by The Hong Kong Institution of Bankers (QBN has contributed to the article on fintech in HKIB Banking Today)
Hong Kong, China , December 2021 – The Central People’s Government of the People’s Republic of China’s strong commitment to the Hong Kong Special Administrative Region’s (HKSAR) financial sector continues to add fresh impetus to the two-way opening-up of the financial industry through Connect platforms that facilitate cross-border capital flows. At the same time, the Greater Bay Area (GBA) has been tasked to be the key geographic location to support a range of initiatives initiated by the Central Government in the further opening-up of Mainland China’s capital markets. Prime examples comprise Connect platforms that include Shanghai – Hong Kong Stock Connect in 2014, Mutual Recognition of Funds in 2015,
Shenzhen – Hong Kong Stock Connect in 2016 and Northbound Bond Connect in 2017 as well as the Southbound Bond Connect and Wealth Management Connect in 2021.
Connect platforms and their characteristics
All the Connect platforms operate on a “closed loop” system. Taking the Northbound Bond Connect platform as an example, offshore investors in Hong Kong can use Renminbi (RMB) acquired in Hong Kong or in Mainland China to purchase onshore Chinese bonds in the China Interbank Bond Market (CIMB) from onshore investors or market-makers/underwriters. In the event of the disinvestment of the offshore trading counterparties, the RMB proceeds from the sale would then be transferred back to Hong Kong. All trades therefore are cross-border, with one counterparty located onshore and the other offshore.
The essence of the closed loop arrangement (CLA) is designed to address a legitimate concern over the CIBM being excessively manipulated by offshore market participants while striking a careful balance between opening-up the onshore market and preserving financial stability. In an event where there is no such an arrangement, the bonds may be used as collateral and for onward trading in the offshore market; and as a result, offshore market participants may be able to exert greater influence on the onshore CIBM market.
Lessons learned from the experiences of currency crises in other jurisdictions underline that whenever a currency was influenced by speculators, the issuer of that currency (i.e. the
Central Bank) would defend its currency by increasing interest rates in order to regain exchange rate stability. Such drastic interest rate movements tend to induce offshore investors to offload the bonds denominated in that currency in the offshore market. The result usually sparks a currency-cum-bond market crisis. Prime examples include the currency crisis that roiled the financial markets in Thailand, Malaysia, Korea and Indonesia in 1997-98, and most recently in Turkey during the summer of 2021.
The CLA was designed to contain or even eliminate this potential currency-cum-bond market risk. Onshore China bonds bought by offshore market participants can only serve a “buy and hold” purpose and cannot be used for collateralisation or onward trading in the offshore market. Therefore, the risk of the onshore bond market being manipulated by offshore market participants is limited.
A CLA has been applied to the Stock Connect, Bond Connect and the Mutual Recognition of Funds as well as the Wealth Management Connect platforms. However, as noted by a veteran market practitioner, “the CLA has never been the best friend of both onshore and offshore investors, but its existence is considered by the Mainland Chinese authorities as a necessary device to reduce the chance of a financial crisis befalling on China.” Meanwhile, Dr Frank TONG, Managing Partner of QBN Capital notes how CLA is increasingly becoming part of the Connect landscape evidenced by a balanced track record achieved over the past seven years. “One sees a chance of further optimising this arrangement as a result of Fintech
development,” he suggests.
Can tokenisation be the trigger for spurring innovation?
Alongside the development of Fintech and digitalisation is tokenisation, which supports underlying financial assets such as bonds and shares, and even physical assets such as property, and enables them to be transferred into special purpose vehicles to support the issuance of security tokens. Tokenisation can help to expand the investor pool to include
investors who are keen to hold financial assets in digital form. For example, investors unable to afford minimum buyin levels in other asset classes. This could open a new window
of opportunities by attracting token investors to participate in the onshore capital markets by investing in tokens backed by products, as well as further development of Connect platforms
including the GBA Wealth Management Connect and Bond Connect.
The question of whether tokens backed by onshore financial assets can be subject to more flexible trading arrangements in the offshore market of Hong Kong, such as collateralisation
and onward trading needs to be explored further. Dr TONG is not too optimistic. He is concerned that tokenisation could undermine the spirit and intent of the CLA, unless sufficient safeguards can be put in place. This would include safeguards to ensure that onshore financial stability will not be undermined, even if the tokens could be used as collateral or traded on offshore platforms.
