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Hong Kong's off-exchange derivatives market is thriving as foreign funds prevented from using a landmark Hong Kong-Shanghai trading link by technical and regulatory hurdles look for a back door to gain exposure to China's record-breaking stocks rally.
The development is a blow for Beijing, which has long-feared an influx of anonymous, footloose foreign money could increase volatility in China's already wild stock markets, and comes as regulators globally look to clamp down on opaque off-exchange trading.
Some of the biggest global banks were already able to offer so-called "synthetic" equity products that provide clients with exposure to mainland China stocks, known as "A-shares", using shares purchased through restricted investment quotas.
Because such over-the-counter (OTC) derivatives are traded off-exchange, the identity of the underlying investor, and the size of the market, is often unclear to regulators.
By allowing foreign investors to trade Shanghai shares directly via the more transparent Hong Kong exchange, Beijing had hoped Stock Connect, launched on Nov. 17, would kill off this multi-billion dollar grey market.
But for many U.S. and European funds grappling with the scheme's operational and legal quirks, including unusual settlement rules and confusion over share ownership rights, OTC products remain the only way to gain exposure to China stocks.
And because any Hong Kong broker can now snap-up Shanghai shares, business in these products is booming.
Several brokers and fund managers told Reuters that the vast majority of trading on Hong Kong-Shanghai Stock Connect is happening away from Beijing's gaze in Hong Kong's OTC market.
"Synthetic equity products are the main vehicle for accessing the A-share market at the moment," said Stephane Loiseau, head of cash equities for Asia-Pacific at Societe Generale in Hong Kong.
"Because of the regulatory and technical challenges, it's the only way to trade for most investors. It doesn't look like this is going to change unless access to Stock Connect is made easier for institutional investors. "
In the meantime, these funds are buying so-called p-notes - relatively simple products that entitle the investor to the performance of a Chinese stock, or basket of stocks, that the brokerage actually purchases and holds on its own books. P-notes command higher fees than standard trading services, sometimes costing up to twice as much as an on-exchange trade, said one asset manager.
Less regulated funds, meanwhile, have been buying more complex, higher-value equity swap products which are often very profitable for the bank that typically finances the trade.
An equity swap involves counterparties agreeing to exchange two future cashflows, known as "legs" - one leg might be pegged to a market interest rate, for example, and the other tied to a stock or index performance.
"We have all types of clients trading synthetics, including long-only institutional funds," said Sebastien Mailleux, head of forward trading, Asia, at BNP Paribas Securities in Hong Kong. BNP's synthetic trading activity on A-shares has been fairly evenly split between p-notes and equity swaps, he added.
Hong Kong, which serves as a regional hub for many banks, is home to Asia-Pacific's most active OTC equity derivatives market, accounting for around 34 percent of regional turnover with a notional value of roughly $1 trillion, according to end-2012 data published last year by consultancy Celent. Information on China A-share equity derivatives was not available.
Data on p-note activity in Hong Kong is not available, so it is difficult to assess the size of the market, but by comparison the value of outstanding p-note investments in India - where such products are also actively traded by foreign investors - stood at around $40 billion in October.
China stocks have soared more than 25 percent over the past five weeks, driven by a surprise cut in interest rates on Nov. 21, but trading has been volatile, with the Shanghai Composite Index posting its biggest one-day fall in 5 years on Dec. 9.
Concerns that the OTC grey market might exacerbate such volatility are not Beijing's only worry.
Synthetic equity products do not typically confer ownership or voting rights to the end investor, a critical means of boosting corporate governance among China companies, said Sally Wong, chief executive of the Hong Kong Investment Funds Association.
She added: "For the mainland regulators, a key objective of Stock Connect is to diversify the investor base with the ultimate objective of boosting corporate governance."