Hong Kong/China mutual recognition on its way
December 2014

Following the November 2014 launch of the Stock Connect trading links between the Hong Kong and Shanghai stock exchanges, the Hong Kong and Mainland China regulators have now been focusing their attention on the scheme which is to permit distribution of commingled investment funds in each other's market. While there has been no official statement on expected timing, market sentiment is that it may go live in the first quarter of 2015.

Reforms such as Stock Connect, use of which to date has proved relatively subdued after the initial euphoria, and mutual recognition, are key components in the steady opening up of Mainland China's capital markets, presenting new opportunities for many firms.

The concept of mutual recognition for eligible investment funds was first proposed by the Hong Kong Securities and Futures Commission (SFC) and China Securities Regulatory Commission (CSRC) in 2013. Given its significance, the Hong Kong Investment Funds Association led an industry delegation on a visit to the CSRC in Beijing, and formed a working group which shared a series of suggestions and recommendations with the SFC, with a wide-ranging remit which extended to fund operations, tax and accounting. Incorporating such representations from the fund management community, the two regulators developed a framework and worked together to reach agreement on fund qualification criteria, manager eligibility and investor protection disclosure requirements.

By April 2014, speaking at FundForum in Hong Kong, Alexa Lam, deputy chief executive officer of the SFC, explained that the two regulators had begun the final run of administrative procedures, which has included putting in place staff secondments to understand each other's approach to authorizing funds.

Hong Kong already has in place a pair of mutual recognition arrangements, with Taiwan (for exchange-traded funds) and Australia. These simplify the process of creating funds, seeking authorization and selling them between the respective jurisdictions. When it comes to Mainland China, however, there is an extra layer of complexity: restrictions on currency convertibility. To date, under the Renminbi Qualified Foreign Institutional Investor (RQFII) scheme, institutions have been able to set up offshore funds for investment into the Mainland, but these have been subject to an aggregate quota, amounting to CNY 270 billion (US$45 billion) for the route from Hong Kong. With this cap almost exhausted, the Hong Kong government has been lobbying the Mainland government for an increase.

The RQFII's success underscores the strong appeal of the renminbi, and the attraction of the Mainland market. Mutual recognition will take things further, adding a fresh channel for international investors to gain exposure to the Mainland and, significantly, opening the gate to mutual traffic flow for the first time. The SFC says it wants as many international fund managers as possible to participate in distributing their funds on the Mainland, just as the new arrangement will also open up huge potential for Mainland fund managers to distribute their funds via Hong Kong.

Under the arrangement, qualifying SFC-authorized funds, domiciled in and operating from Hong Kong, will enjoy the status of 'recognized Hong Kong funds'. Similarly, qualifying Mainland funds will enjoy an equivalent 'recognized Mainland funds' status. With authorization from their regulator, these recognized funds can then be sold directly in the other's market.

This latest initiative will open the gate to mutual traffic flow, for the first time

This mutual recognition scheme is sure to enrich the product offerings available in Hong Kong, through bringing access to a diverse pool of Mainland funds. These should have strong appeal to Hong Kong investors and to the wider international investment community, generating new sales opportunities for product distributors.

Asset owners in Greater China, and across North Asia generally, are reaching out to global asset managers for advice and practical help on international investment opportunities. Reforms such as Stock Connect and mutual recognition are seen as key drivers behind the generation of new business for many firms. They have had a part to play in Deutsche Bank's August 2014 relocation from Singapore to Hong Kong of Ravi Raju, Managing Director and Asia Pacific Head of Asset & Wealth Management.

Mr Raju explains: "Our base in Hong Kong helps us capture opportunities in Greater China and across the wider North Asia region. These key reforms will allow domestic Chinese investors to invest internationally, and we are in a good position to help them implement their investment strategies. We also have many international investors who wish to invest into the domestic Chinese market through A-shares and Mainland fund products."

