The War for Capital – China's Stock Market Reforms in 2019

However, retail investors still take up almost 80% of the onshore stock market. In more mature markets like Hong Kong and the U.S., the opposite is true with institutional investors outnumbering their retail counterparts. As retail investors are prone to chasing rallies and pulling out when stocks plunge, China's stock market is characterized by high volatility and inefficiency.

Foreign investors, most of whom institutional, help bring in more professional investment practices. However, compared with more than 40% participation in other Asian markets, foreign investors represent only around 4% of the Chinese market despite being higher than ever. This paltry sum becomes increasingly precarious as growing geopolitical tensions threaten to pull global capital out of China as well as Chinese corporations' ability to fundraise overseas.

In response to these problems – low institutional participation, low foreign participation, growing geopolitical uncertainties – Chinese regulators in 2019, spearheaded by the new CSRC chief, targeted three main areas for reform:

• Further open up China's A-shares market through Stock Connect reform
• Facilitate Chinese corporate equity financing by loosening listing requirements
• Expand foreign investors' investment scope and choices through QFII/RQFII reform

A-Shares opening up

Far and away, the most popular channel through which foreign investors access China's A-shares market is "Stock Connect" – the trading link between Hong Kong's stock exchange and the two main exchanges on the mainland, Shanghai (SSE) and Shenzhen (SZSE). As such, many of China's stock market opening up reforms are geared towards improving the scheme.

The global index provider MSCI framed its decision to begin including A-shares in its benchmark indexes in 2018 around Stock Connect, referring to it over 50 times in an explainer for its decision. The indexes are tracked by global passive funds, which allocate money in accordance with changes in the makeup of the indexes.

In February 2019, MSCI announced it would add more A-shares and quadruple the inclusion factor to 20% over the course of the year. Since then, the CSRC and the Hong Kong Stock Exchange (HKEX) have introduced several measures to enhance Stock Connect in preparation for increased foreign investment inflows.

A key area is the derivatives market, which has seen opening up and innovation both onshore and offshore. In March, HKEX and MSCI collaborated to introduce futures contracts on the MSCI China A Index, giving foreign investors a hedging tool as they trade A-shares in Shanghai and Shenzhen through the northbound Connects. Then in November, the CSRC approved the launch of new exchange-traded fund (ETF) options as well as CSI300 index options on the China Financial Futures Exchange. Most recently, in December, the SZSE introduced a pilot for trading stock options for qualified market makers.

Speaking at ASIFMA's annual China Capital Markets conference in Hong Kong in November, Jessica Morrison, Executive Director at Morgan Stanley, highlighted the importance of derivatives for international investors as a tool to hedge risks.

"There has been lots of mumbling onshore about whether there will be liberalization of the index derivatives markets," she said. "Whether that's going to be something that can gain CFTC (U.S. Commodity Futures Trading Commission) approval, which is going to be extremely important for international investors, and whether we end up with both onshore and offshore derivatives contracts that we can start using to hedge – there's been progress on that onshore (in China)."

In 2019, global investors also saw promises made the previous year in action. An ASIFMA report published in June highlighted the "visible improvement" in the level of trading suspensions in the market (when listed companies suspend trading of their shares to prevent their price dropping significantly). The SSE and SZSE had tightened suspension rules in late December 2018. The report by the industry group, comprised of leading financial institutions from both the buy and sell side, also welcomed the end of "window guidance" (窗口指导) as a practice in October 2018. Previously, the SSE and SZSE would interfere in trading by issuing verbal warnings to brokers over how to handle client orders.

IPO reform

Partly due to growing geopolitical uncertainties, China has pushed for more of its companies to list at home in recent years, whether it be in Shanghai, Shenzhen or Hong Kong. 2019 was no exception to this trend, with initial public offerings (IPOs) on the New York Stock Exchange and Nasdaq by Chinese tech companies dropping two-thirds from the previous year according to Dealogic. Although 2018 was an exceptional year in this regard, the drop cannot be viewed merely as regression toward the mean. Both mainland Chinese and Hong Kong regulators have reformed listing rules in the bid to attract more home listings by Chinese companies.

