Hong Kong – Southbound Bond Connect.

On the date of the announcement, the PBOC has published a notice and FAQs, and some of the infrastructure services institutions (namely, China Foreign Exchange Trade System & National Interbank Funding Center (“CFETS”), Shanghai Clearing House (“SHCH”) and Central Moneymarkets Unit (“CMU”) operated by the HKMA) have also published their rules or operational arrangements, for Southbound Bond Connect1 . As we await the publication by other infrastructure services institutions of their rules, we summarise in this Bulletin the details of Southbound Bond Connect that are already in the public domain and set out a few of our observations.
 

Background
 

The Bond Connect scheme was established in July 2017 as a new mutual market access scheme allowing investors in mainland China and overseas investors to trade in each other's bond markets through a linkage between the financial infrastructure services institutions in mainland China and Hong Kong SAR. The Bond Connect scheme started in July 2017 with Northbound trading (that is, offshore investors accessing the China Interbank Bond Market) only. After four years, Southbound trading (that is, mainland investors accessing offshore bonds via the Hong Kong SAR bond markets) has now been announced. The launch of Southbound Bond Connect marks another milestone in the development of mutual market access between the capital markets of Hong Kong SAR and mainland China.
 

Eligible Investors and offshore market makers
 

The PBOC has tentatively defined the investor scope for Southbound Bond Connect as 41 bank-type financial institutions which belong to the list of “Tier 1” dealers recognised by the PBOC in 2020 for open market business. Nonbank financial institutions and rural financial institutions are not included in the list of eligible investors.
 

Qualified domestic institutional investors (“QDIIs”) and renminbi qualified domestic institutional investors (“RQDIIs”) are also permitted to trade under Southbound Bond Connect.

CFETS stipulated in its trading rules that onshore eligible investors may provide “ancillary services” for Southbound trading to other onshore eligible investors; it remains to be seen what services are permitted as the relevant rules will be separately set by CFETS.
 

Eligible investors may only use Southbound market information they obtained via CFETS’ trading platform for trading purposes. In particular, the use of such market information for index compilation and provision of derivatives without the authorisation of CFETS is prohibited under the CFETS trading rules.
 

Eligible investors will trade with offshore market makers designated by the HKMA. At the launch of Southbound Bond Connect, the offshore market markets comprise the following 13 financial institutions in Hong Kong SAR: Agricultural Bank of China Limited, Hong Kong Branch, Bank of China (Hong Kong) Limited, Bank of Communications Co., Ltd., Hong Kong Branch, BNP Paribas, Hong Kong Branch, China CITIC Bank International Limited, China Construction Bank (Asia) Corporation Limited, Citigroup Global Markets Asia Limited, Credit Agricole Corporate and Investment Bank, The Hongkong and Shanghai Banking Corporation Limited, Industrial and Commercial Bank of China (Asia) Limited, J.P. Morgan Securities (Asia Pacific) Limited, Mizuho Securities Asia Limited and Standard Chartered Bank (Hong Kong) Limited.
 

Eligible Products
 

The PBOC notice provides that eligible investors can trade bonds issued offshore and traded with liquidity in the Hong Kong SAR bond market under Southbound Bond Connect. At first sight, the scope of tradable bonds under Southbound Bond Connect appears to be extremely broad although it remains to be seen if any liquidity criteria will be further prescribed for such tradable bonds and if such criteria will apply not only to secondary market trading under Southbound Bond Connect but also to primary issuance as well.
 

For Southbound trading through CFETS, CFETS said it will provide a list of tradable bonds on its trading platform, and such list will be refreshed in accordance with market conditions and investor demands. The bonds eligible for Southbound trading through CFETS and settled via CMU will also need to be supported by settlement in the Cross-Border Interbank Payment System (CIPS) and subject to CMU’s update to its participants from time to time. Trading is limited to cash trade at the initial stage of Southbound Bond Connect.
 

Trading link
 

Under the Southbound trading link, the onshore electronic trading platform operated by CFETS may offer offshore bond trading services via a linkage with offshore electronic trading platforms (expected to be Tradeweb Markets and Bloomberg at launch), or via offshore market makers connecting to the CFETS electronic trading platform directly. Onshore eligible investors that are QDIIs or RQDIIs may also continue to use channels permitted under existing regulations applicable to them to trade offshore bonds (such as over-thecounter trading).
 

Eligible onshore investors need to have (or open) trading accounts with the CFETS onshore electronic trading platform and activate Southbound authorisation to trade through the CFETS Southbound link, while offshore market makers designated by the HKMA are required to submit certain business information to CFETS before commencing their business in Southbound Bond Connect.
 

Through the CFETS Southbound trading link, an eligible onshore investor will be able to directly submit its request for quotes (RFQ) through CFETS’ electronic trading platform to one or more offshore market makers. Offshore market makers can then submit their reply quotes to the onshore investor. If done via an offshore electronic trading platform, the offshore market makers are deemed to agree to the trade details calculated by such offshore platform based on the reply quotes in accordance with its terms and relevant market practice, as well as to the display of such information by the CFETS onshore electronic trading platform to onshore investors for confirmation. In accordance with the “home market rules” principle, the offshore market makers’ submission of quotes must comply with Hong Kong regulatory requirements.
 

