Newsflash: The Shenzhen–Hong Kong Stock Connect

December 06, 2016

The Securities and Futures Commission of Hong Kong (SFC) and the China Securities Regulatory Commission (CSRC) issued a joint announcement on 25 November 2016 approving the launch of the long-awaited Shenzhen-Hong Kong Stock Connect and trading commenced on 5 December 2016. This supplements the prior joint official announcement made by the SFC and the CSRC in August 2016. 

The Shenzhen-Hong Kong Stock Connect is a cross-boundary investment channel which provides mutual stock market access between the Shenzhen Stock Exchange (SZSE) and the Stock Exchange of Hong Kong Limited (SEHK) in a manner similar to that via the existing Shanghai-Hong Kong Stock Connect.1 Global investors may now access Mainland China’s new generation of private sector companies listed in Shenzhen using this new link, which include innovative internet and technology companies (in contrast, shares listed on the Shanghai Stock Exchange are those of primarily “large cap” state-owned enterprises). In the same vein, eligible investors in Shenzhen will be able to purchase shares listed on the HKSE via their respective local securities brokers. 

Key Features 

Eligible Shares 

Northbound Trading. Eligible shares under the Shenzhen-Hong Kong Stock Connect include: (i) constituent stocks of the SZSE Component Index and the SZSE Small/Mid Cap Innovation Index; and (ii) all SZSE-listed shares of companies that have issued both A shares and H shares. 

Southbound Trading. Eligible shares include: (i) constituent stocks of the Hang Seng Composite LargeCap Index and Hang Seng Composite MidCap Index; (ii) constituent stocks of the Hang Seng Composite SmallCap Index; and (iii) all shares of companies listed on the SEHK that have issued both A shares and H shares. 

The SZSE currently has 1,798 listed stocks, whereas the Shanghai Stock Exchange only has 1,177 listed stocks. 417 Hong Kong stocks will be traded in Shenzhen, compared with the 318 Hong Kong stocks currently tradable via the Shanghai-Hong Kong Stock Connect. Global investors will be able to trade 881 Shenzhen-listed stocks that are components of major local indexes. 

However, the Shenzhen-Hong Kong Stock Connect (unlike the current Shanghai-Hong Kong Stock Connect) restricts investors who are eligible to trade shares that are listed on the ChiNext Board of SZSE to “institutional professional investors”2 (as such term is defined in the Hong Kong Securities and Futures Ordinance3 and the SFC Code of Conduct for Persons Licensed by or Registered with the SFC)4. In the future, other categories of investors may be allowed to trade via the Shenzhen-Hong Kong Stock Connect, “subject to the resolution of related regulatory issues”. 

To provide greater investment opportunities for both domestic and overseas investors, and given the diversity of exchange-traded funds (ETFs) available on the SEHK, ETFs will be included as “eligible securities” (whereas they are not “eligible securities” under the Shanghai-Hong Kong Stock Connect). The effective date to invest in ETFs via the Shenzhen-Hong Kong Stock Connect is to be confirmed, but is eagerly anticipated by the market given the continued popularity of ETFs in Asia. 

Investment Quotas 

The Shenzhen-Hong Kong Stock Connect daily quota will be RMB 13 billion (approximately US$ 2 billion) for the northbound link and RMB 10.5 billion (approximately US$ 1.5 billion) for the southbound link, which is the same as the current daily quotas applicable under the Shanghai-Hong Kong Stock Connect. 

The most significant change to the operation of the Shanghai-Hong Kong Stock Connect has been the removal (which took immediate effect in August upon the initial announcement of the Shenzhen-Hong Kong Stock Connect) of its market-wide aggregate quota of RMB 550 billion (approximately US$ 82 billion); the aggregate quota limited new purchases via the Shanghai-Hong Kong Stock Connect whenever aggregate purchases exceeded aggregate sales by the quota amount. In practice, the aggregate quota was not relevant, as buy and sell orders generally offset each other over time. There is similarly, no aggregate quota restriction applicable to the Shenzhen-Hong Kong Stock Connect. 

New Stock Issues 

Currently, overseas investors cannot trade in initial public offerings on the Mainland Chinese stock exchanges and Mainland investors cannot subscribe to new stock issues in Hong Kong. It remains to be seen whether this prohibition will be retained or relaxed as regards new stock issues that will be available via the Shenzhen-Hong Kong Stock Connect. 

Investor Protection 

Hong Kong’s Investor Compensation Fund compensates investors (of any nationality) for any losses arising from the default of a Hong Kong-licensed entity or authorized institution in relation to traded products in Hong Kong. However, since southbound trading under either Stock Connect program will be conducted by Mainland securities brokers that are neither licensed nor regulated with the SFC, and northbound trading relates to securities that are not listed on the SEHK, investors who purchase stock via the Shenzhen-Hong Kong Stock Connect will not have the benefit of coverage under the Investor Compensation Fund. 

Conclusion 

The launch of the Shenzhen-Hong Kong Stock Connect comes after three months of intensive work following the initial announcement, to finalize the necessary trading and clearing rules and other relevant rules and to iron out the daily quota mechanism and other regulatory and operational arrangements. The SFC and CSRC have signed a memorandum of understanding on regulatory and enforcement cooperation and have also agreed on the principles and arrangements for cross-boundary regulatory and enforcement cooperation relating to the Shenzhen-Hong Kong Stock Connect. 

While the Shenzhen-Hong Kong Stock Connect program will facilitate access by global investors to a new pool of Mainland Chinese listed stocks (which may be of more interest to an investor than the primarily “large-cap” state-owned enterprises listed on the Shanghai Stock Exchange), it remains to be seen whether the level of usage of this new program will overtake the current levels of activity under the Shanghai-Hong Kong Stock Connect. 

Footnotes 

1) For further information regarding Hong Kong’s Stock Connect with Shanghai, please refer to Dechert OnPoints, The Through-Train Leaves the Station: Hong Kong-Shanghai Stock Connect Launches and Chinese Regulator Responds to Lingering Concerns over Ownership of Stock Connect Securities.
2) For further information, please refer to Dechert OnPoint, The Hong Kong Professional Investor Regime.
3) Cap 571, Laws of Hong Kong.
4) A registered, regulated collective investment scheme like a registered fund under the U.S. Investment Company Act of 1940 (as amended) with the U.S. Securities and Exchange Commission or an Undertaking for Collective Investment in Transferable Securities (UCITS) or an Alternative Investment Fund (AIF) will fall within the definition of an “institutional professional investor”.