HKEX’s China based strategy: fruitful past, uncertain future

HKEX’s China based strategy: fruitful past, uncertain future
A key reason behind Hong Kong’s high rank in terms of capital market development, in spite of being the 37th largest economy in the world, is its vicinity to China. Hong Kong acts as a conduit between Chinese companies and international investors, helping Chinese companies access capital from the outside world as well as providing Chinese investors access to investment opportunities in the Asian region; around half of companies listed on the HKEx are from China. Consequently, since the mid-1990s, Hong Kong’s capital market growth has largely been driven by growth of the mainland economy. Hong Kong’s exchange operator, the HKEx group, has built its core business around the China growth story and came out relatively unscathed from the crisis of 2008. A dominant theme in the group’s recent strategy has been to move even closer to the mainland market by connecting to the mainland’s stock exchanges and providing members of two exchanges mutual access. In November, 2014, HKEx launched the Shanghai-Hong Kong Stock Connect program, enabling Chinese investors to trade shares listed and traded in Hong Kong and vice versa; Shenzhen HK connect is planned in the near future. In the last three years China has been opening up the Renminbi (RMB), and Hong Kong is positioning itself as China’s offshore RMB center by building RMB capability and developing diversified RMB products. HKEx is looking to capitalize on this opportunity as well. The mainland’s high demand for raw materials and international trades in commodities is another driver for the HKEx group. It recently acquired the London Metal Exchange (LME) Group to signal its intent to grow a commodity business. Leveraging on this acquisition it plans to build an “East Wing” of commodities clearing for the whole Asian region and during Asian time zone. HKEx’s future prospects, like its historic growth, are contingent on the mainland dynamics. While it has many upsides, too much reliance on China can have downside risks in case of slowing down of the Chinese economy or emergence of policy hurdles. Recent slowdown of Chinese economy has raised concerns about the prospects for its future growth and its potential adverse impact on the China-Hong Kong trading link. On the commodities front China seems uninterested at this point in taking help from other markets. Furthermore, commodities trading practices differ between China and Hong Kong as investors in China, unlike those in Hong Kong, want physical delivery. This requires significant warehouses that the HKEx is still in the process of developing. Lastly, neighboring Singapore will present competition in the OTC space as it also plans to be a major player in the region focusing on South East Asia and China.

HFT on the radar of Indian and Chinese regulators

HFT on the radar of Indian and Chinese regulators
High Frequency Trading (HFT) received its share of attention in the US last year with the publication of Michael Lewis’ Flash Boys.  Recently it has received attention from somewhat unexpected quarters – regulators from India and China. India’s securities market is regulated by the Securities and Exchange Board of India (SEBI), while Reserve Bank of India (RBI) mainly deals with the country’s banks and monetary policy. However, in a recent Financial Stability report, it expressed worries about trends in algorithmic trading (a cousin of HFT) in the country. Algo trading was introduced in India around 2008 with allowing direct Market Access (DMA) in the local market; colocation was allowed subsequently in 2010 to promote its adoption. Even though it didn’t take off immediately due to overall macroeconomic condition persisting around 2008, it now represents a sizable share of around 40 per cent of cash segment trades conducted at the two major exchanges, up from around 15 per cent in 2011. More worrying for the RBI is its share in cancelled orders – of all cancelled orders, around 90 per cent comes from algo orders, and this has become a cause for concern for the RBI. To be sure, India, like many other emerging markets, has conservative regulations in all aspects of its financial services markets and promotes innovation in the markets gradually trying to contain potential risks to the maximum extent possible (for example, new algorithms need to be tested and approved by exchanges). A while ago SEBI indicated that it would come out with guidelines to curb very high order-to-trade ratio. SEBI is now considering measures to control some aspects of algo trading. One idea floating around is a lock-in proposal that prevents traders from cancelling an algo order for a given period of time. Another idea is to install a two-queue system, which allows trades by brokers with co-location and another without. China’s securities regulator is also scrutinizing high-frequency traders since its recent stock market troubles raised concerns about its financial system, though China is still at a nascent stage in its adoption of advanced trading tools and technology. Like India’s case, order cancellation seems to be their cause of concern as well. These two may be isolated incidents, but serve to underline two important themes; first is the obvious growing scrutiny on algo and high frequency trading from regulators world-wide. Equally important is the trend that while emerging markets look to emulate and adopt innovations taking place in the developed world, they are also keen to do it ‘their way’; and this is most apparent in their practices of risk management and market safeguard.