PBOC notice provides that onshore eligible investors can subscribe for primary issuance of offshore bonds under the Southbound Bond Connect and the relevant mainland and Hong Kong market infrastructures shall put in place operational mechanism to support the southbound investors’ subscription. The commencement date of primary market operations for Southbound remains to be confirmed.
 

Settlement and Custody Link
 

The nominee holding structure which international investors in the bond markets are familiar with (and which has been adopted for Northbound Bond Connect) will be used in Southbound Bond Connect as well. Onshore investors are given the choice to custody their bonds either with a mainland bond registration and settlement institution recognised by the PBOC (expected to be SHCH and China Central Depository & Clearing Co., Ltd. (“CCDC” and together, the “Onshore CSDs”)) or a designated onshore custody and settlement bank. The first batch of onshore custody and settlement banks recognised by the PBOC are Industrial and Commercial Bank of China, Bank of China and China CITIC Bank. However, the settlement and custody structure in relation to the onshore custody and settlement banks does not yet appear to be set out in detail.
 

If the onshore investors choose to custody and settle their bonds with an Onshore CSD, they (or their designated custody banks) can open “Southbound bond accounts” with an Onshore CSD to record the amount of bonds they are holding at such Onshore CSD. Bonds settled via an Onshore CSD would need to be traded via the CFETS Southbound trading link. The PBOC notice stipulated that the relevant Onshore CSD shall open nominee accounts with CMU to record the aggregate amount of bonds it is holding on behalf of onshore investors. SHCH’s Southbound Bond Connect rules provide that onshore investors have bondholder rights and SHCH will exercise such rights after consultation with bondholders and in accordance with their instructions. Settlement at the SHCH will be on a gross basis.
 

If the onshore investors choose to custody and settle their bonds with an onshore custody and settlement bank recognised by the PBOC, the PBOC notice stipulates that such bank can establish a link with CMU or custody banks in Hong Kong (through opening nominee accounts in Hong Kong SAR) to provide the relevant Southbound custody and settlement services. Although the details of such link are not yet clear, it seems to leave open the possibility of the inclusion of bonds held by the Hong Kong custodians at ICSDs other than CMU (e.g. Euroclear and Clearstream) within Southbound Bond Connect.
 

Quotas
 

Although investment quotas do not apply to Northbound Bond Connect trading, the Southbound leg is subject to daily and aggregate quotas. Crossborder net fund outflows are subject to an annual aggregate quota of RMB500 billion (or its equivalent) and a daily quota of RMB20 billion (or its equivalent). Quotas may be adjusted by the PBOC.
 

Investments by QDIIs and RQDIIs will not be counted towards the quota usage for Southbound Bond Connect.
 

The real-time usage of quotas will be monitored by CFETS. Once quotas are used up, eligible investors will only be to submit sell trades but not buy trades.
 

RMB settlement and foreign currency conversions
 

For onshore investors who custody their bonds through the link between Onshore CSDs and CMU, funds settlement after the execution of a Southbound trade shall be conducted via CIPS. Such onshore investors must either be direct participants of CIPS or engage a settlement bank in CIPS for the making and receiving of payments in connection with Southbound Bond Connect. CIPS is a payment system which offers cross-border RMB clearing and settlement, and the Bond Connect northbound has been settled via CIPS. Thus, while the PBOC notice does not restrict the denomination of the bonds eligible for trading through Southbound Bond Connect, given the fund settlement requirements on day one, the currency denomination of the bonds that can be purchased through Southbound Bond Connect at launch may in practice be more limited.
 

Subject to such fund settlement limitations, the PBOC notice provides that eligible onshore investors can use both RMB and foreign currencies when trading under Southbound Bond Connect and convert RMB into foreign currency or hedge its foreign currency risk via the onshore interbank FX market.
 

Fund flows under Southbound Bond Connect operate on a “closed-loop” basis. The relevant funds remitted offshore under Southbound Bond Connect must be used for bond investments only. Proceeds from investment (either from a redemption or sale of the bonds) have to be remitted back onshore (and, if originally funded in RMB, converted back into RMB) when the relevant investor no longer needs the funds to invest under Southbound Bond Connect.
 

Qualified domestic institutional investors (“QDIIs”) and renminbi qualified domestic institutional investors (“RQDIIs”) are also permitted to trade under Southbound Bond Connect.

The PBOC stipulated that, consistent with the approach for Northbound, trading and settlement activities under Southbound Bond Connect will be governed by the supervisory requirements and rules in the place where the relevant trading and settlement occurred. The PBOC and the HKMA have also updated their memorandum of understanding on supervisory cooperation to enhance the supervisory cooperation arrangements and liaison mechanisms under Bond Connect. Mainland regulators will continue with their see-through principle in information collection, supervision and risk management.
 

Linklaters Zhao Sheng has extensive experience in advising infrastructure services institutions as well as banks and financial institutions on a wide spectrum of China Connect-related work (including Stock Connect, Bond Connect and GBA Wealth Management Connect). We have assisted, and continue to assist, our clients in developing China Connect trading terms and conditions, structured and repackaging transactions and related collateral arrangements. In relation to Southbound Bond Connect, we are pleased to have advised some of the infrastructure services institutions in their participation in this important scheme. 
 

 

For further information, please contact:

 

Chin-Chong Liew, Partner, Linklaters

chin-chong.liew@linklaters.com