The recent trade war between the US and China has captured the world’s attention, depriving the upcoming Stock Connect scheme between London and Shanghai of the consideration it deserves. The Shanghai-London link has been on the cards ever since President Xi visited the UK in October 2015 and expressed his willingness to create a system which would allow investors to trade shares on each other’s markets. If this program were to launch successfully, it would place Shanghai up there next to London, New York and Hong Kong as a principle fountainhead of global capital.
Introduction
Jason Lui, head of Asia Pacific equity derivative strategy at BNP Paribas, heralded the symbolic as well as economic significance of this initiative, explaining how it would encourage homegrown Chinese companies to list abroad whilst also allowing Chinese domestic investors to trade a foreign company in their own markets for the first time. This deal would also be welcomed by international investors, both institutional and retail, who would be granted direct access to A-shares* of Chinese companies listed on the domestic Shanghai Stock Exchange (SSE).
China’s decision to welcome greater foreign participation in its mainland capital markets and to allow its own investors to invest abroad should be understood in light of the dragon’s desire to show the world (especially the US) that, after decades of stringent state capitalism, it can make its market more competitive and inclusive, and finally take centerstage in the global financial system.
The launch of this program is imminent as there is speculation that it is supposed to go live by the end of the year. HSBC recently announced its intention to be the first to float in Mainland China whereas China-based Huatei Securities, one of the Mainland’s largest brokerages, intends to be the first to make itself available to foreigners via the London Stock Exchange (LSE).
This arrangement would function through the complex depositary receipt (DR) system which, if handled well (big emphasis on the if) would revolutionize the equity capital markets as we know them. Nevertheless, many have questioned whether this initiative is capable of living up to its potential, whether China is really going to play fair and refrain from imposing on this new link all the regulations and restrictions which have disturbed the West in the past.
However, before launching in a full analysis regarding the pros and cons of this program, some financial jargon needs to be explained. Indeed, unless most of you are familiar with complex financial securities, you will be wondering what on earth the terms depositary receipt means. Considering that this stock connect scheme is going to function exclusively through the DR system, it is necessary to explain it. Essentially…
II. WTF ARE DR’S?
When wanting to list on a stock exchange, foreign public-listed companies usually choose the “ordinary issue” route. This means they choose to list their shares directly on a stock exchange which is not their own. So if I am an investor in the target market, I can purchase a share and directly hold it. On the other hand, when companies issue depositary receipts, they are choosing to list indirectly. A DR is a type of transferable financial security* (usually in equity) which represents a claim on a bundle of a company’s shares. Essentially, the DR is a physical certificate which gives investors the opportunity to hold shares in the equity of foreign countries without actually trading in the foreign international market.
The first kind of DRs were American Depositary Receipts (ADRs) and were (unsurprisingly) invented in 1927 by J.P. Morgan to facilitate investment by Americans in Selfridge, the British retailer. Indeed, prior to 1927 it was a nightmare if for example, as an American, you wanted to buy stocks of foreign companies. Rules at the time dictated that shares could be purchased on international exchanges only, meaning that you had to directly engage with another stock exchange. This wasn’t really ideal. Imagine being a US investor and wanting to buy shares in Selfridge. You would have to navigate the different currency exchange rates, languages and foreign stock exchange rules.
On top of this, you would also need a solid understanding of different rules and risks related to investing in companies without a US presence. This was a lot of stress. The genius of ADRs was that investors could diversity their portfolio as they pleased by investing in foreign companies without using a foreign brokerage account* and without having to directly deal with rules and regulations of other stock exchanges.
A-shares are companies incorporated in mainland China, listed on the Shanghai Stock Exchange or the Shenzhen Stock Exchange, quoted in renminbi, and only available to mainland investors and qualified foreign institutional investors.Dual-class sharesWhen multiple share classes are typically issued: one share class is offered to the general public, while the other is offered to company founders, executives and family. The class offered to the general public has limited voting rights, while the class available to founders and executives has more voting power and often provides for majority control of the company.H-sharesPublic Chinese companies offering H-shares are listed on the Hong Kong Stock Exchange. In addition, H-shares are quoted in Hong Kong dollars and freely traded by all types of investors.