One area in which reform efforts have targeted are companies with dual-class share structures. In 2018, HKEX enacted its most significant reforms in three decades, one of which was to allow companies with weighted voting rights to list there for the first time – a decision which directly led to Alibaba's $13 billion secondary offering in Hong Kong in November. These companies have a dual-class share structure giving founders greater control over their companies, a practice that is especially popular among tech companies including Facebook and Google.

In August, HKEX, SSE and SZSE came to an agreement over how to allow mainland investors to conduct "dual-class share trading." Two months later, Xiaomi and Meituan Dianping, two other Chinese tech giants with weighted voting rights, were included in the Stock Connect program after months of delay, making their shares available to trade by mainland investors for the first time. The two Hong Kong-listed companies are the first companies with weighted voting rights to be included in Stock Connect.

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"The STAR board's innovative features make it one of the most significant developments for China's stock market in 2019."

Shanghai

There has also been reform to dual-class shares rules onshore. The new Science and Technology Innovation Board (STAR) in Shanghai, launched in June, marks the first time that China is allowing companies with weighted voting rights to list onshore. Moreover, the board has a registration-based system for companies looking to list rather than an approval-based one, speeding up the traditionally arduous onshore listing process.

The STAR board's innovative features make it one of the most significant developments for China's stock market in 2019, says Kejun Guo, a Beijing-based partner at Zhong Lun Law Firm.

"The STAR board has five listing requirements, which are more or less fulfilled by tech companies trying to list on the board," Guo said. "In the short term, these requirements will not be further lowered, unless in the future we see Shenzhen offering better standards to attract companies to list there. Then maybe SSE will reflect and offer better standards there."

Although the STAR board is significantly liberalized compared to the main exchanges, it still has significant barriers to entry of its own for investors. Retail investors must have at least 500,000 yuan in investment capital and two years equity trading experience. Underwriters meanwhile must invest their own money into the company they are sponsoring, a rule designed to discourage them from setting IPO prices too high.

ASIFMA has called on the SSE to make the underwriting rule optional rather than mandatory. Whether this will happen remains to be seen. However, there are already plans in place to expand STAR board rules to other boards, starting with the registration-based listing system. In late December, China's legislature approved an amended PRC Securities Law (中华人民共和国证券法) to come into effect on Mar. 1, 2020. The revised law paves the way for a full roll-out of the registration-based listing system across the entire A-share market, although no timetable has been provided. Guo believes the first board to be reformed will be Shenzhen's ChiNext.

"There is a possibility for ChiNext in 2020 [to move to a registration-based system]. But it is less clear for Shanghai and Shenzhen's main exchanges."

The STAR board has also paved the way for the wider roll-out of other market reforms. Companies yet to make a profit are allowed to float shares there for the first time in China, a major boon for tech startups, which typically do not turn a profit in their early stages of development. The revised Securities Law reflects this by lowering the minimum requirement for a company to be listed from "capable of sustained profitability" to "capable of sustainable business operations."

In addition, the revised law tightens information disclosure requirements and provides for heavier punishments for non-compliance. Fraudulent companies will now face fines up to 20 million yuan ($2.9 million), a significant increase from 600,000 yuan previously. Listed companies that fail to meet listing requirements will also be directly delisted rather than suspended under new rules already in place on the STAR board.

"This reform will simplify the existing delisting process, shorten the delisting cycle, and increase the delisting rate," said Xiang Zhenhua, a Beijing-based partner at Jingtian & Gongcheng. "It will accelerate the exits of companies that fail to meet listing requirements from the market, thereby improving the overall quality of the Chinese stock market."

