After MSCI’s recent announcement on the inclusion of China A-Shares in its Emerging Markets Index and other major global indexes, the inaugurated launch of the long-awaited Bond Connect scheme today marks another significant breakthrough in China’s capital market development, coinciding with the celebration of the twentieth anniversary of the formal establishment of the Hong Kong Special Administrative Region.
Bond Connect is a new mutual access scheme for offshore investors to access the mainland China bond market (“Northbound Trading”) and for onshore investors to access the Hong Kong bond market (“Southbound Trading”) through a market infrastructure linkage between the mainland China and Hong Kong.
The initial phase of Bond Connect only supports Northbound Trading. Southbound Trading will be explored at a later stage. This article will primarily examine the key features and legal issues relating to Northbound Trading.
King & Wood Mallesons had the honour of acting as the legal adviser to the China Foreign Exchange Trade System & National Interbank Funding Centre (“CFETS”) in developing this ground-breaking initiative. If your institution is considering investing through, or offering services relating to, Bond Connect, we would be delighted to advise on the key legal issues and/or assist with the relevant documentation.
A list of the key rules and regulations relating to Bond Connect are set out at the end of this article.
Recap on the current state of the China bond market
Market size and structure
The mainland China bond market is the third-largest in the world after the US and Japan, comprising the China interbank bond market (commonly referred to as “CIBM”) and an exchange-traded bond market. In May 2017, the amount of bonds issued in the PRC market amounted to a total of RMB 2.9 trillion (approximately USD 427.3 billion), with a depository balance amounted to RMB 67.1 trillion (approximately USD 9.9 trillion).
CIBM is an over-the-counter wholesale market, which accounts for over 90% of outstanding value and 80% of trading settlement of the mainland China’s overall bond market. Participants in CIBM include mainly financial institutions and also various investment vehicles, including pension funds, mutual funds and private equity funds.
Exchange-traded bond market (Shanghai Stock Exchange and Shenzhen Stock Exchange)
The exchange-traded bond market is retail-oriented, and accounts for less than 10% of the mainland China’s overall bond market.
Potential for foreign participation in China’s bond market
Over the past decade, China has made significant progress in developing its bond market, with measures ranging from steadily liberalising interest rates to gradually easing capital controls.
As of the end 2016, foreign holdings of China’s domestic bonds have reached a new high of RMB852.6 billion (approximately USD125.7 billion), 13% higher than the previous year.
Clearing and settlement for mainland China bonds
There are three central securities depositories for the mainland China’s bond market as below:
- China Central Depository & Clearing Co., Ltd (“CCDC”) and Shanghai Clearing House (“SCH”) are responsible for custody and settlement for the CIBM; and
- China Securities Depository and Clearing Corporation (“CSDC”) is the custodian, settlement and clearing house for the exchange-traded bond market.
Snapshot of the infrastructure and key participants of Bond Connect
This diagram illustrates the infrastructure, and interaction between the key participants, of Bond Connect. We have included a brief explanation of the key roles and functions of each party involved in Bond Connect below.
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Trading and settlement of bonds under Bond Connect – what do market participants need to know?
Home rules principle
Bond Connect will abide by the relevant laws and regulations of the bond markets of Hong Kong and the mainland China. Foreign investors investing in the CIBM through Northbound Trading will be subject to the CIBM bond market regulations in China. This is similar to the principles applicable to foreign investors investing in CIBM through the existing QFII/RQFII regimes.
According to the Bond Connect Interim Trading Rules, CFETS will determine the eligibility of offshore investors according to the criteria set out in PBOC Notice No. 3 of 2016 and PBOC Notice No. 220 of 2015 (please refer to our previous article for more information).
Offshore investors eligible to trade through Bond Connect include:
Eligible bonds under Northbound Trading
Eligible offshore investors under Northbound Trading may conduct spot trading of all cash bonds currently traded in the CIBM (for example, national bond, local-government debt, central bank bond, financial bond, corporate credit bonds, inter-bank deposit receipts and asset-backed securities). Based on the published rules, eligible offshore investors will have access to the primary and secondary bond market through Northbound Trading.
It is expected that the scope of eligible products may expand to include transactions such as bond repurchasing, bond lending, bond forwards, interest rate swap and forward rate agreements in the future, although these products are not permitted under the existing scope of Northbound Trading.
No specific investment quota limit
According to the rules and regulations published to-date, there is no investment quota limit for Northbound Trading.