Market sentiment is that while the mutual recognition scheme may offer great potential, its impact in the short-term may be muted. Alan Naughton, Managing Director and Head of Securities Services at Standard Chartered Bank, comments: "We estimate that there are approximately 400 Hong Kong domiciled funds that may be eligible for distribution in China, however we are seeing, and are gearing up in anticipation of, an increasing number of local and international fund sponsors looking to create fund products to take advantage of the mutual recognition scheme. Equally, we believe that on the southbound route, Mainland fund managers are already identifying distribution opportunities for recognized funds that have specific appeal for Hong Kong investors. So whilst it may take a little time for cross-border distribution to materialize, and the transfer agency mechanisms to get finalized, we foresee a healthy two-way flow of funds between the centres in the medium term."

International managers wishing to break into Mainland China face challenging fund distribution economics. The big four banks, Bank of China, China Construction Bank, Industrial and Commercial Bank of China and Agricultural Bank of China, dominate distribution, making for unattractive pricing and difficult access. A prerequisite for managers is a strong brand, if they are to stand a chance of winning business and negotiating reasonable pricing in the distribution channel.

The industry recognizes that the Chinese authorities will not open the floodgates to international managers. Quotas are sure to be applied, for a carefully-managed, phased introduction, in a similar fashion to the RQFII arrangement. It is highly likely that, at the outset, the scheme will be limited to well-established, stable and strongly performing product offerings, with it later being opened up to new products and to a wider array of offerings to satisfy the different risk/return profiles of investors.

A key factor which will drive distribution strategies is the level at which a quota is set. This will likely impact the viability and choice of alternate distribution models, and the scale of distribution and servicing which a firm opts for, in seeking to reach out to this huge and complex market.

We are seeing distribution opportunities on both northbound and southbound routes ... and foresee a healthy two-way flow of funds between the centres in the medium term

Fund manufacturers seeking to expand their global distribution are also weighing up two other passporting arrangements within the Asia Pacific region. Taken live on August 25, 2014 was the Association of Southeast Asian Nations (ASEAN) Collective Investment Scheme framework. Scheduled for early 2016 is the Asia Region Funds Passport. These initiatives, and their likely impact on distribution of UCITS funds, are examined in close-up in our article 'UCITS: where next, what next?' in the July 2014 edition of our Executive Briefing.





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Following the November 2014 launch of the Stock Connect trading links between the Hong Kong and Shanghai stock exchanges, the Hong Kong and Mainland China regulators have now been focusing their attention on the scheme which is to permit distribution of commingled investment funds in each other's market. While there has been no official statement on expected timing, market sentiment is that it may go live in the first quarter of 2015.

Reforms such as Stock Connect, use of which to date has proved relatively subdued after the initial euphoria, and mutual recognition, are key components in the steady opening up of Mainland China's capital markets, presenting new opportunities for many firms.

The concept of mutual recognition for eligible investment funds was first proposed by the Hong Kong Securities and Futures Commission (SFC) and China Securities Regulatory Commission (CSRC) in 2013. Given its significance, the Hong Kong Investment Funds Association led an industry delegation on a visit to the CSRC in Beijing, and formed a working group which shared a series of suggestions and recommendations with the SFC, with a wide-ranging remit which extended to fund operations, tax and accounting. Incorporating such representations from the fund management community, the two regulators developed a framework and worked together to reach agreement on fund qualification criteria, manager eligibility and investor protection disclosure requirements.

By April 2014, speaking at FundForum in Hong Kong, Alexa Lam, deputy chief executive officer of the SFC, explained that the two regulators had begun the final run of administrative procedures, which has included putting in place staff secondments to understand each other's approach to authorizing funds.

Hong Kong already has in place a pair of mutual recognition arrangements, with Taiwan (for exchange-traded funds) and Australia. These simplify the process of creating funds, seeking authorization and selling them between the respective jurisdictions. When it comes to Mainland China, however, there is an extra layer of complexity: restrictions on currency convertibility. To date, under the Renminbi Qualified Foreign Institutional Investor (RQFII) scheme, institutions have been able to set up offshore funds for investment into the Mainland, but these have been subject to an aggregate quota, amounting to CNY 270 billion (US$45 billion) for the route from Hong Kong. With this cap almost exhausted, the Hong Kong government has been lobbying the Mainland government for an increase.

