Bond Connect – The Fast and Furious Way to the China Interbank Bond Market

Following announcement of the proposed launch of a bond trading link between China and Hong Kong (Bond Connect) earlier this year, Bond Connect officially launched on July 3, 2017. Bond Connect allows foreign institutional investors to invest in bonds and other debt instruments traded on the China Interbank Bond Market (CIBM), which is currently the third largest bond market in the world¹. Bond Connect provides foreign institutional investors more streamlined access to the CIBM than other access programs. 

Investor Eligibility 

Investor eligibility is more limited than the Shanghai and Shenzhen Stock Connect programs. The Bond Connect will be open only to foreign institutional investors that satisfy the current entry requirements for the CIBM (Foreign Institutions), which comprise: 

• Foreign central banks or currency authorities, sovereign wealth funds, and international financial organizations; 
• Qualified Foreign Institutional Investors (QFIIs) and Renminbi Qualified Foreign Institutional Investor (RFQIIs); 
• Foreign financial organizations (including fund managers, commercial banks, insurance companies, securities companies, and other asset management organizations) and investment products issued by these organizations; and 
• Other mid- to long-term institutional investors that are approved by the People’s Bank of China (PBoC), including pension funds, charitable funds and donation funds. Some market participants have interpreted “mid- to long-term” institutional investors to exclude hedge funds (regardless of the investment horizon of such funds). 

Coverage 

Initially, Bond Connect permits only “northbound” trading (i.e., trading of Chinese bonds by foreign investors). A southbound trading link permitting Mainland investors to buy international bonds will commence later. 

Unlike traditional access routes into China (e.g., the QFII and RQFII programs and the CIMB program announced last year),² there is no investment quota limit applicable to the Bond Connect. 

Applicable Bonds and Debt Instruments 

All bonds and debt instruments that are currently traded on or subscribed through the CIBM will be available through the Bond Connect. Such instruments include: treasury bonds; local government bonds; bonds issued by government-backed institutions, commercial banks, policy banks and non-bank financial institutions; debt financing instruments issued by non-financial corporations; corporate debt; and asset-backed securities. 

As of now, Northbound Trading will only support spot cash transactions, but it is expected that this will gradually be extended to other types of instruments, including: repurchase, lending and rehypothecation agreements; forward contracts; interest rate swaps; and forward rate agreements. 

Trading Mechanism and Procedures 

Registration and Account Opening at CFETS 

In order for a Foreign Institution to trade under the Bond Connect, it must first engage a registration agent to apply for registration by the PBoC Shanghai Head Office. Approved registration agents include (among others): China Foreign Exchange Trade System & National Interbank Funding Centre (CFETS); domestic bond custodians recognized by the PBoC (i.e., China Central Depository & Clearing Co., Ltd (CCDC) and Shanghai Clearing House); and settlement agents in the CIBM. Upon receiving a registration notice from the PBoC after an application has been accepted, the Foreign Institution will need to apply to CFETS to open a trading account, the name of which will be the same as that appearing on the registration notice. 

Placing of Orders 

CFETS will be the “trading centre” of the Bond Connect. A registered Foreign Institution can place trade orders and instructions directly via approved electronic trading platforms that are linked to CFETS (for example, Tradeweb). 

The trading process starts when the Foreign Institution sends a request for quotations on the trading platform (minimum order size of ¥1 million), which will be transmitted to CFETS in real time. Onshore traders will then provide quotes in response to the Foreign Institution’s request. A trade is concluded when the Foreign Institution accepts a quote from an onshore trader within the time limit specified by the onshore trader. 

Clearing, Settlement and Custody 

Similar to the Stock Connect, bonds and debt instruments traded through the Northbound Trading link of the Bond Connect are held by the Hong Kong Monetary Authority Central Money Markets Unit (CMU), as overseas custodian on behalf of Foreign Institutions. A Foreign Institution must therefore open a nominee account at the CMU through a CMU member. 

