HKEX’s China based Strategy: Fruitful Past, Uncertain Future

A key reason behind Hong Kong’s high rank in terms of capital market development, in spite of being the 37th largest economy in the world, is its vicinity to China. Hong Kong acts as a conduit between Chinese companies and international investors, helping Chinese companies access capital from the outside world as well as providing Chinese investors access to investment opportunities in the Asian region; around half of companies listed on the HKEx are from China. Consequently, since the mid-1990s, Hong Kong’s capital market growth has largely been driven by growth of the mainland economy. Hong Kong’s exchange operator, the HKEx group, has built its core business around the China growth story and came out relatively unscathed from the crisis of 2008. A dominant theme in the group’s recent strategy has been to move even closer to the mainland market by connecting to the mainland’s stock exchanges and providing members of two exchanges mutual access. In November, 2014, HKEx launched the Shanghai-Hong Kong Stock Connect program, enabling Chinese investors to trade shares listed and traded in Hong Kong and vice versa; Shenzhen HK connect is planned in the near future. In the last three years China has been opening up the Renminbi (RMB), and Hong Kong is positioning itself as China’s offshore RMB center by building RMB capability and developing diversified RMB products. HKEx is looking to capitalize on this opportunity as well. The mainland’s high demand for raw materials and international trades in commodities is another driver for the HKEx group. It recently acquired the London Metal Exchange (LME) Group to signal its intent to grow a commodity business. Leveraging on this acquisition it plans to build an “East Wing” of commodities clearing for the whole Asian region and during Asian time zone. HKEx’s future prospects, like its historic growth, are contingent on the mainland dynamics. While it has many upsides, too much reliance on China can have downside risks in case of slowing down of the Chinese economy or emergence of policy hurdles. Recent slowdown of Chinese economy has raised concerns about the prospects for its future growth and its potential adverse impact on the China-Hong Kong trading link. On the commodities front China seems uninterested at this point in taking help from other markets. Furthermore, commodities trading practices differ between China and Hong Kong as investors in China, unlike those in Hong Kong, want physical delivery. This requires significant warehouses that the HKEx is still in the process of developing. Lastly, neighboring Singapore will present competition in the OTC space as it also plans to be a major player in the region focusing on South East Asia and China.

China’s road towards Currency Internationalization

China is the world’s second biggest economy, largest exporter and second largest importer. Yet China’s currency, the Renminbi (RMB), accounts for less than 1% of global FX turnover. The Chinese authorities have been making concerted efforts since late 2008 to internationalize the Renminbi by trying to increase its use in international trade and investments. Their efforts are paying off as RMB settled trade has grown since late 2010 and accounts for 8-10% of all international trades at present. The following highlights some major successes of their efforts: •    From October 2010 to June 2012 value of RMB payments grew by 17 times. Currently 91 countries are processing renminbi payments. •    Hong Kong is the dominant offshore centre for RMB trading accounting for around 80% of all renminbi payments; share of Singapore, Taiwan are also significant. UK is positioning itself as a major offshore trading centre for renminbi. •    RMB is among world’s top ten currencies traded. Three FX markets exist for RMB: onshore CNY market which is tightly controlled, offshore CNH market in Hong Kong which is relatively free, and USD denominated non-deliverable forward market. The currency sometimes trades at different rates in the CNY and CNH markets and many firms, especially large ones with subsidiaries outside borders, use it to conduct exchange rate arbitrage in these two markets. Given that China’s currency is not fully liberalized, this arbitrage sometimes is not settled by market forces and it creates pressure on the currency, as was evident late last year. Some therefore argue that significant proportion of RMB settlement comes from speculation in the two markets while imports are still invoiced and mostly settled in US dollar. Bank of China Hong Kong (BOCHK) and Bank of China, Macau, are the only two entities approved to clear offshore RMB transactions. Other banks can engage in offshore RMB business through agreement with BOCHK, or through relationship with other banks which have existing agreement with BOCHK. This presents an opportunity for many regional and international banks to tap into this burgeoning market of RMB clearing and trade related services. Moreover, two of the world’s biggest exchanges, the Hong Kong Exchange (HKEx) and the CME Group, recently announced plans to launch offshore yuan futures in Hong Kong by the end of 2012. This is likely to facilitate exporters and importers hedge their currency risks, especially now that the currency is showing some volatility. The forwards market at present is very efficient with tailor made contracts; therefore some think currency futures may not gain traction immediately among traders. However, along with importers and exporters who use currency futures and forwards to hedge exposure, this will also attract asset managers and other financial institutions as the contracts will be standardized and tradable at the exchanges. The outcome of these initiatives remains to be seen, but these moves are likely to further strengthen China’s efforts towards Renminbi internationalization. It must be mentioned that in spite of these developments, there are challenges with China’s efforts to internationalize the RMB. At a broad level, RMB is mostly used to settle imports, but not exports. Even in imports, invoicing is often done in US dollars while settlement happens in RMB. It is argued many Chinese corporations use the different currency markets (CNH-CNY) to engage in speculative activities and not that much for pure trade purposes. This effectively allows for interest rate speculation between the two markets as well. Many of these problems are intertwined as China has traditionally had very strict capital control, and the internationalization of renminbi is taking place before fully liberalizing its interest rate, exchange rate or capital account. Therefore how China attempts to internationalize its currency and manages its key rates at the same time will be closely watched.