| Term | Definition |
|---|---|
| Equity Security | An equity security represents ownership interest held by shareholders in a company, realized in the form of shares. |
| Brokerage account | A brokerage account is an arrangement between an investor and a licensed brokerage firm permitting the investor to deposit funds with the firm and place investment orders through the brokerage. |
| Clearing | In banking and finance, clearing denotes all activities from the time a commitment is made for a transaction until it is settled. This process turns the promise of payment into the actual movement of money from one account to another. Clearing houses were formed to facilitate such transactions among banks. |
| Settling | Settlement of securities is a business process whereby securities are delivered, usually against (in simultaneous exchange for) payment of money, to fulfill contractual obligations, such as those arising under securities trades. |
Because economics is all about herd mentality, and because the ones to follow are usually the Americans, when other countries realised the opportunities offered by these financial instruments, they were quick to replicate them in their own markets. Now we also have Global Depositary Receipts (GDRs) which are different to ADRs in that they are not unique to the US market; rather, they are issued by international firms who wish to access multiple markets. They have the exact same perks as ADRs, the only difference is the G in front of them!
In the London-Shanghai link, Chinese companies would be the ones issuing GDRs on the LSE stock exchange. On the other hand, international companies would be issuing “CDR”s (you guessed it, Chinese depositary receipts!) on the Shanghai Stock Exchange.
This all sounds very cool, but how does it actually happen? How are these depositary receipts actually issued? Who creates them? Where do they come from?
First off, a company wanting to issue DRs on a foreign stock exchange, must transfer its shares to a “custodian bank” in its home country. The company issuing shares then then has the responsibility of identifying a depositary bank in the target market to which the custodian bank will then transfer the shares. Depositary banks are present in all markets and essentially have the responsibility of facilitating investments in securities. The depositary bank will then have the actual responsibility of using those shares to created DRs which it will then sell to investors in the foreign market.
If this confuses you, just think of the inherent difference within the names! A depositary bank is a bank where you deposit and a custodian bank is a bank which will have your shares in custody. Although the custodian bank will be the one to who the company entrusted the shares in the first place, legally those will still be kept in a safe-keeping account by the depositary in the target market, once it has the shares, the depositary bank can create new securities, which we know are called “depositary receipts”. These DRs will be linked to the actual shares in the bank by a ratio and will represent a specific number of them. This means that, for example, each DR is worth 10 shares. If you buy one DR you are entitled to 10 shares of x company.
Overall this mechanism has created two securities: the receipt (which we as shareholders would hold) and the actual foreign share (held by the depositary bank).To make this simpler, imagine a UK company, Barclays for example, wanted to list on the Shanghai Stock Exchange through depositary receipts; this is how the process would work:
- Barclays entrusts its shares to custodian bank in the UK.<l/i>
- Issuer nominates depositary bank in target market which custodian will transfer the shares to.
- Depositary bank will be a bank in Mainland China.
- Depositary bank then receives shares of foreign issuer and holds them.
- Depositary bank in China then creates CDRs whose value is given by the underlying shares of the foreign company which it holds.
- Each CDR will be worth x number of shares.
- Price of each CDR would be issued in Chinese renminbi converted from the equivalent UK price of shares being held by the depositary bank. (This makes it simple for Chinese investors to buy stock of a UK-based company.)
CDRs can now represent local UK shares held by the depositary. - CDRs can now be offered to investors in the local market and can be freely issued and traded on the Shanghai Stock Exchange.
Chinese investors are are then able to trade, clear* and settle* these CDRs in their own market, in their own currency, according to their own procedures. Indeed, this is the catch. Security regulations will apply only to the securities held by the local buyers (so the CDRs held by Chinese investors in our example) but NOT to the shares of the original company (those held by the bank). Indeed, DRs are generally subject to the trading and settlement procedures of the market in which they trade. Overall, intermediating this transaction through the depositary receipt mechanism is a win-win for all: local buyers can access foreign investments whilst still complying with domestic regulations (something China is deeply committed to), and foreign companies can reach a larger investor base and gain more international notoriety and momentum than what it otherwise would by listing through an ordinary share form. On top of this, as mentioned above, the foreign company can avoid the regulatory and procedural burdens which come when listing on a new market by transferring these responsibilities straight to the depositary bank. Most of you are probably thinking this process sounds like a massive hassle. Why not just go for ordinary listing? Essentially…
III. WHY DR’S? HOW WOULD CHINA BENEFIT
1. EXPANDED SHAREHOLDER BASE ABROAD AND INCREASED INTERNATIONAL RECOGNITION
No matter how hard China tries to isolate itself, if it wants its growth to continue, opening up its markets looks like a good idea. Indeed, just 10 days ago stats were released which revealed that the growth of China’s economy “only” reached 6.5% this year, marking the slowest year-on-year quarterly growth since the first quarter of 2009. As a result, Fang Xinghai, vice-chairman of the China Securities Regulatory Commission (CSRC) urged China to “open up further” the market as “foreign investment accounts for just 2 percent of the total value of the A-share market”. Through cross-listing in GDRs, Chinese companies will expand their shareholder-base, raise more capital and gaining more publicity and recognition internationally; all this whilst also circumventing the disadvantages of foreign investment restrictions.
