable for global investors.
Despite these collaborative actions, several operational challenges remain for global investors trading and settling trades in China, as the non-DVP and pre-delivery challenges in the equities market have only been partially addressed. The inclusion of Chinese stocks and bonds in major global indices in recent years makes things even more complex, as it places increased pressure on global investors that rely on a passive investing strategy to review their operational challenges for high volume cross-border transactions into China.
These operational constraints faced by global investors in the equites market have led industry lobbyists to push for Stock Connect transactions to be settled DVP on T+2, instead of the current non-DVP with pre-delivery process. There have been little action as Chinese regulators understandably focus on protecting and increasing the efficiency of capital utilization for domestic investors.
For the interbank market, lobbying for enhancements in settlement arrangements is less challenging, because the Chinese Interbank Bond Market caters to both domestic and global institutional investors. This is demonstrated through the DVP settlement arrangement made available for global investors by China Central Depository and Clearing shortly after the launch of Bond Connect, and by the extension of the settlement cycle for Bond Connect transactions.
To correct the misalignment in settlement arrangements between the Chinese stock market and other global markets, one option is to offer different settlement arrangements for retail investors and institutional investors through the creation of a standalone trading board with a DVP settlement process.
This option will allow the current T and T+1 settlement arrangement for retail investors to be maintained while an alternative T+1 or T+2 DVP settlement arrangement could be created for domestic and global institutional investors, assuming there is sufficient market demand and liquidity to justify a new trading board. This adjustment should not impact today’s market practice while providing global investors with more time to manage the settlement process and avoid trade fails due to time zone differences.
Change to industry practices is likely to take time and can only happen with collaboration between market infrastructures, the industry, policymakers and regulators. In the meantime, the most effective way for market participants to cope with discrepancies in settlement methodologies is to make the post-trade process as efficient as possible by evaluating procedures and technologies and leveraging established best practices when possible.
This article is reproduced from a July 2020 World Economic Forum Insight Report on “China Asset Management at an Inflection Point”.