Shenzhen

Although the STAR board dominated headlines in 2019, its older counterpart in Shenzhen, ChiNext, has seen various reforms too designed to meet Chinese companies' financing needs. In October, the CSRC scrapped profitability requirements in M&A deals involving ChiNext-listed companies, paving the way for backdoor listings on the board and reversing 2016 rules barring them. Soon after, it relaxed controls over private placements by listed companies, by far the most popular financing tool for companies before it was cracked down on in 2017. ChiNext-listed companies would no longer have to be profitable for two consecutive years before conducting a follow-on offering.

Guo expects to see more reforms loosening financing restrictions in 2020. "China will target listed companies' financing problems by offering them more channels to refinance in the markets in order to give them more opportunity to secure capital."

One promising area is the growing cooperation between Chinese and European bourses. In June, the Shanghai-London Stock Connect was launched, connecting two of the world's largest stock exchanges (currently suspended due to political tensions). Listed companies on both sides were allowed to list in the other through the issuance of depository receipts (bank certificates representing shares in a foreign company). Under the revised Securities Law, depository receipts are specified as securities for the first time and will therefore be regulated as such.

There are plans to launch another linkage with Frankfurt, which would be the first on continental Europe. Zhong Lun is already working with several Chinese companies to arrange their IPOs in Frankfurt, Guo revealed. However, he does not expect a wholesale shift towards the European market from other markets due to language and cultural unfamiliarity. "We think Europe is increasing in popularity, but it won't be the main market in the short term."

QFII/RQFII

Although Stock Connect is the dominant investment channel for global investors to tap China's stock market, it is not the only game in town. Global investors can also access the market through the Qualified Foreign Institutional Investor (QFII) scheme, which dates back to 2002, as well as its yuan-denominated equivalent (RQFII). However, since Stock Connect was launched in 2014, trading volumes through the QFII scheme have dwindled.

Nonetheless, 2019 was a significant year for the traditional investment channel. The CSRC built on significant reforms enacted the previous year by China's central bank and foreign exchange regulator liberalizing funds repatriation restrictions and allowing foreign-exchange derivatives trading for the first time.

The CSRC certainly wasted no time under its new leadership when it released draft rules in January 2019 combining the QFII and RQFII schemes and removing quantitative entry criteria. The draft rules also proposed to expand the scope of investment permitted to include stocks on the National Equities Exchange and Quotations (NEEQ) market, financial futures, and options. Securities lending in stock exchanges would also be allowed for the first time, which is important for investors as it helps cover for settlement failure.

Then in September, all investment quotas under the QFII program were scrapped. Although large portions of the quotas were not being used, the signal to global investors was clear that QFII remained important for Chinese regulators. Jack Ko, Executive Director at Goldman Sachs, said at the ASIFMA conference that the relationship between QFII and Stock Connect is supplementary rather than competitive.

"The QFII/RQFII consultation in January by CSRC is setting up the framework for international investors to access China in a cross-asset platform," he said. "Over time, [we will] definitely see new measures coming out across different channels that will make the eco-system very fluid."

2020 outlook

Needless to say, the main overseas market for Chinese companies, the U.S., looks increasingly unstable. Despite a limited phase one deal being agreed, the wider bilateral relationship between China and the U.S. has deteriorated amidst growing bipartisan calls in the U.S. for the country to decouple from China economically, including in capital markets. In November, a bipartisan group of senators introduced a bill to ban a federal pension fund from investing in Chinese stocks. The board overseeing the fund had planned to shift its benchmark to the MSCI indexes that includes Chinese stocks. There have also been reports that the Trump administration is considering delisting U.S.-listed Chinese companies as a potential weapon in the ongoing trade war.

"There are forces in the U.S. intending to close their capital markets to Chinese companies," said Lyndon Chao, Managing Director at ASIFMA's Equities Division. "That only makes it more urgent for China to figure out how to bolster their own capital markets to make it more robust and attract more capital to support their real economy." He points to the so-called "Equitable Act" making the rounds in Congress as something to monitor in the coming year. The bill proposes to delist Chinese companies that fail to disclose to the U.S. Public Company Accounting Oversight Board (PCAOB) important financial information considered sensitive by China.

