Regulators in Hong Kong and China recently announced the imminent launch of “Stock Connect” on next Monday, November 17, 2014.¹  Stock Connect gives a wide array of fund managers, private investors, and other market participants their first means of trading Shanghai-listed equities. According to the joint release of the China Securities Regulatory Commission and the Hong Kong Securities Futures Commission, “the necessary trading and clearing rules […] and other regulatory and operational arrangements have now been finalized. The stock exchanges and the clearing houses have […] reported that the systems are ready”. But with day 1 of trading fast approaching, what can investors do to prepare?

Get to Know the Trading Rules

Stock Connect permits buy-orders only when market-wide quotas are available. Quotas, while available to all market participants, may initially be in short supply because they rely on a rough balance of buy and sell orders placed through the program. But on the first day of trading, there will be no sell orders. It may take time for buy-and-sell orders to balance out.

While participants in Stock Connect are largely subject to Hong Kong law (they are trading using Hong Kong brokers and a subsidiary of the Hong Kong Stock Exchange), Chinese and Shanghai Stock Exchange rules will apply to shareholdings. As a result, Stock Connect participants should get to know local rules on foreign ownership limits, short swing profits and large shareholder disclosures.

Reach Out to Existing Hong Kong Brokers

Fund managers and other Stock Connect investors should first confirm whether their brokers are participating in the program—Stock Connect allows any investor to participate via their Hong Kong broker, but not all brokers have elected to participate. Brokers may also ask their clients to update brokerage agreements to reflect, inter alia, the Chinese securities regulations described above, as well as prohibitions on intra-day trading, naked short-selling and OTC transactions in Stock Connect securities.

Consider the Custody Implications

Stock Connect raises several issues related to custody, particular for UCITS and U.S. retail funds. Among other things, securities in the program may be held in a broker’s clearing account (i.e., outside of a custodial account) during a “trade pre-check” process on the day before a trade. Furthermore, although trades originate with Hong Kong brokers’ orders, they are ultimately cleared through China’s central clearinghouse, ChinaClear. The program permits Hong Kong Securities Clearing Company Limited (“HKSCC”) to act as a nominee within ChinaClear on behalf of the ultimate beneficial owners (e.g., Stock Connect investors). This practice has generated concern among market participants in the event of a dispute or insolvency of HKSCC, because the concept of beneficial ownership under Chinese law is not officially recognized in many other regulatory contexts. However, Stock Connect regulations expressly extend the concepts of beneficial ownership and nominee holders into China: the terms of the program provide that beneficial owners possess the rights and benefits of Stock Connect securities (including the rights to receive dividends and send voting instructions to HKSCC).²  Furthermore, if HKSCC were to become insolvent, the regulators have stated that Stock Connect securities would not be regarded as general assets of HKSCC.

While these are promising developments, investment advisers (and particularly managers of retail funds) need to consider Stock Connect’s custody arrangements closely. Many UCITS depositaries are still evaluating the complex web of custody under Stock Connect—some custodians may not initially participate in the program due to these uncertainties. U.S. retail funds need to assess Stock Connect under their existing foreign custody arrangements. We can outline some of the remaining issues and assist managers in this process. Dechert’s financial services group will provide additional updates on Stock Connect as market practice develops.