With China set to open stock trading, investors lay groundwork

A trader is seen at the stock exchange in Hong Kong.
Philippe Lopez | AFP | Getty Images
A trader is seen at the stock exchange in Hong Kong.

O'Connor, the $5.6 billion hedge fund owned by UBS, has been has been expanding its presence in Asia. It has hired traders from UBS's proprietary trading desk to work in its Hong Kong and Singapore offices. In August, it hired John Yu, a former analyst at SAC Capital Advisors.

It is not alone. Bankers, brokerage firms and hedge funds have all been quietly expanding their Asian operations to take advantage of one event: the biggest opening into China in years.

China plans to connect the Shanghai stock exchange to its counterpart in Hong Kong over the next month as part of an initiative announced by Premier Li Keqiang this year to open China's markets to foreign investors who have been largely shut out.

The move will allow foreign investors to trade the shares of companies listed on the Shanghai stock exchange directly for the first time, and Chinese investors to buy shares in companies listed in Hong Kong.

The potential rewards of an open market between the mainland and Hong Kong are enormous for investors. Currently, the only way for foreign investors to trade Chinese stocks is indirectly through a limited quota program that allows a trickle of foreign money into the country.

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"This is the single most important development in China's intention to internationalize this market," one senior Western banker in Asia said of the planned reform, speaking on the condition he not be named because he was not authorized to speak publicly on the matter.

The program, called the Shanghai-Hong Kong Connect, will create the second-largest equity market in the world in terms of the market value of the combined listed companies, said Dawn Fitzpatrick, the chief investment officer of O'Connor.

"It is also going to create a much more efficient way for the global marketplace to value many Chinese companies, and this attribute alone makes the market more attractive," she added.

The formal starting date for the program has not been announced,but officials have been aiming for sometime next month. Employees at brokerage firms across Hong Kong have been working extra weekend shifts since August, participating in mock trading sessions to test their readiness for the new program. On one recent weekend, 97 brokerage firms accounting for about 80 percent of the trading turnover in the Hong Kong market simulated a failure of their backup data systems for the Shanghai-Hong Kong two-way trade.

O'Connor, for its part, is among a small group of hedge funds that have already participated in the quota program, named the qualified foreign institutional investors program. They buy and sell shares denominated in both renminbi and Hong Kong dollars.

Where to place your bets ahead of Chinese stock link
Where to place your bets ahead of Chinese stock link   

The wide-open connection will allow hedge funds like O'Connor to expand their business between the two exchanges and trade directly.

Still, challenges remain, and some significant questions have not been answered.

The program is part of a broader reform package announced by President Xi Jinping last year. Critics point to other reform initiatives, like the building of new and planned free trade zones, that have been slow to takeoff.

Last September, regulators in Shanghai agreed to let a small group of United States and British hedge funds raise $50 million each from Chinese investors as part of a pilot program. One of these firms has complained that progress has been slow and weighed down by bureaucratic hurdles.

Linking the Hong Kong and Shanghai exchanges is not a new idea.In 2007, Hong Kong officials announced a similar plan to allow Chinese investors to gain access Hong Kong's stock market. That plan never took off.

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And while foreign and Chinese investors will have the chance to invest in hundreds of companies that were previously off limits, they will still be limited by quotas. The combined two-way trading volume will be capped at 23.5 billion renminbi ($3.8 billion), about 20 percent of the combined average daily trading volume on both markets. Individual mainland Chinese investors will need at least 500,000 renminbi in their brokerage account to buy Hong Kong shares, a threshold that excludes most retail investors.

Foreign buyers of Shanghai stocks will not be able to buy shares and sell them on the same day. It is still unclear whether they will be allowed to buy shares using margin financing or to engage in short-selling. And, in another hurdle, all trades will be settled in renminbi, introducing additional risk for foreign investors.

There are also unresolved issues over taxes. Foreign investors in mainland China's stock markets are technically liable for paying capital gains taxes, but China has historically not taxed such investments under the existing quota scheme. It remains an open question whether that practice will change.

Given these and other uncertainties, companies like MSCI — which compiles indexes that are tracked by funds with trillions of dollars invested in stocks around the world — have so far declined to include mainland Chinese shares in their indexes.

That could change as soon as next year, when MSCI is next scheduled to review Chinese shares.

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"Were China's domestic A-shares to be included in the MSCI benchmarks, it would be a game-changer, attracting billions of dollars of capital," analysts at HSBC in Hong Kong wrote this month in a research report.

Regardless, some investors are pushing ahead.

Before he was hired by O'Connor, Mr. Yu was a China analyst at SAC, which since April has become a $10 billion family office called Point72 Asset Management. He will be based with O'Connor's Asia team in Hong Kong. BlueCrest Capital Management, a hedge fund based in London, also recently hired several SAC traders.

Charles Li, the chief executive of Hong Kong Exchanges and Clearing, the stock market operator, has been forthright about the limitations of the trading program.

"It's not perfect," Mr. Li wrote in a post on his official blog last month. "While we have managed to find a solution to most of the challenges of aligning two very different markets, some of the differences were so significant that our solutions will inevitably constrain the market."

Mr. Li added that, despite these constraints, "I believe that it is important to move forward rather than such an important opportunity pass us by."