For global asset managers, China offers up the prospect of huge asset pools – with some predicting that the country will account for one-third of net inflows to mutual funds globally as soon as 2020. This is being helped along by the July 1, 2015 miletone in the loosening of China's tight controls over cross-border investment, as the Mainland China/Hong Kong Mutual Recognition Framework (MRF) gets underway. For Chinese asset managers, this is expected to be the first step in a series of bilateral agreements to allow them to gain access to investors around the world.
The MRF, which introduces a fund passport for approved Hong Kong and Mainland Chinese mutual funds, has been a hot topic in cross-border fund distribution circles, ever since first being proposed publicly by the Hong Kong Securities and Futures Commission and China Securities Regulatory Commission at the beginning of 2013. Several months are sure to pass before it builds up a head of steam, but hopes are high for a healthy two-way flow of funds in the medium term.
As ever, China is taking steady steps as it widens access for international investors into the capital markets of the world's second-largest economy, while also permitting outward investment by high net worth investors and a growing middle class on the mainland. A total initial quota for mutual fund sales under MRF has been set at 600 billion yuan ($97bn), split evenly in each direction. Fund managers seeking MRF approval for locally registered funds will need to apply for a share of the quota. The Hong Kong regulator has made clear that, at the outset, the framework will be limited to established, stable and strongly performing product offerings – and will only later be opened up to new products and to a wider array of offerings to satisfy the different risk/return profiles of investors. "It is sure to enrich the product range in the retail fund market on the mainland and accelerate the expansion of Chinese fund managers connecting to international investors," says Florence Lee, Head of China Sales and Business Development, EMEA for HSBC Securities Services. The two regulators have stated that the MRF will lay the foundation for joint development of a common fund regulatory standard.
The scheme is limited to funds domiciled in Mainland China or Hong Kong. Accordingly, an international fund manager wishing to reach the growing investor base on the mainland cannot simply use an existing cross-border UCITS fund. While some market participants hope that UCITS funds might be brought into the MRF at a later date, this seems a distant prospect given the Beijing government's aim of developing Hong Kong as a major financial services hub in its own right and leveraging off this to expand the asset management industry on the mainland. Furthermore, as a bilateral arrangement, the European Union would have to agree to the distribution of equivalent Chinese funds across member states – something that is highly unlikely in the foreseeable future.
Mutual recognition follows the November 2014 launch of the Stock Connect trading links between the Hong Kong and Shanghai stock exchanges – due to be joined by a similar arrangement between the Hong Kong and Shenzen bourses, perhaps as soon as the second half of 2015. The new initiatives are particularly welcome, as Beijing's cap of 270 billion yuan for Hong Kong institutions under the Renminbi Qualified Foreign Institutional Investor (RQFII) programme is almost exhausted – and lobbying for a higher quota by the Hong Kong government appears to have fallen on deaf ears, while they have been testing the waters with RQFII allocations for the likes of Australia, Singapore, Canada, France, the UK and Qatar – and, most recently, Luxembourg, Chile and Hungary, each granted a 50 billion yuan quota.
As we reported in December 2014, 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.
While distribution into Mainland China is challenging, this is a mature market for fund clearing. Retail positions are recorded through the highly automated infrastructure of China Securities Depository and Clearing Corporation Limited (CSDC). In contrast, Hong Kong operates wholesale omnibus positions with the majority of order instructions being handled manually by fax. "We consider it unlikely that Chinese distributors and fund managers will allow manual orders to and from Hong Kong," Sebastien Chaker, Head of Asia for Calastone, tells us at FundForum in Monaco. "It's equally unlikely that Hong Kong would be able to cope with a large influx of manual retail orders from China."
According to industry sources, the first few MRF approvals may be obtained as soon as the end of July. A steady increase in the volume of trades in Hong Kong unit trusts is expected, which will likely act as a driver for Hong Kong fund distributors to gear up their operating models to automate these trades.
