Connect's pre-trade checking 'solution' fails to take off

Hong Kong’s new segregated accounts system could end up as another Stock Connect failure amid a muted reaction from the market more than a week after going live.

The city bourse’s attempt to address criticisms over pre-trade checking rules has received mixed reviews and faces the fate of its disappointing short-selling system. Market participants have so far opened a mere 40 accounts under the new segregated system.

The lack of a synchronised cash settlement on the new system has created counterparty risks for investors, especially those overseas, adding to the list of criticisms.

Under the special segregated accounts system (SPSA), which went live on April 20, custodians on behalf of their clients can now open segregated accounts on Hong Kong Exchanges and Clearing’s (HKEx) central clearing and settlement system.

The new system aims to help eliminate worries over pre-delivery of shares on the Hong Kong-Shanghai Stock Connect, whereby custodians would have had to transfer shares to a broker a day before it can be sold. This model left open worries over potential holes in trading strategies.

The new scheme attempts to bypass the issue of pre-delivery on HKEx’s clearing and settlement system by taking a snapshot of an investor’s A-share positions held under its custodian.

But the new system, which has so far seen 40 SPSA accounts opened by local, mainland and international market participants, has received mixed reviews.

Eugenie Shen, a managing director at the Asia Securities Industry & Financial Markets Association, said that one of the biggest problems now could be the lack of synchronised cash settlement.

If an investor orders the sale of A-share stock on a Friday, for example, the shares being sold would need to be transferred to the buyer on the same day, but the seller would only receive payment for it on Monday, presenting counterparty risk over the weekend.

“That is not acceptable to most institutional investors and especially funds which have retail investors.  A model that can provide [delivery versus payment] will be much more useful,” said Shen.

However, some brokers in the market are currently filling in this space by providing synthetic DVP. Some brokers are giving sellers cash for their shares on T+0 and settling the shares with HKEx’s Hong Kong Securities Clearing Company on the same day, while taking on the risk by receiving cash from HKSCC on T+1.

Similarly, the short amount of time for settlement could also mean that a limited number of foreign investors, especially those outside of Hong Kong, could be left out.

Within a span of two and a half hours after every trading day – between 3pm and 5:30pm when Stock Connect closes and when settlements must be made – market investors and intermediaries must set off a chain reaction from the broker to the global custodian, local sub-custodian and finally to HKEx, to ensure same-day settlement.

“The reality is that many of those steps just can’t be done in two and half hours, especially if investors are not set up in Asia, such as US funds based on the east coast or west coast,” said the broker.

“Are they awake at all? Are their systems up and people working? Even if they are, what about the custodians? Are their systems up and running?”

The list of complaints from market players has led to worries that segregated accounts could end up like HKEx’s unsuccessful launch of short-selling, which has processed no orders so far due accusations that the system is overly restrictive.

“It’s not a particularly useful model,” said another broker, who declined to be named. “One of the things we need to look out for is whether there is going to be a repeat of short-selling, which began in early March and so far not a single order has gone through.”

The broker has yet to help his clients set up segregated accounts, despite having customers in Europe and the US aware of SPSA and its upsides and downsides for the past month. However, he still expects some clients may be interested in the system in the future.

“I think everyone is looking for someone else to be the test. They want some other funds to go first and once it’s all settled down then maybe they’ll think about it,” said the broker.

Arthur Tse, legal counsel for AllianceBernstein, said that there was room for improvement: “The model could certainly be improved upon. What the market has right now is a good starting point, and I am sure some fine-tuning will be needed along the way to get us to the optimum point.”

Tse, who is currently looking to sign up to SPSA, noted that a challenge the market is currently facing is having to deal with the huge amount of paperwork involved with signing on different brokers and different custodians to get their fund ranges and separate institutional accounts on board.

“Each of the funds and separate accounts may use different global custodians and sub-custodians, and they will want to have the ability to execute trades through a broad range of brokers to achieve best execution,” noted Tse.

“Each of these arrangements will have to be separately documented by paperwork, which are independent from global arrangements.”