A feasible solution could be found through the e-CNY issued by the People’s Bank of China (PBoC). To the extent that the tokens backed by onshore bonds are traded against the e-CNY between counterparties in the offshore market in Hong Kong, the tokens could be used as collateral or used for onward trading without compromising the Mainland authorities’
market surveillance capabilities. This could be achieved because the PBoC would have precise information relating to the movement of the e-CNY. In other words, instead of monitoring the movement of the tokens, the PBoC can achieve the same market surveillance objectives by following the movement of the e-CNY.
Dr Jason HO, Head of Bonds at Commerzbank AG in Asia notes how this might give rise to a new window of opportunity for optimising the Bond Connect platform. Using the Northbound Bond Connect as an example, the onshore bonds can be used as underlying assets for tokens to be offered and permit the tokens to be traded and collateralised in the offshore market in Hong Kong. The use of e-CNY as means for settlement can support the
furtherance of the opening up of the onshore capital markets. This could also change the way that the traditional over-the-counter (OTC) bond market operates and could give rise to an "exchange form" of trading of onshore bonds.
William PANG, founding Partner of Summer Capital, believes that collateralisation and trading in the offshore market is important to generate liquidity and further promote the development of the Connect platforms. “Using tokens might not be as direct as using bonds but could be the second-best solution within the existing environment,” he says.
Barriers to implementation
While Asia’s capital markets have been in existence for several decades, Fintech applications are still in the early days of being adopted across the transaction origination and execution
processes. Even though parts of the underwriting process, such as book-building, deal search and trading have been semiautomated, Blockchain, Distributed Ledger Technology (DLT) and Fintech applications have not been fully deployed in the bond market execution processes. While there are more than a dozen global Fintech enterprises that have the technical capabilities to handle all standard processes from documentation automation to payment and settlement automation, to date, these technical capabilities have not been utilised in Asia’s capital markets or for that matter, in the global capital markets.
Some argue that a lack of “common commercial interest” is one of the main reasons hindering the development and application of Fintech in Asia’s capital markets. Furthermore, the lack of Fintech infrastructure development in the standard issuance process in Asia’s capital markets also poses challenges. “There are also legal issues that need to be addressed,” says Agnes TSANG, Partner of Allen & Overy. These include transfer arrangements and safekeeping/custody considerations with respect to tokens, know-your-customer (KYC), anti-money laundering (AML) procedures, and security of the service
platform, TSANG explains. Meanwhile, Commerzbank AG in Asia’s HO explains, obtaining widespread consensus to implement security token offerings (STO) into the capital markets system would likely take years. “Overhauling the entire execution process could take decades, with no certainty of success,” he adds. In order to take Asia’s capital markets to the next level, it would require time and effort from all stakeholders, from policy and regulation to infrastructure development, but most importantly, market participants, which includes, but is not limited to, regulators, legal counsel, rating agencies, financial institutions, investors and settlement managers. Nevertheless, the need to “upgrade” is crucial in order to take Asia’s capital markets to the next level.
The benefits of adoption
With the development of new technologies such as DLT and tokenisation of underlying assets such as bonds and shares, it is now technically possible for listing and trading in the exchange or automated trading system. However, the need for market transparency and concerns over financial stability being jeopardised by offshore speculators remain key considerations for Mainland Chinese authorities. Instead of Mainland China’s authorities needing to forgo CLA, confining the trading of tokens in Hong Kong to using e-CNY provides one possible solution.
In addition to providing an important capital market payment option, tokenisation and e-CNY can shorten the settlement cycle. Meanwhile, with development efforts in progress since 2014, Mainland China is setting new frontiers in the development of Central Bank Digital Currency (CBDC). While CBDC development remains a “work in progress” in many countries and jurisdictions, Mainland China is ramping up testing by moving forward with widespread Digital Currency Electronic payment (DCEP) proof-of concept trials and potential future use functions, particularly in the area of cross-border applications.
Whether it is through application during the Beijing 2022 Winter Olympics, collaboration with the Hong Kong Monetary Authority (HKMA), the Bank of Thailand and the Central Bank of the UAE, or through capital markets financing or digitalising the investment process of the Connect platforms, the PBoC is laying down major milestones in the development of digital currencies and initiatives that further enhance the internationalisation of the RMB.
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