So, to give you a practical example of why issuing GDRs on the LSE would be convenient for Chinese companies: if I asked you readers whether you would be more willing to invest in McDonalds or Kweichow Montain Co, where would you be more likely to place your bets? Aside from the fact that you want McDonalds to keep raising capital so that it can continue to produce and offer those delicious chicken nuggets, you would probably go for the big M because you are familiar with it and you know it will probably keep being profitable. But…what if I told you that China-based Kweichow Moutai Co, distiller of baijiu, is now more valuable that McDonald’s Corp? Would you then change your mind? Probably. The problem is that the Chinese market has always been subject to heavy rules and regulations which prevented it from being fully transparent, depriving investors of the necessary information to evaluate stocks such as this one. By issuing GDRs Kweichow would simultaneously access more capital and boost its prestige in the global market.
2. WANTING TO LURE FOREIGN CAPITAL INTO ITS OWN DOMESTIC MARKET
Another big reason why the Chinese government is pushing for these GDRs is because it wants to lure capital from China-born tech giants back into its home market to boost the domestic economy. So, for example, I’m referring to the big tech trinity composed by Alibaba, Tencent or Baidu who, despite being Chinese companies, are not listed in the domestic stock market. Instead, you can find their shares sitting on the New York or Hong Kong stock exchange, or both! How frustrating must it be for Chinese citizens to know that three of the most valuable companies in the world are their own and yet they cannot access them?
Indeed, these companies cannot be listed or purchased on a Chinese stock exchange, This is because Mainland China has imposed numerous legal and technical barriers to IPOs in domestic markets. For example, Chinese regulations (Hong Kong excluded), currently forbid dual-class shares* which are instead heavily favored by tech companies because it means they can raise capital whilst retaining control. Chinese regulators in the past have claimed that the primary job of a bourse is to keep shareholders happy and to look after their interests. Endorsing dual-class shares would, in their opinion, completely disregard this principle as it would rob investors of the right to veto transactions, censure directors or more generally voice their concerns. However, the CSRC recently disclosed that it is considering revising current company law to allow shares with different voting rights. Another issue is that in China companies must have three years of profits before they are allowed to go public. This is a big no-no for companies, especially tech ones, which before actually making some returns burn through cash as they scale up.
So you can see why companies refuse to list there. But why does the Chinese government so desperately want them to? The answer is because China’s capital markets could not be more prepared to welcome the CDRs: with a capital market worth US$8.5 trillion, the Mainland would have enough liquidity to absorb all these CDRs. Goldman Sachs recently released predictions which see the largest tech companies (Alibaba, Tencent, Xiaomi, Netease, Baidu, and JD.com) in a position to raise 60 billion between them through the issuance of CDRs. Ok this sounds cool, but how would China make sure people will actually invest in these CDRs? Well, in a pre-emptive attempt to stabilize the market, regulators have already thought about this and have approved the establishment of six mutual funds, also known as “unicorn funds” which have been created with the purpose of investing in CDRs for a period of at least three years. In a “dream scenario” idealized by BNP Paribas, the Mainland’s attempt to connect its isolated capital markets to the global financial system could create 1.3 trillion-1.45 trillion of foreign demand for yuan assets. Not bad stats.
Ok, this all sounds well and good for China, but..
IV. WHAT’S IN IT FOR INTERNATIONAL INVESTORS?
Well, as mentioned before, because of all the barriers to entry plaguing the Mainland’s capital markets, international investors would be able to use CDRs to access the Mainland’s market without having to worry about any rules or regulations. Because the Chinese market is huge, they would be able to raise substantial amounts of capital from numerous different investors.
