Hong Kong Exchanges and Clearing is entering an open-ended period of consulting with market participants about moving its blockchain-based prototype for post-trade processing into deployment.
Tae Yoo, managing director of HKEx’s market development division, told DigFin there is not yet a target date to deploy the solution for Stock Connect. But the reception from asset managers, brokers and custodian banks so far has been positive, he said.
The prototype, developed by vendor Digital Asset, was completed at the end of 2018.
Scaling challenge
It was designed to solve the specific problems of workflows required to allow international investors’ trades in mainland Chinese A shares to settle on time. This problem has been manageable in the early years of Stock Connect, a program first launched in November 2014 that enables international fund managers to trade and settle A shares via Hong Kong’s infrastructure (and vice versa). That’s because volumes were small.
That is changing, however, now that MSCI is expanding its quota of eligible A shares that global pension funds and other investors using index funds must track. FTSE Russell and S&P Dow Jones Indexes are also adding China to their emerging-market indices.
This has never been done before in the history of capital markets
Tae Yoo, HKEx
Despite last year’s terrible year for A shares (the Shanghai bourse lost 25% and Shenzhen 33%), the number of accounts at HKEx registered by foreign fund managers to trade mainland Chinese equities has soared by 180%. Yoo says HKEx expects the three global index providers will drive about $47 billion of flows to Stock Connect in 2019.
This massive inflow via Stock Connect will worsen the existing problems with ensuring settlement, which is a combination of China’s particular rules and simple time zones.
China challenges
Mainland China settles trades on the same day and its regulators have a “no fail” rule. Settlement in Hong Kong, on the other hand, takes two days, as it does in the U.S. To meet mainland regulations, foreign investors have to compress two days’ worth of work into a four-hour window, from 3 p.m. to 7 p.m. Hong Kong time.
Not only is that a tight deadline, but it occurs when the U.S. and most of Europe is asleep.
The current way of doing business – everywhere, including China – is for a fund manager to trade through a broker with a seat on the exchange, and to safekeep the assets with a custodian.
All parties must communicate with one another to settle a trade. But they do so through a variety of systems and bilateral communications that have evolved over decades. Each party has its own I.T. setup but all of them engage in the same process of reconciling and confirming transactions. The workflow to settle a trade thus involves lots of repetitive processing because no one has a clear view of the entire process, or a transaction’s status at any given point.
From Stock Connect to beyond
“This all limits scalability,” Yoo said, speaking at a blockchain conference. “How do we compress a two-to-three day workflow into four hours while the investment managers are sleeping? With our current technology, we can’t.”
This kicked off an extensive review of technology providers. “We needed to find a way to do real-time and transparent synchronization of communications,” Yoo said, to move away from sequence-driven (one step at a time) processing.
“We want to apply this to Stock Connect,” he added, “but if it works for that, then it could apply to other markets.”
He says custodians, asset managers and brokers have signaled their approval of the prototype built by Digital Asset (which is also working with Australia Stock Exchange to replace its post-trade infrastructure). Now HKEx wants to go into more technical details with its users and counterparties to see how the distributed ledger tech can be deployed.
New paradigm
The solution developed by Digital Asset lets market players work in tandem, see where trades sit, and understand where they are in the workflow.
“This has never been done in the history of capital markets,” Yoo said. “This is the first time anyone is doing this. We’re learning as we go.”
He says the integration requirements on other firms is manageable, as it’s meant to connect to existing technologies to manage portfolios, orders and trade execution, as well as status-quo tech for data and analytics.
The main novelty is using Digital Asset’s proprietary language for smart contracts, which give the exchange and a portfolio manager the power to let designated brokers or custodians see their transaction information – but no one else.
This “single source of truth” lets permissioned parties see the entire workflow for a transaction. Therefore it eliminates the need for reconciliation among different players – and creates a simpler means of updating everyone when the regulator or the exchange changes its rules.
The result should be lower settlement costs and reduced settlement risks, Yoo said. In turn this should expand the capacity of Stock Connect to handle more activity from global investors.