A concluded trade will be cleared and settled onshore on a delivery versus payment (DVP) basis by a domestic custodian (i.e., China Central Depository & Clearing Co., Ltd or Shanghai Clearing House). Payments are made on a real-time basis, involving the CMU and the domestic custodian through the Cross-Border Interbank Payment System (CIPS). The trade is settled by the relevant CMU member through the CMU on behalf of the Foreign Institution. 

Use of Foreign Currency 

Foreign Institutions will be allowed to fund their investments using either Renminbi or any foreign currency. The use of foreign currency will require the Foreign Institution to open a special Renminbi capital account at an approved clearing house in Hong Kong, which will handle currency conversion and clearing for the Bond Connect. However, once an instrument has matured or is sold, if the Foreign Institution does not intend to make any further investments, the principal amount will be converted back into the relevant foreign currency – this is to prevent the Bond Connect from being used as a tool in currency arbitrage. Foreign Institutions will have the option of hedging their foreign currency through their nominee holder. 

Enforcement of Rights and Governing Law 

As a platform for cross-border transactions, the Bond Connect will be subject to both PRC and Hong Kong systems of law. The rules and regulations provide that the trading and clearing activities will be governed by the law of the place where the relevant activity takes place. 

In relation to enforcement of rights associated with bonds and other debt instruments traded through the Bond Connect, a Foreign Institution may: 

• Enforce its rights through the CMU in accordance with Hong Kong laws, given that Hong Kong law recognizes the concept of beneficial interests; or 
• Institute legal proceedings in Mainland China under the PRC laws in its own name against a bond issuer, if the Foreign Institution is able to prove that it has a direct interest in the claim. 

Governing Rules and Regulations 

Below are the relevant rules and regulations for the Bond Connect: 

• Interim Administrative Measures for the Bond Trading Link between China and Hong Kong, issued by the PBoC 
• Trading Rules for Bond Connect (Trial Implementation), issued by CFETS 
  
• Guide on Registration of Overseas Investors for Northbound Trading in Bond Connect, issued by the PBoC 
• FAQ on the Interim Measures, issued by the PBoC 
• CCDC Notice of Implementation of the PBoC’s Bond Connect Settlement Provisional Operation Instructions 
• Rules on Registration of Bond Connect Custodial and Settlement Services, issued by CCDC 
• Shanghai Clearing House Practical Guidelines for Northbound Trading of Bond Connect 
• Shanghai Clearing House Detailed Operation Rules for Registration, Custody, Clearing and Settlement of Bond Connect Cooperation between the Mainland and Hong Kong 

Next Steps 

For fund managers, Bond Connect largely raises similar issues as earlier access programs. As with Stock Connect, foreign institutions will need to consider the interaction of Bond Connect with local regulation;³ in particular, managers will want to work through who holds fund assets at each stage of the order/clearing/settlement process against a backdrop of the Investment Company Act of 1940, UCITS directives, AIFMD and ERISA regulation. Similarly, as with other China access programs, the agreements and addenda necessary to access Bond Connect can potentially tip the balance of a fund manager or fund’s existing contractual trading and custody arrangements; fund managers must take care when reviewing these agreements. Finally, the electronic trading platforms for Bond Connect should represent an improvement over the trade processes currently used by most foreign investors in the China Interbank Bond Market. Access, but managers should understand how they alter the trading process operationally. Overall, Bond Connect represents another welcome step forward in the opening of China’s securities markets. 

Footnotes 

_{1) For further information regarding the Bond Connect and the CIBM, please refer to the following Dechert OnPoints: China-Hong Kong Bond Connect on its way! and
2) Foreign Institutional Investors are Granted Unprecedented Access to China’s Interbank Bond Market
3) For example, the Irish Central Bank took a position on Stock Connect after significant study of how depositaries of Irish funds could comply with their obligations within Stock}