Shifting Focus of Hedge Funds: From West to East

Hedge funds in the US and UK have come under greater scrutiny from regulators in the aftermath of the financial crisis. New York currently accounts for about 45% of global hedge fund assets, while London accounts for about 15%. But recent proposals regarding hedge fund regulations have not only prompted fund managers to cancel or delay plans to set up new shops in London and New York, many are moving their offices to Asia, mainly to Hong Kong and Singapore. As a result more Asian hedge funds from Hong Kong and Singapore are gaining prominence and market share. The following can be attributed as drivers affecting this shift: • Stable economies, workforce, less stringent regulations favoring financial services, good financial infrastructure in Hong Kong and Singapore. • Tax incentives, licensing exemptions offered by Singapore and Hong Kong governments. • Extensive tax treaty network with other countries which reduces tax liability in treaty countries. • Easy access to Asia’s growing pool of investors whose risk appetite is also on the rise. • Market conditions and high economic growth potential (India and China) – managers who previously invested in Asia from offices in London or America now prefer to be located in the region within same time zone and with easier access to local information. • Investment firms have had to separate their prop desks from other activities – many ex prop traders are setting up their own shops in the region. As a result of these, assets managed by hedge funds in Hong Kong and Singapore has recovered fast post crisis. Though it hasn’t got back to pre crisis levels yet, these two countries have seen significant number of new hedge funds entering the market in the last 12 months. While the two countries look similar in many aspects with respect to the hedge fund industry, there are subtle differences. While Singapore’s policy framework is more relaxed, Hong Kong has stringent regulatory set up. Hong Kong is closer to mainland China and has better access to Chinese markets and investors. This factor coupled with the fact that Hong Kong had a year’s head start over Singapore regarding hedge fund entry has made Hong Kong the biggest centre for hedge funds in Asia – but Singapore is catching up fast. In both countries the industry is concentrated by top few players; in Hong Kong top 20 funds account for 56% of industry AuM while for Singapore top 7 firms account for 20% of total AuM. Singapore attracts a larger proportion of smaller funds (0-50m) while Hong Kong draws a larger proportion of bigger funds (100-500m funds); this is helped by a regulation by Monetary Authority of Singapore (MAS) which proposed managers with less than $183 million and serving less than 30 investors need not be licensed. This competition between the two countries to attract hedge funds is likely to continue in the future and the industry is expected to register high growth in AuM in the next 12 to 18 months.

UCITS: Knocking on Asia’s Doors !

Undertakings for Collective Investments in Transferable Securities (UCITS) are investment schemes that allow for free cross border sales of instruments with a single authorization from any one of the Euro-zone member states. They have become tremendously popular in Europe. Off late UCITS are gaining in popularity with international investors.Today, Asia has the lion’s share of all internationally distributed UCITS. Hongkong, Singapore and Taiwan are emerging as hubs for the distribution of UCITS to the wider East, South East and Central Asia Region. Bahrain has become a pivotal center for UCITS distribution in West Asia and Africa.

Majority of investments finding their way into UCITS in Asia are routed into Equity (39%) , Money Market (23%) and Bond (20%) Funds. Most UCITS promoters I spoke to believe that though Asia will continue to be the biggest overseas geography for UCITS sales, challenges remain. These include – taxation issues, distribution complexity because of non-standard platforms , fragmented market and low automation levels. Will be interesting to see how distributors in Asia respond to this opportunity and how newer markets in Asia react to the UCITS offerings. Celent has just released a report on the subject: UCITS IV Directive: Implications for the Asset Management Industry in Europe.

