A mutual fund recognition system between Hong Kong and its mainland neighbour has potential to produce a major change in the size and scope of the investment sector.

The world of fund management in North Asia, and elsewhere in Asia, looks set to take a decisive turn with the arrival of the Hong Kong/China Mutual Recognition system - or MRF. Already, organisations such as Cerulli Associates, the research firm, have argued that mainland China looks set to have the upper hand in this relationship, but time will tell.

The new funds regime kicks off from 1 July and allows eligible funds domiciled in either Hong Kong or the mainland to be marketed to the public and distributed across both territories. There are echoes of the European Union’s UCITS structures of “passportable” funds that can be bought and sold across national border - policymakers in Beijing and Hong Kong no doubt hope to emulate what is seen as one of the more successful examples of European financial market integration.

This publication recently spoke to Sebastien Chaker, head of Asia at Calastone, the global funds transaction network, about how it sees the regime working in practice, what is required, what firms are recommended to do, and any traps to avoid.

What, in broad terms, is the significance of this for the Asian investment and fund management market?
This is the first time that “foreign funds” (specifically, funds deriving from Hong Kong) will be allowed for direct public sale within mainland China. Foreign fund managers with a Hong Kong fund range will now be allowed to directly target retail investors in China, a market made up of approximately 300 million investors.  

Through the MRF, Hong Kong investors will obtain direct investment access to Chinese domestic asset managers and funds.  This is already providing a boost to the Hong Kong investment fund and asset servicing industries since many foreign fund managers are in the process of, or are planning to, either re-domicile fund ranges to Hong Kong or create new funds in HK.  Indeed there is evidence that this trend has been occurring for the past 18 months.

What types of Mainland funds can get SFC authorisation in HK and what will not be allowed, and why? Conversely, what sort of funds will be authorised from HK in the mainland and what will not be?
Initially, only fairly straight-forward products such as general equity funds, bond funds, mixed funds, unlisted index funds and physical index-tracking exchange traded funds will be eligible under the MRF. It is possible that the SFC and CSRC [regulators in Hong Kong and mainland] may consider extending the MRF to include other types of products in the future.

What are the minimum requirements for funds that want to be part of this (investment minimums, liquidity, investor protection, documentation, custody of assets, fees, or other)?
First and foremost, the funds must be domiciled in Hong Kong or China. For publicly offered funds, these need to be recognised by either the SFC or CSRC. The fund must be established for more than one year and have a minimum fund size of not less than RMB200 million ($32 million) or its equivalent in a different currency.  

There are restrictions in terms of primary investments, for example the Hong Kong market must not primarily invest in Chinese funds, and the mainland market must not primarily invest in Hong Kong funds. Furthermore, the value of shares or units in the fund sold to Hong Kong investors shall not be more than 50 per cent of the value of the fund’s total assets, and vice versa for Hong Kong funds sold in China.

Are there any requirements that you regard as unnecessary or which are likely to change?
We believe it is the levels of quota that will most likely change. Initially, the dual quota of RMB 300 billion ($48.3 billion) seems reasonable, but this amount will almost certainly get increased over time. We feel that the requirement for values of shares or units not exceeding more than 50 per cent of the value of the fund’s total assets could be very restrictive for Hong Kong-based funds. This is because of the massive difference between the sizes of the two markets, with 7.5 million people in Hong Kong versus 1.3 billion in China.

There has been very little apparent lead time on this new regime - how much of an issue is that? Will a lot of firms not be able to join from 1 July?
The regulatory framework such as eligibility criteria and the general “rules of the game” have been in place for a while, allowing fund managers to appropriately prepare their respective fund ranges. The first movers are already preparing their applications for eligibility and there is no doubt that regulators will be receiving those first applications on 1 July. Sales and marketing people have already been in discussions to appoint their sales agents and should be ready to operate once regulators approve the first applications.

It is the operational aspects, however, that are still being worked out. It is fair to say that with only five weeks between the notice of 22 May and the official launch date of 1 July, the announcement has taken the market by surprise. Getting ready to process the first trades will be a major challenge, especially for the Hong Kong market.

From Calastone's point of view, what sort of issues do you think should be flagged up in terms of how this new mutual recognition system will work?
Mainland China operates retail positions through CSDC’s highly automated infrastructure, in contrast with Hong Kong operating wholesale omnibus positions on a mostly manual basis (by fax). Because of this, it is unlikely that Chinese distributors and fund managers will allow manual trades to and from Hong Kong. It is equally unlikely that Hong Kong fund managers and their respective transfer agents would be able to cope with manual retail trades from China, a country made up of approximately 300 million investors.  

It is absolutely key that fund managers, custodians and distributors in Hong Kong find ways to connect electronically to China and vice versa. Hong Kong players are now faced with having to make a rapid decision on how to structure their operating models in order to send and receive orders to and from China.

How does the mutual recognition regime work alongside the Hong Kong / Shanghai Stock Connect link?  
This is simply another channel that opens up the China capital account towards full liberalisation of the renminbi. In other words, it is another way for capital to move in and out of China.

Which other jurisdictions do you think might eventually be brought into this system?
If successful, China could potentially replicate this model with other markets such as Singapore, Taiwan, Australia and even the UK. Alternatively, we could see this scheme merging with one of the two other regional passporting schemes and creating the basis for an “Asian” UCITS.
 
When do you expect the system to be fully operational, assuming 1 July is too tight a deadline?
Some industry observers believe that the first trades could be as soon as the end of July, though we believe that it is more likely that the first trades will go through electronically across the border from September 2015.  

Who, in terms of investors/other, are most likely to benefit from this development and why?
Investors in both markets will be allowed access to more fund choice for their investments. The HK fund industry will see a boost of fund registration. Chinese asset managers will collectively obtain their first foothold outside of the mainland and build experience in global funds distribution. Global asset serving firms will have a great opportunity to expand their business and showcase their flexibility to support existing clients and new Chinese fund managers.

What has Calastone been doing in preparation? Have you had to take on staff, shift resources, other?
Calastone has been working with China Clear (CSDC – SSCC) to develop a fund transaction messaging link between China and Hong Kong. A special task force has been set-up with the aim of creating an automated link between Hong Kong and China funds markets. The task force is comprised of business analysts, sales, developers, the infrastructure team and product managers.  

Our Hong Kong office has been growing steadily, now incorporating business analysts, infrastructure support and IT development, on top of our original sales and relationship management function. We have also reinforced our Asia-Pacific operations team, as well as adding more Mandarin speakers across all of our departments.

Do you think other examples of cross-border fund recognitions (such as in the EU's UCITS regime) have had a galvanising effect?
Yes, creating an Asia UCITS has been in the air for a long time. Last year the ASEAN scheme between Singapore, Thailand and Malaysia went live. Next year the ARFP scheme is planning on being operational. The MRF has been in discussions for several years and is finally here. All of these schemes have the same objective - to create an Asian version of UCITS. The growing success of UCITS in Asia has certainly galvanised these initiatives.

Do you think this system might give Hong Kong any sort of wealth management edge vs Singapore and if so, why?
The initiative will definitively give an edge to Hong Kong in becoming the major fund centre in Asia. Fund managers wanting to access the Chinese market are now required to set up funds Hong Kong. However, all this will depend on what is next on China’s agenda.

What other points would Calastone like to make about the significance of this?
There is little uncertainty as to whether Chinese fund managers and distributors will be ready on 1 July. Indeed, from their perspective the operational flows will, most likely, not change much. The risk will be whether Hong Kong players will be ready.  Because there is a choice when it comes to choosing a specialised messaging provider between Hong Kong and China, one with a proven track record can constitute a key difference for success.