Prime brokers rethinking QFII strategy

Sep 7, 2014

As China opens its capital account, the country's foreign investor quota system is seen as declining in importance. In the second of two articles, AsianInvestor examines how prime brokers are responding.

Prime brokers in Hong Kong are considering changing how they use their qualified foreign institutional investor (QFII) quotas because Stock Connect will offer investors an alternative method of accessing China’s A-share market.

They are likely to see their commissions shrink as investors will no longer need to rely on their QFII quotas to trade Chinese equities onshore.

Because the Shanghai and Hong Kong bourses will impose the quotas, foreign investors who trade A-shares through the link will not need to have a quota themselves or rely on a broker's quota.

That would free up some investment banks’ QFII quota for other Chinese securities. Likely candidates are Chinese convertible bonds with an A-share option embedded.

As a result broker-dealers, who have been investing for clients via the QFII quota system since it was introduced in 2002, will lose their stranglehold on access to China’s capital market.

Several sources that AsianInvestor spoke to said they were thinking about how to restructure their business as a result, including how to use their QFII quotas for purposes other than trading Chinese equities.

Nathan Davison, Asia head of prime services distribution at Barclays, said the bank's equities division is exploring how its QFII business will evolve. Other options include conducting more exchange-traded funds and index-related business. He declined to go into further detail.

One issue fund managers face is that many would like to run a Chinese domestic convertible bond position strategy but cannot, as they either do not have their own QFII quota or their prime brokers have used their QFII quota to access equities.

In such a convertible arbitrage trade, the manager would go long an A-share convertible bond that is deemed undervalued and short the equivalent H-share to hedge the equity market risk, which would produce a market-neutral position.

Some brokers say the more popular of these securities traded by convertible arbitrage managers are those issued by Bank of China and Ping An Insurance.

However, prime brokers also say that as managers tend to hold convertible bonds for longer and trade them less frequently than equities, they would probably charge a higher price for the former.

Until Stock Connect goes live, expected in October, investors can only access China’s equity market with dollars using QFII quota, either their own or their broker’s. But the trading link will enable investors to trade directly through the exchanges without the need for individual quota.

A daily quota of Rmb3 billion ($2.1 billion) will be in force for northbound trades – that is, for offshore investors to trade A-shares on the Shanghai Stock Exchange. Southbound trades – mainland investors trading H-shares – will be subject to a quota of Rmb10.5 billion. The quotas apply only to buy orders.

Banks that have a large portion of their quota allocated to products – such as participatory notes and swaps – used to access China's market, could be left with a hole in their budget and earn fewer commissions.

One example is a China A-share/H-share spread trade, which some relative-value hedge funds have engaged in using their prime brokers’ QFII quota.

The trade relies on a stock dual-listed across both markets being cheaper in Shanghai than in Hong Kong.

Davison expects many managers who trade the A-share/H-share spread to be likely to execute through Stock Connect when it launches.

Because access to A-shares has been limited, many H-shares have been trading at a premium to their mainland counterparts. But this differential is likely to narrow after Stock Connect comes in as investors look to sell H-shares and buy A-shares to benefit from the premium, argued some, such as CLSA's Andy Maynard.

As at the end of July, Beijing has awarded a total of $57.9 billion QFII quota to foreign financial institutions.

To read a full feature story on prime brokers’ QFII business, see the September edition of AsianInvestor magazine.