Equity market upheaval in China

Equity market upheaval in China
The recent restrictions being placed by the Chinese government on trading in the Chinese market are creating an artificial barrier to the normal and efficient functioning of the market. The equity market is mainly a reflection of the structural economic underpinnings of the economy. If the economy and the firms in it are doing well, then the stock market would also perform well. If not, then it would be normal to expect a downswing in the market. By focusing on the equity market and not on the economy itself, the Chinese government might be ignoring some of the structural weaknesses in its economy that are creating the downward pressures in the markets. Creating an artificial bubble is normally not in anyone’s interest, although an argument might be made that it has become more de riguer after the spate of quantitive easings and similar regulatory interventions in the aftermath of the financial crisis. Another issue that has been pointed out by some observers is that the weighting and role of Chinese stocks in leading global indices also becomes unrepresentative due to such interventions, and the index managers have to then weigh the balance of having such stocks against the imbalance created by having them in the index. Furthermore there is less incentive for the market participants to pick stocks on the basis of firm and industry performance, since the intervention seems to be keeping up the prices of stocks that would otherwise have been expected to not perform as well. Hence, there are several issues that can arise from such an action and it might be in the interest of Chinese regulators and the markets as a whole to reduce the level of intervention.

AIIB, NDB and the global capital markets

AIIB, NDB and the global capital markets
We have recently seen the advent of two multilateral lending institutions that could have important ramifications for the global financial markets, including specifically the capital markets. The Asian Infrastructure Investment Bank (AIIB) is an initiative led by China, and the New Development Bank (NDB) is a combined effort of the BRICS nations, namely, China, Russia, Brazil, India, and South Africa. The AIIB would be based in Beijing and the NDB in Shanghai. If successful, these banks could challenge the domination of the IMF and the World Bank, and strengthen China’s claim as being a counterbalance to the US domination of the global financial markets. But not everyone sees these new organizations as competitors for existing lending bodies. The World Bank and IMF have themselves come out in support of the AIIB, as it could create a much needed emphasis on infrastructure development in Asia. Also, AIIB is hoping to learn from the past experience of World Bank, including by hiring its alumni. Such new banks could also lead to changes at the IMF and World Bank which might be forced to streamline their operations in order to remain meaningful. From the capital market point of view, an important effect of AIIB and NDB could be an increase in the importance of the Renminbi as a reserve currency, and a decrease in the relevance of the US dollar. While this would make for a more diverse marketplace, it might also create friction between the leading global economies, as evidenced by the US refusal to support the AIIB at a time when all its allies welcomed or indeed joined it. Finally, it is possible to see AIIB & NDB as institutions that allow emerging markets such as the BRICS countries to assert themselves on the world stage, something that IMF has not allowed them to do, as it has failed to reform in the last few years to take their economic growth and increased buying power into consideration. We will just have to wait and see to find out if they are indeed able to live up to their promise in this regard.

On the cusp: regional integration in Asia

On the cusp: regional integration in Asia
It’s 2015, the mid-point of the decade and a good time to start looking at major trends in Asian financial services over the next five to ten years. One of the major themes will be regional integration, which is another way of saying the development of cross-border markets. There are at least two important threads here: the ongoing internationalization of China’s currency, and the development of the ASEAN Economic Community (AEC) in Southeast Asia. RMB internalization is really about the loosening of China’s capital controls and its full-fledged integration into the world economy. And everyone seems to want a piece of this action, including near neighbors such as Singapore who are vying with Hong Kong to be the world’s financial gateway to China. The AEC is well on its way to becoming a reality in 2015, with far-reaching trade agreements designed to facilitate cross-border expansion of dozens of services industries, including financial sectors. While AEC is not grabbing global headlines the way China does, we see increasing interest in Southeast Asia among our FSI and technology vendor clients. From Celent’s point of view, both trends will open significant opportunities across financial services. In banking, common payments platforms and cross-border clearing. In capital markets, cross-border trading platforms for listed and even OTC products. In insurance, the continued development of regional markets. Financial institutions will be challenged to create new business models and technology strategies to extract the opportunities offered by regional integration. It’s the mid-point of the decade, and the beginning of something very big.