Eligible offshore investors are required to comply with the following filing procedure with the PBOC Shanghai headquarter to trade through Bond Connect:
- an eligible applicant may file an application through a qualified institution with PBOC;
- PBOC will issue a filing notice within 3 working days upon PBOC’s acceptance of the filing application; and
- upon receipt of the PBOC filing notice, the approved offshore investor can apply to CFETS for trading account opening.
What are the trading days and hours for Northbound Trading?
Trading days: CIBM trading days in mainland China (regardless of whether it is public holiday in Hong Kong)
Trading hours: 9:00 am to 12:00 pm and 13:30 pm to 16:30 pm (Beijing time)
How is a spot bond trade concluded under Northbound Trading?
Trades under Northbound Trading will be executed through a “request for quotation” mechanism between an eligible offshore investor and an onshore market maker at CFETS, subject to a minimum order size of RMB1 million (approximately USD147,520). Broadly speaking, the procedure for concluding a spot bond trade under Northbound Trading is as follows:
Custody, clearing and settlement arrangement for Northbound Trading
The basic arrangements for the custody, clearing and settlement under for Northbound Trading are as follows:
(a) All registration, custody, clearing and settlement services in respect of Bond Connect trades are provided jointly by:
- Central Moneymarkets Unit (“CMU”) and Central Securities Depository (“SCH”) jointly – SCH is the ultimate CSD and CMU is the nominee holder of the Eligible Bonds; and
- CMU and CCDC jointly – CCDC is the ultimate CSD and CMU is the nominee holder of the Eligible Bonds.
(b) Gross DvP settlement method
Northbound Trading transactions will be cleared and settled on a gross and delivery versus payment (“DvP”) basis.
(c) Payment mechanics
Payments (including funding for bond trades concluded via Bond Connect and interest accrued from such bonds) are made on a real-time gross basis between CMU and SCH/CCDC through Cross-Border Interbank Payment System (CIPS).
(d) Settlement finality
Both SCH and CCDC have published rules to recognise the finality of settlements made via SCH/CCDC.
How do eligible offshore investors fund the purchase price for a bond trade under Northbound Trading?
Eligible offshore investors can either use Offshore RMB (CNH) or FX converted into Onshore RMB (CNY) to purchase a CIBM bond under Northbound Trading.
Using Offshore RMB (CNH)
Eligible offshore investors using their own Offshore RMB to fund its bond investments through Northbound Trading do not need to appoint an RMB Participating Bank or open a segregated RMB capital account.
Using Onshore RMB (CNY) through FX conversion
An eligible offshore investor can use FX (in whole or in part ) to fund its bond investments through Northbound Trading. An eligible offshore investor intending to use FX to fund its purchase of CIBM bonds under Northbound Trading must open a segregated RMB capital account with an eligible RMB Participating Bank in Hong Kong to convert its FX into Onshore RMB.
There are certain restrictions in using Onshore RMB to fund its Northbound Bond Connect trades, including:
- all Onshore RMB converted using FX must remain in the segregated RMB capital account and must be used for FX currency conversion and RMB remittance and settlement for the purposes of Northbound Trading; and
- all RMB funds resulting from the redemption or sale of bond investments made through Northbound Trading can remain in the segregated RMB capital account for further Northbound Trading investments – otherwise, the Onshore RMB funds must be reconverted to the original foreign currency through the RMB Participating Bank.
Eligible offshore investors may, through CMU members, conduct FX risk hedging with RMB Participating Banks.
Positions generated by RMB Participating Banks from providing FX/RMB conversion services can be unwound on the onshore interbank foreign exchange market.
Who owns the legal and beneficial title to the bonds invested through Bond Connect?
Trading in CIBM bonds through Bond Connect is settled in SCH or CCDC. The holding of CIBM bonds acquired through Bond Connect involves multiple levels of ownership, which arises from the clearing and settlement arrangements for CIBM bonds as summarised below:
- after clearing and settlement with SCH or CCDC, the CIBM bonds acquired under Northbound Trading are registered in the name of HKMA and held through the onshore nominee accounts opened by CMU (in the name of HKMA) in the mainland China with SCH and/or CCDC (as the case may); and
- CMU members will settle trading in CIBM bonds through CMU on behalf of eligible offshore investors.
HKMA (as the registered holder of the CIBM bonds) is entitled to exercise its rights as against issuers of the bonds (through SCH/CCDC). Prior to exercising a bond holder’s rights against the relevant CIBM bond issuer, HKMA (as the nominee holder for eligible offshore investors under Northbound Trading) will consult with the eligible offshore investors and take actions accordingly.