The RQFII's success underscores the strong appeal of the renminbi, and the attraction of the Mainland market. Mutual recognition will take things further, adding a fresh channel for international investors to gain exposure to the Mainland and, significantly, opening the gate to mutual traffic flow for the first time. The SFC says it wants as many international fund managers as possible to participate in distributing their funds on the Mainland, just as the new arrangement will also open up huge potential for Mainland fund managers to distribute their funds via Hong Kong.

Under the arrangement, qualifying SFC-authorized funds, domiciled in and operating from Hong Kong, will enjoy the status of 'recognized Hong Kong funds'. Similarly, qualifying Mainland funds will enjoy an equivalent 'recognized Mainland funds' status. With authorization from their regulator, these recognized funds can then be sold directly in the other's market.

This latest initiative will open the gate to mutual traffic flow, for the first time

This mutual recognition scheme is sure to enrich the product offerings available in Hong Kong, through bringing access to a diverse pool of Mainland funds. These should have strong appeal to Hong Kong investors and to the wider international investment community, generating new sales opportunities for product distributors.

Asset owners in Greater China, and across North Asia generally, are reaching out to global asset managers for advice and practical help on international investment opportunities. Reforms such as Stock Connect and mutual recognition are seen as key drivers behind the generation of new business for many firms. They have had a part to play in Deutsche Bank's August 2014 relocation from Singapore to Hong Kong of Ravi Raju, Managing Director and Asia Pacific Head of Asset & Wealth Management.

Mr Raju explains: "Our base in Hong Kong helps us capture opportunities in Greater China and across the wider North Asia region. These key reforms will allow domestic Chinese investors to invest internationally, and we are in a good position to help them implement their investment strategies. We also have many international investors who wish to invest into the domestic Chinese market through A-shares and Mainland fund products."

Market sentiment is that while the mutual recognition scheme may offer great potential, its impact in the short-term may be muted. Alan Naughton, Managing Director and Head of Securities Services at Standard Chartered Bank, comments: "We estimate that there are approximately 400 Hong Kong domiciled funds that may be eligible for distribution in China, however we are seeing, and are gearing up in anticipation of, an increasing number of local and international fund sponsors looking to create fund products to take advantage of the mutual recognition scheme. Equally, we believe that on the southbound route, Mainland fund managers are already identifying distribution opportunities for recognized funds that have specific appeal for Hong Kong investors. So whilst it may take a little time for cross-border distribution to materialize, and the transfer agency mechanisms to get finalized, we foresee a healthy two-way flow of funds between the centres in the medium term."

International managers wishing to break into Mainland China face challenging fund distribution economics. The big four banks, Bank of China, China Construction Bank, Industrial and Commercial Bank of China and Agricultural Bank of China, dominate distribution, making for unattractive pricing and difficult access. A prerequisite for managers is a strong brand, if they are to stand a chance of winning business and negotiating reasonable pricing in the distribution channel.

The industry recognizes that the Chinese authorities will not open the floodgates to international managers. Quotas are sure to be applied, for a carefully-managed, phased introduction, in a similar fashion to the RQFII arrangement. It is highly likely that, at the outset, the scheme will be limited to well-established, stable and strongly performing product offerings, with it later being opened up to new products and to a wider array of offerings to satisfy the different risk/return profiles of investors.

A key factor which will drive distribution strategies is the level at which a quota is set. This will likely impact the viability and choice of alternate distribution models, and the scale of distribution and servicing which a firm opts for, in seeking to reach out to this huge and complex market.

We are seeing distribution opportunities on both northbound and southbound routes ... and foresee a healthy two-way flow of funds between the centres in the medium term

Fund manufacturers seeking to expand their global distribution are also weighing up two other passporting arrangements within the Asia Pacific region. Taken live on August 25, 2014 was the Association of Southeast Asian Nations (ASEAN) Collective Investment Scheme framework. Scheduled for early 2016 is the Asia Region Funds Passport. These initiatives, and their likely impact on distribution of UCITS funds, are examined in close-up in our article 'UCITS: where next, what next?' in the July 2014 edition of our Executive Briefing.