There also remains plenty of work to do before offshore investors can get the full extent of access that they want through the QFI regime, while not being physically located in China. “They would like to have more choice, like short selling, bond repo and exposure to government bond futures,” says Natasha Xie, partner at law firm Junhe.
The small number of QFIs who are lending or borrowing China equities are engaging directly with beneficial owners. But the new reforms come with mechanisms that are not aligned with international practices. For example, equity lending and borrowing have to be conducted through the China Securities Finance Corporation (CSFC), which prescribes that collateral is ring-fenced by the borrower and does not allow an offshore custodian to be part of the clearing process. The CSFC can also demand 150-200% of margin for stock borrowing.
“They launched QFI access to stock borrowing and lending at the end of December and so there are teething issues,” says Chao at ASIFMA. But it is nonetheless important progress. Some participants have continued to conduct their securities lending activities and hedges from offshore synthetically, via derivatives, until the kinks are worked out.
Meanwhile, eligibility for stock lending among offshore asset owners using Stock Connect is restricted to exchange members, although it is understood that regulators see the benefits of permitting this if they can control aspects of short selling that they view as harmful.
Added to that, China has no concept of agency lending in securities finance. When an offshore institution wants to finance the Stock Connect shares in their inventory to generate cash, they either do so as a principal using their custodian for support, or they pledge the China A-shares acquired under the Stock Connect scheme, in which case the shares are held by triparty agents.
A lack of global offshore holders negatively impacts liquidity, but it doesn’t seem to have prevented securities lending volumes onshore rising 1,025% from October 2019 to October 2020, according to Finadium. The current $20 billion of equities borrowed is dwarfed by the $11.4 trillion market capitalization of shares listed across the Shanghai Stock Exchange ($6.5 trillion) and the Shenzhen Stock Exchange ($4.9 trillion).
“The lack of support for an agent lending concept means a substantial number of foreign investors will be unable to participate, because they don’t have the ability to handle reconciliations, taxes and other aspects of securities lending,” says Wannenmacher.
By far the biggest catalyst for the opening up of China has been its inclusion since 2018 in major equity and bond indices by the likes of MSCI, FTSE Russell and Bloomberg Barclays, which are heavily tracked as benchmarks for passive investments such as exchange traded funds (ETFs).
Another major event was China’s inclusion in the International Monetary Fund (IMF) “special drawing rights” basket alongside major reserve currencies such as the U.S. dollar and euro, providing more weight to those considering Chinese debt as a form of highly liquid assets in their portfolios.