The CMU nominee holding arrangement is similar to the nominee holding arrangement under Stock Connect. To understand the ownership issues regarding CIBM bonds acquired through Bond Connect, we need to look at two levels of holding:
- holding by HKMA as the “nominee holder”; and
- holding by the eligible offshore investors through CMU members as the “beneficial owners” of the CIBM bonds.
At the SCH/CCDC level in the mainland China, the CIBM bonds traded through Bond Connect are registered in the name of HKMA as the registered holder and legal holder of such bonds under PRC law. The CIBM bonds are held by HKMA in its capacity as the nominee of the eligible offshore investors under Northbound Trading.
At the CMU level, the CIBM bonds acquired through Bond Connect are allocated to, and recorded as separate holdings of, the relevant CMU members (either as their proprietary investment or, as client assets in their custody role).
The diagram below illustrates the nominee holding structure under Northbound Trading:
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Key points to note
How does an eligible offshore investor enforce its rights in CIBM bonds invested through Bond Connect?
PBOC has indicated in a recent Bond Connect press conference that an eligible offshore investor could either enforce rights in the bonds through HKMA/CMU or in its own name in accordance with the applicable laws in Hong Kong. The SCH Rules expressly provide that eligible investors “enjoy the rights and interests of the [bonds] according to applicable laws.”
Hong Kong law recognises that investors hold the beneficial interest in bonds acquired for them by their custodian (i.e. CMU members and HKMA). Eligible offshore investors (as beneficial owners of the bonds) should be able to exercise their rights in CIBM bonds in accordance with the laws and regulations of Hong Kong regarding nominee holders and custody arrangements.
Under PRC law, the plaintiff to a legal claim is any citizen, legal person or any other organisation with a direct interest in the claim. Subject to an eligible offshore investor providing evidence that it is the ultimate beneficial owner of the relevant CIBM bonds (i.e. certificate/proof provided by CMU and CMU members showing that such eligible offshore investor is the legitimate beneficial owner under Hong Kong law), the offshore investor should be entitled to bring a legal claim in its own name in the PRC courts.
What are the consequences if an eligible offshore investor is found to have contravened the relevant Bond Connect rules and regulations?
CFETS may investigate any actual or potential breach by eligible offshore investors of the Bond Connect trading rules and/or other rules and regulations relating to the CIBM.
Certain trading activity and behaviour will be more likely to be considered as “unusual” by CFETS.
What are the key takeaways for offshore service providers providing custody and settlement services for Bond Connect?
The rules are clear that RMB Participating Banks providing FX/RMB conversion services to eligible offshore investors are generally expected to conduct the basic know-your-client procedures in respect of eligible offshore investors to whom it provides services to.
We recommend all RMB Participating Banks providing Bond Connect-related FX/RMB conversion services to obtain specific declarations from eligible offshore investors to whom it provides currency conversion services to that all Onshore RMB converted by the RMB Participating Bank must be used for settling Bond Connect trades (failing which must be re-converted to the original foreign currency).
Discrepancy in trading days
If the business days of the offshore service provider is not the same as the CIBM trading days (being the trading days for Bond Connect trades), such offshore service providers should ensure it obtains an acknowledgement from the eligible offshore investors to whom it provides Bond Connect-related services to that the services will only be provided to the eligible offshore investor during the working days and hours of the service provider.
What are the tax implications? Are eligible offshore investors required to pay PRC taxes (e.g. stamp duty or capital gain tax) in respect of its Northbound Trading activities?
We understand that the regulators have yet to publish rules on the tax implications on bond investments made through Northbound Trading.
Foreign participation in China’s bond market has remained at around 2.52% of the PRC onshore market, and 3.93% of the sovereign debt market. This is significantly lower than other countries such as Japan, U.S. and even some emerging markets.
Bond Connect is another breakthrough after the launch of Stock Connect. We believe Bond Connect will play a significant role in:
- advancing the level foreign participation in China’s domestic bond market; and
- offering an improved and easily accessible market infrastructure to further broaden and deepen China’s bond market for global access.
This is an encouraging development after the recent inclusion of China A-shares in MSCI indexes. We have been working closely with the key parties involved in Bond Connect and expect to see further innovative developments in this ground-breaking programme.
Key rules and regulations applicable to Bond Connect (Up to 2 July 2017)
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 These data are obtained from the Proposal on the Mainland-Hong Kong Bond Market Connect published by the FSDC in November 2016, at http://www.fsdc.org.hk/sites/default/files/Bond%20connect%20_E.pdf