"China has to date deemed this information state secrets, so they do not allow this information to go offshore," Chao explained. U.S. regulators have tried in the past to access this information but to no avail; the proposed law would require Chinese companies to disclose the information within three years or be delisted.

Chao believes that China and the U.S. are not just at loggerheads over trade. Rather, there also appears to be a "war for capital" being fought. As the U.S. adopts an increasingly unwelcoming stance towards Chinese companies looking to list there, demand for domestic IPOs will only grow as well as the need for onshore listing reforms to meet that demand. "China from a risk management perspective recognizes that the clock is ticking, so they need to pick up the pace [of reform]."

Reform is made even more urgent as foreign investment inflows look set to increase in 2020. The growing representation of A-shares in global indexes shows little sign of abating as more index providers follow the example of MSCI. FTSE Russell has already begun including China A-shares in its global benchmarks in a three-step process ending in March 2020, while S&P Dow Jones began including A-shares in their benchmark indexes in September. An Invesco survey has found that four in every five global investors plan to increase their China allocations in 2020, with onshore equities the asset class of choice.

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China and the U.S. are not just at loggerheads over trade. Rather, there also appears to be a "war for capital" being fought.

Improvements to market access and infrastructure are needed for China to fully capitalize on the possible additional windfall in the coming year. ASIFMA's 2019 report lists several areas in which the adoption of global trading standards would make China's stock market more appealing to global investors. These include settlement cycle, derivatives trading, securities lending, and "omnibus" trading reform (allowing fund managers to place multiple orders on behalf of different clients). MSCI has made similar demands as conditions for further inclusion of A-shares in their indexes.

"Ever since MSCI made the announcement of A-share inclusion, we've been encouraged by constructive interactions with a very receptive CSRC," Chao said. "We go up to Beijing regularly with recommendations by the Industry to improve the market and they have been quick to action them. They've been so progressive, sometimes even a little bit ahead of us." He cites the example of a three-second trade reporting delay at the SSE which global investors had complained about. It was quickly fixed in late November.

Projects in the pipeline suggest that Hong Kong is determined not to sit on its hands either despite an eventful few years of reform. On the investors' side, HKEX is working on allowing omnibus trading under the Stock Connect program as well as a post-trade platform built on distributed ledger technology (the basis for Blockchain) to help reduce risk and increase transparency in the settlement process. Global investors could see both projects implemented in 2020 – omnibus trading in Q1, a post-trade platform pilot by the end of the year – according to a source familiar with the matter.

On the listing side, the implementation of the H-share "full circulation" program in November by the CSRC means that Hong Kong-listed Chinese companies are now able to convert their unlisted holdings into shares that can be traded in the city. This should increase the city's appeal to Chinese companies thinking about having an IPO in 2020 on the back of a hugely successful 2019 that saw Chinese tech companies fundraising in Hong Kong jump more than 80% year-on-year, according to Dealogic.

Onshore, there has been progress made on some of global investors' concerns, such as securities lending and derivatives trading opening up under the proposed new QFII rules. Global investors will be eager to see whether these will be implemented in 2020 or even expanded to other investment channels, a potentially significant milestone especially for China's nascent derivatives market. There is also considerable interest in what if any reforms China makes to its unique onshore settlement cycle system in 2020, although the likelihood of that happening is low given the importance of pre-funded settlements in China's retail-heavy stock market.

The removal of foreign ownership limits in the financial industry in 2020 will bring into the market more institutional expertise. The CSRC has provided a timetable for the removal of ownership limits for futures, fund management, and securities companies, from January, April and December respectively. Originally scheduled for 2021, the plan was accelerated by a year and will directly benefit foreign financial firms such as JP Morgan and UBS for whom these ownership limits have long been a source of frustration.

"Looking forward, they will continue to accelerate the pace of reform because they face an increasingly uncertain world," Chao said. "Let's hope they have the courage to embrace that uncertainty and keep doing the right thing."