Launch of Shenzhen-Hong Kong Stock Connect: New opportunities for Luxembourg funds

The Shenzhen-Hong Kong Stock Connect (“Shenzhen Connect”), the link between the Shenzhen and the Hong Kong stock exchanges, was launched on Monday, 5 December. Shenzhen Connect is another milestone in deepening mutual access between the capital markets in China's mainland and Hong Kong. Shenzhen Connect is the second link of its kind to boost the opening up of the mainland China's capital market after a similar link between the Shanghai and Hong Kong exchanges was launched in 2014. The market infrastructure arrangements under Shenzhen Connect replicate those provided for under the original Shanghai-Hong Kong Stock Connect (“Shanghai Connect”) pilot programme.

The Shenzhen Connect is aimed at giving global investors access to stocks in the tech-heavy Shenzhen market via Hong Kong Stock Exchange (“HKEX”), it provides access to China’s new economy. A total of 417 stocks on the HKEX are eligible for trading, and 881 stocks are eligible on the Shenzhen Stock Exchange (“SZEX”). The list of stocks that are eligible for Northbound trading is available in the Stock Connect section of the HKEX website and will be updated daily.

Before Shenzhen Connect went live, HKEX has completed three rounds of connectivity testing and market rehearsals to ascertain technical readiness of the market infrastructure and operational readiness of market participants.  One hundred forty-two China Connect Exchange Participants (CCEPs) are expected to be eligible to participate in the two Stock Connect programmes from 5 December 2016, while other Exchange Participants (EPs) can also apply to become CCEPs later upon satisfaction of relevant requirements[1].

Luxembourg investment funds have traditionally been exposed to the Chinese capital markets through different schemes and channels. Marc-André Bechet, Director Legal & Tax at the Association of the Luxembourg Fund Industry (ALFI) outlines that “China has emerged as one of the world’s leading economies following decades of growth that has hovered around 10% annually. The Shenzhen Connect provides international investors with another direct link to access China’s domestic A-shares market outside of the existing route of getting a foreign investor license through the Qualified Foreign Institutional Investor (QFII) and Renminbi QFII (RQFII) programmes. Practically, Stock Connect allows managers to increase their China A-Shares exposure via an alternative channel without having or using their own QFII or RQFII license or quota. Stock Connect also allows managers without a QFII or RQFII license to increase their China A-Shares direct exposure without having to rely on more expensive China A-Shares access products.”

Luxembourg acts as China ́s gateway to Europe and vice versa and is one of Europe ́s leading centres for international RMB business. In April 2015 the People's Bank of China granted a 50 bn RMB RQFII quota to Luxembourg^[2]. Subsequently, increasing numbers of international asset managers are choosing Luxembourg as the domicile for their funds ranges that invest into China.

Access to a new asset class

Luxembourg UCITS are marketed in up to 70 different countries, so setting up a UCITS which invests in China through the Stock Connect links or through RQFII gives access to not only an asset class but re-inforces the interest of an international investor base for Luxembourg products, which is extremely beneficial regarding distribution. Luxembourg was the first European jurisdiction to authorise the use of an RQFII quota in the context of a UCITS fund back in 2013. After the launch of Shanghai Connect in November 2014 a Luxembourg UCITS fund has become the first to receive authorisation to use the Stock Connect programme and since that time over 125 additional UCITS have received authorisation. Supported by the continuous engagement by ALFI, the Luxembourg fund industry embraced the new access link and the first UCITS funds used Shenzhen Connect from the beginning. The CSSF confirmed that it accepts the new programme on a similar basis as the Shanghai Connect programme two years ago.

A number of Luxembourg UCITS have already seen the opportunity offered by this second link and sent their applications to the supervisory authority or are about to update their investor information and where necessary the legal and contractual documentation.

Factors to consider by Luxembourg funds

There are a number of factors which require careful consideration and appropriate solutions for those Luxembourg UCITS funds considering accessing this market through the Shanghai or Shenzhen Connect. The Luxembourg UCITS fund, the management company and depositary designated by the fund must give due consideration to a number of factors and ensure that their risk management procedures adequately cover them. These factors include:

• accounts opened by the depositary of the UCITS with a sub-custodian in Hong Kong are segregated at the level of the UCITS' sub-funds or structured as UCITS client assets omnibus accounts of the Luxembourg depositary with that sub-custodian;
• broker models limiting counterparty risk are to be preferred;
• the prospectus, and most particularly the KIID, will contain a specific disclosure to inform investors of the specific legal risks linked to compulsory requirements of the local CSDs, HKSCC and ChinaClear for custody of securities on a cross-border basis.

Furthermore, as the market infrastructure arrangements under Shenzhen Connect align with those provided for under the original Shanghai Connect pilot programme, launched in November 2014, most of the disclosures needed for implementing Shanghai Connect are still valid and will also similarly apply for the Shenzhen Connect.

Moreover, as a general rule the prospectus shall provide an indication to which extent the new programme will reflect the investment strategy of a UCITS compartment or whether the new programme is simply added as one additional way of investing in Mainland China.

Given that Shenzhen Stock Exchange gives access to corporates of small and medium size and operating in other economic sectors than the entities listed on Shanghai Stock Exchange, the investment policy of the UCITS intending to invest through Shenzhen Connect must ensure that investor information is in line with this specific asset class and sector.

Finally, as a general principle, the UCITS, its management company, the appointed portfolio managers, its depositary must undertake and maintain their usual due diligence and suitability testings on the additional market framework and practices, on the assets to be invested as well as on the settlement and custody processes before considering investment. In particular, procedures for identifying and monitoring specific risks that may imply these investments must be in place or adapted accordingly before using the Shenzhen Hong Kong Stock Connect.