Charles Li, CEO of Hong Kong Exchanges and Clearing, says digital technology is critical to enabling financial markets to interact with China at a time when China is pulling away from global norms.
From big data to blockchain, he says these technologies will assume a greater importance, because they can give investors and lawmakers comfort while allowing both China and the rest of the world to maintain their own standards, regulations and preferences.
Remarkably, Li says mainland Chinese authorities have not made that much use of Hong Kong, despite it being part of the People’s Republic. Hong Kong is regarded as an international market, in line with New York and London. Given the exchange’s reliance on mainland companies for its IPO business, “That’s a challenge for us,” he said, speaking at a derivatives industry conference.
The Stock Connect program, in which investors can access the other’s stock markets, was the first time Beijing took real notice of Hong Kong’s capital market, he says. (This reading of Li’s ignores the earlier advent of dim-sum bonds, denominated in offshore yuan, but that remains a small market.)
First, Connect
To date, HKEx now has “Connect” programs with the stock markets in Shanghai and Shenzhen, and northbound-only (into China) for bonds. Commodities and derivatives programs are in the works. Global investors trade securities as if they were Hong Kong stocks; the instruments settle and clear in Hong Kong. Mainland investors treat Hong Kong equities as Chinese, settling and clearing on China Securities Depository and Clearing, aka ChinaClear.
This relationship established trust with Beijing because every day, trades are settled only between ChinaClear and HKEx, so there’s a single payment. The actual investor money doesn’t cross the border, so China’s capital controls remain intact.
But this has created a huge amount of market activity. Since the first Connect program launched in 2015, Rmb160 billion (about $24 billion) net has flowed northward, which seems inconsequential. But the Connect mechanism has allowed Rmb1.7 trillion ($250 billion) worth of cross-border ownership of equities, and Rmb17 trillion ($2.5 trillion) in turnover.
With Mifid 2, we struggled like hell. China’s already at Mifid 10
Charles Li, HKEx
As a result, HKEx is the largest shareholder of eligible A-share companies, and ChinaClear is now the biggest shareholder of names such as HSBC (whose biggest investor is Ping An Group, but whose stake is held on its behalf by ChinaClear).
Go your own way
Moreover, this arrangement means Beijing authorities know who bought what, when, and at what price. Because the government has this transparency, it has been keen to see MSCI and other index vendors throw open their quotas on A shares to global investors. And global investors aren’t exposed to, say, a credit risk at ChinaClear, as the Chinese and global risk pools are separate.
This is the first big example in capital markets, aside from pegging the renminbi to the US dollar, of how China has been able to maintain its capital controls and market preferences, while using technology to connect to the rest of the world.
This is allowing China to pursue its own market infrastructure. It initially followed the U.S. example and had tried to mimic its marketplace of investors, exchange members, and central counterparties. The 2008 global financial crisis convinced Beijing it should follow its own path, particularly when its domestic broker-dealers proved to be reckless with investor money.
Today there are no broker-dealers in China. The government established a flat market, based on real-time reporting and same-day settlement. Regulation and surveillance are baked into the trading and settlement software; all margin trading is controlled in a single giant command center.
“With Mifid 2, we struggled like hell,” Li said, referring to intrusive European regulation. “They’re already at Mifid 10. China’s not going to come back and adopt our system…they feel they have the moral high ground.”
Different practices – different skills
But while the bad actors that seem to be an inescapable feature of Western capitalism can’t operate in China, the marketplace is also moribund. Sharks are scary but they make people swim harder. Hence Beijing’s recognition that it needed foreign investors.
But operating a China exposure is difficult for foreign banks and asset managers, because it requires trades be pre-funded. This is very rare in the rest of the world because it’s capital-inefficient.
Encryption technology is the key
Charles Li, HKEx
The world’s financial industry has evolved a massive infrastructure to manage risk at the lowest cost of capital, so that capital can be deployed to revenue-producing activities. Defaults are acceptable so long as they aren’t Lehman-Brothers sized. China, on the other hand, thinks it can use technology to eliminate defaults altogether. As a result, its banks have no experience with capital efficiency or risk management.
HKEx’s project to roll out a blockchain for Stock Connect is aimed at smoothing these hurdles for global investors (as we’ve described here).
So what next?
Li says both China and the rest of the world are adopting digital technologies – artificial intelligence, blockchain, cloud computing, analytics – that require data. By converting data into meaningful products, banks and fund managers will create new revenues and earnings.
China’s digital transformation
This is going to happen differently in China, which Li thinks gives HKEx more opportunities, only instead of connecting securities, HKEx will be connecting data.
The world relies international standards for accounting, and industry bodies such as the International Securities & Derivatives Association (at whose event he spoke) to process contracts.
We’re working to create the world’s first data marketplace
Charles Li, HKEx
This market infrastructure already exists for cash, securities and derivatives. Data will pose new challenges, however, because it can be copied and reused. Data doesn’t move between participants like a security, or get used up like a commodity. So regulators need confidence that data isn’t abused.
“Encryption technology is the key,” Li said. “We need an open-source platform to encrypt whatever the regulator requires” when data should not be shared or monetized.
Data Connect
Li believes this will become a major challenge soon, expecting firms will be turning data into new products within five years. “We need to find a way – not a heavily regulated way – to get that cashflow validated and traced to its rightful owner.”
That means expanding HKEx’s use of blockhain to track economic interests while also maintaining user privacy and security. Li isn’t proposing a specific project, as he believes the industry will come up with ideas on its own. But HKEx might play a coordinating role.
“We want all the players to work together on encryption,” he said. Once a system is in place to validate, settle and clear these data-based propositions, firms and investors will begin deploying capital.
“In the future, we won’t be just listing and trading companies, but also packages of data that ultimately…turn into products,” Li said.
This vision explains HKEx’s decision last year to launch a smaller board for biotech and healthcare. China is using its lead in data and artificial intelligence, along with its command economy, to aggregate health-related data at a staggering pace. Along with this comes challenges of privacy and rules of using personal data, but Li believes this will result in plenty of medical advances, new research, and innovative products.
“We’re working to develop the world’s first data marketplace,” Li said, “using encryption to protect privacy and other elements of data,” including ways to authenticate the relationship between user data and cashflow against products.