There are parallels to be drawn with the 2012 launch of the Automated Fund Information Transmission Service by the Taiwan Depository & Clearing Corporation (TDCC). This allowed distributors in Taiwan to leverage a single local platform to process both Taiwanese funds and offshore funds. Distributors in China will enjoy the same benefit via CSDC. Hong Kong distributors, on the other hand, face the complexity of processing orders in Chinese funds, unit trusts domiciled in Hong Kong and the mutual fund corporations – principally domiciled in Luxembourg and Ireland – which are distributed in Hong Kong.
"One of the key factors behind the early success of Taiwan's automated order-routing service was that TDCC was able to rely on specialized fund messaging networks with strong cross-border transaction expertise," says Mr Chaker. "This provided the immediate critical mass needed to build offshore fund manager participation."
The impact of mutual recognition
We speak with HSBC Securities Services' Florence Lee about the impact that the mutual recognition framework is having.
What are the opportunities?
Long-term trends show that China is significantly increasing its share of global financial flows, yet there is no doubt that this market is still relatively untapped. International managers will consider establishing Hong Kong domiciled funds or re-domicile their existing products to Hong Kong in order to access China through the mutual recognition scheme.
There were over 2,000 SFC-authorized funds as at December 2014, of which only 573 were domiciled in Hong Kong. Funds eligible for MRF on day one will be even less than that figure – potentially around 100, compared to around 850 for Mainland China. This clearly gives room for new entrants to the Hong Kong market with potential opportunities for additional retail fund products.
China has been gradually transformed from a savings nation to an investment nation with the emergence of a middle class and wealth building up in the last few decades. There is more demand on investment products in order to preserve investors' capital and diversify their investments. The current size of the mutual funds market in China has recently exceeded the $1 trillion mark and the pace of growth is strong. The MRF will give international fund managers an opportunity to unleash the potential in this new market.
What has been the international reaction so far?
Some leading international fund managers have been preparing for MRF to go live. The key requirement is to have Hong Kong domiciled funds and many European- and US-based international fund managers launched a renminbi share class for locally domiciled funds last year in readiness. Some top players in the China space also added more renminbi share class funds and diversified income products to their Hong Kong retail platform this year to meet increasing investor demand, as one of the MRF requirements is to have at least a one-year track record.
A number of managers have already publicly announced they will participate in the initiative. However, they are expecting regulators to further clarify the operational issues and provide guidance to market participants.
What are the practicalities of participating?
Under the MRF, Hong Kong funds to be marketed on the mainland will have to receive registration from the CSRC and mainland funds will be subject to approval from the SFC before sales can commence. It is therefore important for foreign managers to start early in order to understand the application process and allow for the lead time in regulatory approval when timing their product launch.
International fund managers in Hong Kong must appoint a qualified institution in China, either a mutual fund manager or licensed custodian, to be their local agent. The responsibilities of the local agent in China include MRF registration, information disclosure, distribution, data transmission, fund settlement, regulatory reporting, communication, client servicing and monitoring. This will be a key role in the success of MRF distribution in China.
How could this impact UCITS in Asia?
UCITS are very popular as a vehicle for gaining access to Hong Kong. Those domiciled in Ireland and Luxembourg represent approximately 85% of SFC-authorized funds. However, UCITS funds do not have access to Mainland China under the MRF as it stands.
Mutual recognition and the other Asian passport schemes (i.e. ASEAN Collective Investment Scheme and Asia Region Funds Passport) could have a significant impact on the role of UCITS in Asia, but predictions of a decline are wide of the mark. The ability to distribute UCITS around the world means that it will remain a platform of choice for firms in Asia and other regions, helping their clients to invest globally. In the long term, we expect UCITS to develop alongside – and perhaps in conjunction with – local and pan-Asian products. It follows that asset managers need to remain flexible over their use of UCITS in Asia.
With the introduction of MRF, we expect managers to take advantage of this newly opened channel for fund distribution. The expansion of MRF to other jurisdictions will be an area for managers to watch.
It is also safe to assume that managers which intend to participate will have a huge amount to do in terms of the preparation of: application documents; due diligence visits to local agents/representatives; distribution channels and product marketing. Also, we believe the SFC and CSRC will further clarify the outstanding operational issues to make this a successful passport scheme.