Challenges with China’s RMB Internationalization Process

Challenges with China’s RMB Internationalization Process
Chinese authorities have been making concerted efforts of late to internationalize its currency (renminbi, RMB) by trying to increase its use in international trade settlement and investment. Their efforts are paying off as international RMB payments and trade settlement have grown rapidly since 2010. The whole process consists of three broad steps beginning with the use of RMB in trade settlement, then investment and then as a global reserve currency. The first step is well underway and has received the most traction of the three – around 10-15% of China’s international trade is settled in RMB at present. China has currency swap agreements with 24 central banks allowing them to directly settle international RMB trade. Use of RMB for investment purposes is still limited due to lack of development of the Chinese capital markets and strict controls imposed by the Chinese authorities. Use of RMB as a global reserve currency is the most ambitious step and likely to take the longest time. At present several central banks have expressed interest for increasing RMB holding as part of their reserve. However, the quantum of holding is small at present and primarily geared towards diversification of foreign assets. In spite of these developments, there are challenges with China’s efforts to internationalize the RMB. Even though the Chinese currency recently broke into the list of top ten currencies globally, its share is still miniscule (~1%) in total global payments. At a broad level, RMB is mostly used to settle imports, but not exports – roughly a third of imports and less than 5% of exports are settled in RMB at present. Even in imports, invoicing is often done in US dollars while settlement happens in RMB. A necessary requirement for RMB internationalization is to first make it fully convertible. China is planning to do this first through the offshore markets. Doing the same in the onshore market by opening capital account and liberalizing interest rate regime will be more challenging. Then there are operational challenges for banks that need to be addressed. New systems and processes will be required to support clearing and settlement of payments in real time by domestic and international players. They also need to support different languages including Chinese, English and other regional ones and to accommodate working hours in different time zones to bring about a truly international system of operations. These will also require strengthening of China’s anti-money laundering (AML) framework. AML practices in China have been in development for over 15 years, however, the AML regulations were largely inadequate until as late as 2006-07. As a result the internal control systems and company culture at banks in China tend to be inadequate, and they do not go beyond meeting basic regulatory requirements at present. Given the rapid developments in the RMB internationalization process over the last three years, there has been a lot of enthusiasm and optimism expressed by several players regarding its potential to bring in major changes in the immediate future. However, it is safe to assume from past experiences that China will follow a planned, controlled, and slow but steady path in trying to raise the importance of its currency at a global level. True internationalization of RMB will require fundamental changes on many fronts including regulatory, market infrastructure, political and geopolitical aspects. An intermediate step in realizing the ultimate goal may be to first make RMB a dominant currency at a regional level (ASEAN/Asian). The extent of its adoption at a global level will however be long drawn and closely watched.

