Primary issuance will be a key new feature of the latest Stock Connect initiative as it links Shanghai to London.
The upcoming Shanghai-London Stock Connect ("London Connect") is an innovative market infrastructure initiative that will create a link between China's largest stock market and Europe's leading financial centre. Expected to go live before the end of 2018, the new scheme is the latest iteration of the Connect initiatives, which since 2014, have successfully led to an unprecedented degree of cross-border access between the securities markets in Mainland China and Hong Kong – first with the stock markets in Shanghai and Shenzhen, and then the domestic bond market.
The London Connect will extend the benefits of market access to new geographies, as international investors will be able to buy into Chinese companies, while investors in China will be able to enjoy a fresh channel to get overseas exposure. The new scheme will also generate new fundraising opportunities by providing Chinese corporates with access to a new pool of capital globally.
Overcoming time differences
London Connect is very different to its predecessors. The substantial time zone difference between China and the UK means that there is no overlap in the trading hours1, with the Shanghai market closing as the London trading day is about to start. Therefore, instead of allowing investors to engage in real-time equity trading between the two markets, London Connect is a two-way programme that allows Chinese investors to trade Chinese Depository Receipts (CDRs) during Shanghai's trading time, while international investors will be able to trade Global Depository Receipts (GDRs) during the British trading hours.
Chinese companies have years of experience issuing depository receipts, especially technology companies with American Depository Receipts (ADRs), and there is a long history of GDRs in London. The Depository Receipts ("DRs"), however, is a new concept for Chinese investors, who have hitherto never had access to markets where they are traded. Since there are no DRs listed in Shanghai, London Connect will require some secondary market activity from companies listed in the UK in the form of a technical listing.
With a minimum market capitalisation requirement of RMB20 billion (around GBP2.3 billion)2 for CDRs and GDRs, according to the current rules, participating companies will likely be blue chips. The amount of share capital that can be allocated to these securities is capped at a maximum of 15 per cent. Chinese companies looking to issue GDRs require approval to undertake a follow-on from the securities regulator, while firms that want to issue CDRs must have been listed in London for at least three years and initially restricted to DRs that do not require capital raising, with the initial inventory to be created by purchasing the underlying asset. After the transaction is completed, the host country rules will govern the DRs trading, while the home country rules applies to the underlying.
Shanghai-London Stock Connect
Motivations to issue DRs
Companies at the opposite ends of the London Connect will likely have different motivations to take advantage of a previously inaccessible venue to list depository receipts. A London-listed company might see it as an opportunity to step up expansion in the world's second largest economy, which has highly liquid equity markets that trade at a much higher valuation than the London benchmark. They will also be able to diversify their investor base by gaining access to the fast growing asset management industry. This will also help some UK-listed companies for brand building in China, making it more visible to the Chinese investors.
A Chinese company on the other hand, will likely be attracted to the international nature of the London market, which is home not only to listed companies from the UK, but also companies from all over the world. Furthermore, the market is a deep pool of capital. It can also help realise expansion plans that rely on acquisitions, since London-listed shares are widely accepted as an acquisition currency.
Brokerages will also have to make some preparations in order to participate in London Connect. Designated brokers will be able to trade the underlying; and to process trades, they will be required to open a securities account in the other market, where they can work with one or two local brokers to gain access to the exchange.
The trading rules are designed to address differences between the trading cycle in China and the UK. Most notably, for the creation of GDRs, there is a T+2 cross border settlement cycle, with redemption taking a day longer at T+3. In order to help brokers manage the risks that could arise from such a discrepancy, brokers can hold a mixture of assets – including cash, underlying shares and their own inventory of stock. But when it comes to the creation and redemption of CDRs, stock borrowing can be used to streamline the process to a T+2 cycle.
Allowing for smooth transactions between markets that have different trading cycles is one of the key challenges for London Connect. Brokers, investors and corporates in China and the UK will have to learn about new market dynamics in faraway exchanges. But the successes from earlier Connect schemes linking mainland China to Hong Kong suggest that it is worth making the effort, as all participants can greatly benefit from increased connectivity between markets.
Trading Hours - Shanghai-London Stock Connect
1 As at 22 November 2018
2 GBP2.3 billion at an exchange rate CNY to GBP at 0.11 as of 9 November 2018