Opportunity knocks in world’s second largest economy

How much potential does China have as a securities lending market – and what needs to change in the medium to long term to truly open up China as a location for securities lending?

In his top five securities lending demand predictions for 2023, Robert Lees, senior vice president securities lending investor services at BBH referred to China’s reopening as being likely to drive increased opportunities.

He suggested that the unwinding of ‘zeroCovid’ and domestic spending would likely be a significant catalyst this year and could drive increased opportunities. Although the removal of restrictions has been broadly welcomed, the ushering in of the new policy could generate potential risks, including rising infection rates, which may impact productivity.

Separately as China’s economy begins to reopen, Lees observed that global supply chains could be under further pressure, particularly the automobiles and technology sectors. Furthermore, inflationary pressure may rise as China increases its demand for commodities and raw materials such as copper, gas, oil, and steel.

Andy McCardle, head of EquiLend Asia acknowledges that it is hard to estimate the potential of a Chinese lending market.

Substantial potential

“However, I think we can all agree it is substantial,” he says. “China may well represent the largest opportunity of any market globally and it seems to be more a question of when it will reach that level rather than if. Having said that, it could be two years or two decades away.”

The obvious shortcoming of the current operating model is that it is really only a domestic model, which has limitations for both market entrants and vendors. “To truly open China to securities lending, the market needs to be more open and accessible to foreign banks,” adds McCardle.

Stewart Cowan, executive director, head of APAC securities finance product at S&P Global Market Intelligence describes China as one of the sleeping giants of the APAC securities lending landscape. “The size of the investment community is vast, and the size of the economy is likely to at least equal that of the US over the coming years,” he says.

“As China moves towards a more technology focused, greener future, the stock market is likely to play a central role in financing new initiatives. To ensure liquidity and fair pricing, the existence of an active and open securities lending facility is essential.”

Operational complexity

The risk to the securities finance community is the operational complexity that may be involved in operating in such a market. However, combined with Hong Kong - where 30% of securities currently on loan are China H shares (mainland China-incorporated securities listed in Hong Kong) the potential to become a significant market for global securities lending participants is enormous.

On the question of the significance of the decision to allow insurance funds to participate in securities lending markets, Cowan says any opening up of the securities lending infrastructure should be seen as a positive.

“This step shows that the authorities understand and have confidence in the market which is a good sign for future developments,” he adds.

The significance of the decision to allow insurance funds to participate in securities lending markets is not the ability of insurance funds to lend per se, but to be able to lend via offshore lending agents - in traditional agency structures - under standard GMSLAs.

That is the view of Simon Lee, managing director, head of business development EMEA & APAC at eSecLending, who reckons the significance therefore is whether this signals the beginning of a wider trend of Chinese institutions to lending via the offshore markets, and possibly the easing of some of the more restrictive limitations impacting the lending of China ‘A’ shares.

Investor limitation

“China is essentially a central counterparty market, which unfortunately limits the typical offshore investor from participation due to non-traditional approaches to aspects such as collateral management, counterparty exposure, indemnification, pricing, and corporate action collection, amongst others,” he adds.

“Until these change to the approaches employed in more traditional international lending programmes, we don’t expect to see much movement in the near term.”

Adnan Hussain, head of agency lending & liquidity services, markets & securities services at HSBC refers to a significant amount of potential in the Chinese market, inclusive of both Stock Connect and onshore lending.

“Generally, it is a positive that there is an ongoing review of the rules and that insurance funds are now included along with banks, brokers and mutual funds,” he says. “However, offshore participation remains limited. Local knowledge on the international securities lending industry continues to increase although asset owners onshore have only recently started exploring alternative sources of yield and discovered lending as an option to do so, including offshore lending.”

Hussain says there are several limitations of the current operating model. From a Stock Connect perspective, participants are limited to exchange participants, with agent lenders not explicitly recognised. Additionally, while beneficial owners can lend they require a local licence (‘qualified institutions’) although the lending function is normally an outsourced activity.

Capital costs

“No offshore agent lenders are currently recognised – an asset owner can lend and generally all activity takes place onshore, through onshore borrowers and lenders,” he adds. “The CCP model is not viewed here as a qualifying CCP (QCCP), meaning there is a higher capital cost incurred. Collateral is also counterparty exposure, indemnification, held centrally by the CCP rather than passed onto the lender. Finally, a broker has to put up large collateral value before borrowing in a segregated account and short sell proceeds also sit within that same account.”

When asked what else needs to change in the medium to long term to truly open up China as a location for securities lending, Hussain makes a number of observations relating to Stock Connect including:

• Allowing more participants, such as agent lenders or affiliates of exchange participants, to join in the short term (longer term, PASLA has discussed a CCP model with HKEX that would align with that of mainland China)

• Ongoing collaboration of multiple stakeholders – HKEX, Shanghai and Shenzhen Exchanges, China Securities Regulatory Commission

• Relaxation of the uptick rule - currently, securities borrowed through securities based lending impact all accounts, including non-lending accounts, and are subject to the uptick rule; there is no segregation of accounts identified in the current rules.