The top five hurdles facing Bond Connect in 2018
Bond Connect launched on 3 July 2017, opening up a fourth major channel for foreign investors to access the Chinese onshore bond market, after the QFII, RQFII and CIBM Direct programmes.
This latest scheme offers a few advantages over its predecessors, including the ability to directly trade on the Chinese interbank bond market through offshore accounts and the absence of investment quotas.
But foreign investors continue to face several hurdles when it comes to using Bond Connect, and the Chinese onshore bonds in general, despite the allure of investing in such a large market, experts told AsianInvestor.
We identified the five areas that foreign investors find most frustrating. If Beijing and Hong Kong can improve conditions in each of these areas it would help encourage more investor flows into China's renminbi bond market.
1. Realtime delivery versus payment
Onshore settlement of Bond Connect trades, including payment and delivery of bonds, is handled by two domestic custodians, the Shanghai Clearing House (SCH) and the China Central Depository & Clearing Co. (CCDC). But CCDC has yet to implement a realtime delivery versus payment (DVP) process, in which the delivery of the bond and the cash payment for the instrument are synced.
“Basically there’s the gap between how you reconcile, or how the bond and the cash can be received at the same time,” Sally Wong, chief executive of the Hong Kong Investment Funds Association (HKIFA), told AsianInvestor. “If I give you the securities, I want the cash [for them] at the same time instead of waiting for three hours before I can get it, or else I will be exposed to counter party risk.”
“It’s not DVP, and technically speaking you’re exposed to that counterparty,” agreed Ashley Perrott, UBS Asset Management’s head of Asia fixed income.
Representative from the Bond Connect Company Limited (BCCL), a joint venture between the China Foreign Exchange Trade System (CFETS) and Hong Kong Exchanges and Clearing Limited (HKEX), confirmed to AsianInvestor that the issue was being worked on by Chinese and Hong Kong regulators, but did not provide a timeline. However, observers hope it is solved in the coming few months.
“I would think it’s fairly imminent, and hopefully a first quarter issue that would get resolved,” Perrott said.
2. Ucits funds approval
The DVP issue is closely related to the next hurdle: getting approval for Ucits funds to use Bond Connect.
Undertakings For the Collective Investment of Transferable Securities (Ucits) is a European Commission-approved regulatory framework that oversees the management and sale of mutual funds. Many European investors use the Ucits funds (often listed in Luxembourg or Dublin) that invest into other regions.
However, so far no Ucits funds have been approved to use Bond Connect. A big reason for this is due to the delivery versus payment issue.
“The key principal is to ensure that the assets are properly segregated and the assets won’t be exposed to additional counter party risk,” Wong explained. “You can say it’s a deal breaker from the perspective of Ucits approval using the Bond Connect.”
The practical impact of this is that Bond Connect is not gaining a great deal of traction with European investors at the moment, and this is likely to be a sticking point until the approval comes through, said Karan Talwar, the emerging market fixed income specialist at BNP Paribas Asset Management.
The lag in getting Ucits funds approval may also be due to the relatively recent development of the Chinese onshore bond market, said UBS’s Perrott. “It takes potentially even more time for regulators outside of China to get comfortable with it,” he said.
To that effect, BCCL has been working with overseas regulators and institutional investors to address any questions about Bond Connect, the company's representative told AsianInvestor. But they declined to offer an estimate as to when the first approval for a Ucits fund to use Bond Connect would arrive.
3. Lack of hedging options
Another major hurdle for investors looking to Bond Connect is that it deals primarily in cash bonds, which limits the ability for foreign investors to hedge the currency or the interest rate.
“If you invest in China, can you hedge the currency risk? Can you hedge duration risk onshore, or interest rate risk?” Manu George, senior investment director of Asian Fixed Income at Schroder Investment Management, told AsianInvestor, reflecting on the concerns of foreign investors.
“A lot of derivative instruments [that are] available onshore, they will not be able to access. So if they want to hedge the risk, interest rate, forex, they probably have to do it offshore,” HKIFA’s Wong added.
This issue is partly mitigated by the fact that foreign investors can manage risk through other routes, such as the CIBM Direct programme, which trades onshore interest rate derivatives. “It’s much easier now to hedge certain exposures, so if you want to hedge out the currency risk, you can now do it through different channels,” BNP Paribas AM’s Talwar said.
However, hedging strategies that require accessing the market through different channels may be too much work for investors, negating the efficiency advantages of Bond Connect. “Depends on which channel you use, you can hedge one or the other—the challenge is how do you get a quick and clean way of accessing the onshore market,” George said.
The BCCL representative said the company is exploring other Bond Connect-related hedging instruments, but offered no timeline.
4. Reliance on Tradeweb
Currently all offshore trade orders on Bond Connect are transmitted through electronic market platform Tradeweb, while the China Foreign Exchange Trade System (Cfets) handles the onshore trade matching and executing.
The performance of Tradeweb is not an issue, but the fact that it is the only offshore platform might deter potential investors who are already using other electronic trading platforms, Wong said.
“They probably don’t want to have another arrangement or contract with another platform, and also probably their internal setup and the linkage with, for example, Bloomberg, or others that they have in place,” she explained.
However, Tradeweb’s large global footprint, with over 2,000 buy-side institutions in its client base, including pension funds, asset managers, banks, and insurance companies, should lessen the impact of this hurdle, Perrott argued.
“I don’t think it’d be a huge issue,” he said. “I would think most of the big firms around the world have got relationships with Tradeweb.”
BCCL’s representative said the company is planning to add more access platforms in the future, but again did not comment on when this is likely to take place.
5. Complicated onshore schemes
The final hurdle is more to do with the variety of means to access China’s bond ecosystem. Bond Connect, the qualified foreign institutional investor (QFII), renminbi-QFII, and CIBM Direct all allow foreign investors to gain ownership of Chinese bonds, but each scheme presents investors with a different set of challenges.
“Each channel is structured differently and offer access differently, and global fund managers and investors need to do due diligence, testing, and study each and every channel individually,” Wong said. “This takes time and adds to the complexity and costs.”
When deciding between these different channels, investors have to take into account whether they want access to the entire bond market or access smaller parts such as onshore derivatives, George explained, as well as weighing the different sets of rules and regulations for each.
“These questions make it challenging for some of the large international investors to be wholeheartedly comfortable in wanting to get involved in China,” he said.
A further wrinkle is the fact that the channels are not fungible, Wong said. “If I buy a bond through CIBM Direct, I cannot sell it via Bond Connect,” she explained.
For Talwar, the different onshore schemes are a positive, giving investors increased access to Chinese bonds through each successive programme and providing them with options to access the market according to their preferences.
“All of these different steps along the path have made it easier for foreign investors to access the interbank bond markets,” Perrott agreed.
The rapid rate at which the Chinese onshore bond market has opened up through these successive schemes could also be cause for hesitation among foreign investors, George said.
“If you wait a bit more, China might put on another scheme where they give you access and everything you wanted,” he explained. “Why waste your time and your scarce resource on an exercise that might be wasted if the Chinese policy makers decide to implement a new channel to access onshore China?”
It would be wise for China’s authorities to make their plans a little more clear, if they want more of the world’s investors to invest into its debt markets. The more certainty they can offer, the more likely it is asset owners and retail investors will be willing to oblige.