Bancassurance, Next Only to Agent Distribution Channel in Asian Insurance Market

While my earlier article discussed in general on how Bancassurance channel is shaping up in various regions in Asia Pacific. This write-up sheds some light in terms of market share and growth of Bancassurance in various regions in A Pac. It is evident that this channel is picking up in most of Asia Pacific region. However the channel is still next only to the dominent Agent channel. In Mainland China, Bancassurance accounted for 27 percent market share of total insurance sales, agent channel dominated the market (37 percent market share) in 2009. Insurance market in China is undergoing structural changes with in the market and this is expected to boost the premium income of insurers via banking channel. In Hong Kong, Banks have become an important distribution channel for life, health and mandatory provident funds, supplying up to 40 percent of the market’s new business. HSBC and Hang Seng Bank together held 40 percent of the Mandatory Provident Fund (MPF) market. In Taiwan, the concept of “One Stop Shop” has become a common philosophy for banks. Premium income for individual life insurance new business from bancassurance accounted for 68 percent in 2009. Banks contributed 88 percent to new individual annuities, 66 percent to new investment-linked businesses, and 51 percent to new life insurance businesses. While P&C market is dominated by agents and brokers (67 percent of the market share). Personal accident/ health Insurance is mostly under taken by Insurance companies themselves, thus accounting for 91 percent of this line of business. In Singapore, insurance agents make up the main sales channel for life insurance. The market share however has declined from 66 percent from 2004 to 61 percent in 2009. Bancassurance accounted for 22 percent of the total weighted new business premium income Bancassurance market share in Malaysia has grown from 45 percent in 2005 to 51 percent in 2008. The agency network had traditionally been the main distribution method but has gradually lost some ground to bancassurance. Agency network accounted for 47 percent market share in 2004 which has come down to 44 percent in 2008. Domestic insurers account for over 80 percent of Bancassurance market. In South Korea, solicitors and internal employees make up the main sales channel for the life insurance industry. In 2008, the bank channel grew to 37 percent next only to solicitors and internal employees of the insurance companies with 54 percent. Indian life insurance market is dominated by tied agents, more so with the state owned Life Insurance Corporation of India (LIC). Over 75 percent of new business premium is generated by individual agents. However, individual agents in private companies account for less than 50 percent of total sales, while more than 40 percent is attributed to the bank and direct selling channel. Banks and brokerage firms have 30 percent and 20 percent respectively of the P&C insurance market. Markets such as Thailand, Malaysia and China have better acceptance of bancassurance channel as opposed to India and Singapore as brokers and agents are still major insurance carriers in these region. It is also noteworthy that all developing and accelerating markets are evidencing high potential for growth in Bancassurance.

Accepting the need for Electronic Trading

In its recent history,the Asian market has been characterized by the adoption of technology in a much more compressed time-frame as compared to its counterparts in the western world. This has been true of the industrial as well as the services sector, where it is also holds true for electronic equity trading. Asia is well poised for a rise in the share of electronic trading in the next few years. Markets such as Japan, Australia, Singapore, Hong Kong and India are seeing a lot of investment happening that is related to Direct Market Access (DMA), Smart Order Routing (SOR) and High Frequency Trading (HFT). The associated infrastructure such as market data services, co-location and so on are also being paid attention to, as is the requirement for helpful regulation. However, in some markets, the regulators are not very confident about and supportive of the needs of greater electronic trading. This is partly because of the financial crisis and rising requirements for risk management, and also due to the flash crashes that have occurred in the NYSE and OSE markets. We expect the regulatory framework to become more flexible in most markets, but there is still an important element that needs to be addressed across the board in the Asia-Pacific. That is the role of smaller brokerages and the buy-side. Unlike larger brokerages, these are still reluctant to adopt electronic trading and to make the investments required to have the same. While attitudes and capabilities do not change overnight, I believe that market investors in Asia need to be made aware of some harsh realities. To start with, the way HFT and algorithmic trading evolved in the US and European markets, there was very little time for market participants to react to and adopt such trading. The change happened so quickly that a number of brokerages and buy-side firms were unable to cope and had to operate in a more constrained fashion or even shut down. The incentive that HFT provides for those trading larger volumes means that the smaller players are at a relative disadvantage. This increases even more if they are slow to react and do not adopt electronic trading. So it is not just the speed of trading that is important to succeed, it is also the speed of thought. Hence, smaller brokerages and buy-side firms in Asia should be more positive and not be afraid of investing in DMA, SOR or HFT. The gains from these might not be apparent immediately, but if the lessons from the western markets teach us anything, it is that the quick and nimble-footed firms were the most successful during the rise of electronic trading. With the trading infrastructure in Asia changing so rapidly, there is little reason to believe things are going to be different here.

Welcome to Celent’s Asia Blog

Celent is continually looking for ways to better connect and interact with the financial and technology communities. Continuing in the tradition of Celent’s industry-specific banking and insurance blogs, we are now launching a blog focused on issues in business and technology strategy in the Asian financial services. Welcome to Celent’s new Asia blog. From the beginning, a differentiator at Celent has been our coverage of financial and technology issues from a global perspective. As part of this commitment, over the past few years, we have been ramping up our research on Asia and India. We have now built up quite a substantial library of research on these regions, which we think is pretty unique. Building on this, we have recently also launched two new research services, one focused on India, the other focused on the rest of Asia. These services essentially bundle reports from our banking, securities & investments, and insurance services into regionally-focused services aimed at firms seeking cross-vertical competitive information on Asia and India specifically. And now the Asia blog. We have a baker’s dozen of analysts ready to lob commentary on what we see developing in the region, as well as on Celent’s activities. We think you will find our essays informative and stimulating. And we encourage you our readers to participate in the feedback loop by sending us your comments and questions. The goal is to create an active dialogue on the evolving financial services and technology markets in India and Asia.