China’s road towards Currency Internationalization

China’s road towards Currency Internationalization
China is the world’s second biggest economy, largest exporter and second largest importer. Yet China’s currency, the Renminbi (RMB), accounts for less than 1% of global FX turnover. The Chinese authorities have been making concerted efforts since late 2008 to internationalize the Renminbi by trying to increase its use in international trade and investments. Their efforts are paying off as RMB settled trade has grown since late 2010 and accounts for 8-10% of all international trades at present. The following highlights some major successes of their efforts: •    From October 2010 to June 2012 value of RMB payments grew by 17 times. Currently 91 countries are processing renminbi payments. •    Hong Kong is the dominant offshore centre for RMB trading accounting for around 80% of all renminbi payments; share of Singapore, Taiwan are also significant. UK is positioning itself as a major offshore trading centre for renminbi. •    RMB is among world’s top ten currencies traded. Three FX markets exist for RMB: onshore CNY market which is tightly controlled, offshore CNH market in Hong Kong which is relatively free, and USD denominated non-deliverable forward market. The currency sometimes trades at different rates in the CNY and CNH markets and many firms, especially large ones with subsidiaries outside borders, use it to conduct exchange rate arbitrage in these two markets. Given that China’s currency is not fully liberalized, this arbitrage sometimes is not settled by market forces and it creates pressure on the currency, as was evident late last year. Some therefore argue that significant proportion of RMB settlement comes from speculation in the two markets while imports are still invoiced and mostly settled in US dollar. Bank of China Hong Kong (BOCHK) and Bank of China, Macau, are the only two entities approved to clear offshore RMB transactions. Other banks can engage in offshore RMB business through agreement with BOCHK, or through relationship with other banks which have existing agreement with BOCHK. This presents an opportunity for many regional and international banks to tap into this burgeoning market of RMB clearing and trade related services. Moreover, two of the world’s biggest exchanges, the Hong Kong Exchange (HKEx) and the CME Group, recently announced plans to launch offshore yuan futures in Hong Kong by the end of 2012. This is likely to facilitate exporters and importers hedge their currency risks, especially now that the currency is showing some volatility. The forwards market at present is very efficient with tailor made contracts; therefore some think currency futures may not gain traction immediately among traders. However, along with importers and exporters who use currency futures and forwards to hedge exposure, this will also attract asset managers and other financial institutions as the contracts will be standardized and tradable at the exchanges. The outcome of these initiatives remains to be seen, but these moves are likely to further strengthen China’s efforts towards Renminbi internationalization. It must be mentioned that in spite of these developments, there are challenges with China’s efforts to internationalize the RMB. At a broad level, RMB is mostly used to settle imports, but not exports. Even in imports, invoicing is often done in US dollars while settlement happens in RMB. It is argued many Chinese corporations use the different currency markets (CNH-CNY) to engage in speculative activities and not that much for pure trade purposes. This effectively allows for interest rate speculation between the two markets as well. Many of these problems are intertwined as China has traditionally had very strict capital control, and the internationalization of renminbi is taking place before fully liberalizing its interest rate, exchange rate or capital account. Therefore how China attempts to internationalize its currency and manages its key rates at the same time will be closely watched.

Global exchange-traded derivatives market expected to grow

Global exchange-traded derivatives market expected to grow
The performance of the exchange-traded derivatives market has been one of the few silver linings of the post-financial crisis period. There are two discernible trends in this market. The first is the clear lead that the developed markets, especially the US, have in terms of innovation. The introduction and success of products such as exchange-traded fund options and volatility index derivatives is a testament to this. The second trend is the sharp growth in volumes of established products such as stock index derivatives, currency derivatives and commodity derivatives once these are introduced in the emerging markets. Korea Exchange is the runaway leader for stock index options, currency futures boomed once they were introduced in India two years ago and the strong underlying demand for commodities in China has meant that it has three of the top commodity derivatives exchanges in the world. However, it would be useful to mention the difficulty that the Asian exchanges have had in terms of introduction of interest rate derivatives. The illiquid nature of the underlying bond market has meant that these derivatives have not been successful outside of Japan and Australia. An important recent development for the exchange-traded market is the introduction of legislation that is going to make central clearing for OTC derivatives compulsory in markets such as the US and Europe. This is going to increase the complexity of trading such products and will drive some volumes towards exchanges where the complexity and cost of trading standardized derivatives is expected to be lower. According to our analysis in an upcoming report, the derivative segment that will benefit from these regulatory changes is currency derivatives, followed by interest rate and equity derivatives. It is important to note that it would be the leading exchanges in the US and Europe that would see the benefit of this migration of OTC derivatives, as most of the OTC trading occurs in these markets.