Despite the excitement surrounding the initiative, people are wary as they foresee numerous hurdles to the smooth implementation of this project. Some have gone so far as to dub this stock connect scheme a “symbolic move” as opposed to a genuine reform actually aimed at increasing foreign investment. So what are the issues?
1. LIMITED PARTICIPATION AND EXTRA REGULATION
First off, it seems that the only overseas-listed Chinese companies who will be allowed to issue CDRs in the Mainland market are ones which can flaunt a market value of more than 20 billion yuan. Under the current guidelines released by the CSRC only seven companies would be eligible to issue CDRs; these include Baidu, Tencent and Alibaba, along with others such as JD.com and NetEase. This means that unless you’re part of the lucky seven you are out of the game (for now at least). This measure is unlikely to please Chinese investors who might be eager to give their money to potential startups like Xiaomi, the smartphone maker who has been renamed “the Chinese Phoenix” by virtue of its recent stellar growth.
Furthermore, the restrictions are not only on who can list CDRs but also on who can buy them. It is currently believed that only individual Mainland investors with a capital base of around 5million yuan (US$720,9000) will have the green light to purchase. The arrangements are similar for Chinese companies wanting to issue GDRs on the LSE who will need to be “blue chip companies” and have large capitalization and profits.
Constraints have also been imposed on how much companies can issue and invest in CDRs. Indeed, with China wanting to curb capital outflows and prevent capital inflows of fresh equity from flooding the domestic markets, the CSRC and SSE recently stated it is very likely that there will be limits on how many securities can be issued. They fear that the moment China opens its capital markets to companies such as Alibaba or Tencent, liquidity will quickly drain out of China’s A-share market as investors will all want to invest in these new companies. This will likely exacerbate the bearish sentiment which has characterized the mainland equity markets recently.
2. MINIMAL IMPACT DUE TO A MORE APPEALING STOCK CONNECT CHANNEL ALREADY EXISTS
Some, on the other hand, take the line of argument that it is just plain useless to set up a stock connect between London and Shanghai, which will likely be subject to numerous restrictions and regulations, if there are already other channels through which international investors can access Mainland stocks. These channels are known as the Shanghai-Hong Kong and Shenzen-Hong Kong stock connect schemes.
In fact, before November 2014, the only way to invest in China was by buying companies listed in Hong Kong (H-shares*). Then, in 2014 and 2016 the Shanghai-Hong Kong and Shenzen-Hong Kong stock market connects were inaugurated in a bid from China to further open up its markets. The schemes allow international investors to directly buy and trade A-shares from companies based in Shanghai or Shenzen which are listed on the Hong Kong exchange, whilst also giving Chinese investors access to Hong Kong stocks. So, whereas the London-Shanghai link would only allow investors to access depositary receipts, the already existing stock connect schemes with between the mainland and Hong-Kong let investors trade shares through local brokerages and offer a much wider menu of stock selection. To illustrate, H-shares represent more than 230 Chinese companies and give investors the chance to invest in all the prominent economic sectors like financials, industrials and utilities.
By virtue of its respected legal system and adherence to international standards and practices, over the years Hong Kong has made a name for itself as a respected centre for international finance. Furthermore, its unique ability to connect Mainland China with global capital markets make it an irresistible destination for international and Chinese investors wanting to trade securities. Now, the obvious question: why would international investors choose to access A-shares through the London connect, which has been criticized for being “just a watered down version of Hong-Kong’s programs” when they can already access them easily through Hong Kong, a free market open to traders worldwide?
What is also arguable is that companies, when faced with a choice, would still choose to list in Hong Kong rather than Shanghai. Indeed, since April 30 the HKEX (the Hong Kong bourse) announced that it would allow companies having dual-shares to publicly list on its exchange. If you recall from earlier, dual shares are shares with allocate different voting rights, and which are currently banned from Mainland Chinese markets. Because this share structure has not been allowed yet by the SSE, and it is doubtful whether it will ever be, this means that if giants like Alibaba were to list in China, they would probably choose to do so through Hong Kong.
3. HOME BIAS
Another compelling argument has been made by those who claim that this program is unlikely to be as successful as it could be because investors are not informed enough. Remember when I mentioned Kweichow Moutai Co earlier? Although we concluded that it is in Kweichouw’s interest to list in London as this will increase its international presence, what is the likelihood that British investors will actually then buy the company’s GDRs? Current stats don’t look very promising: the four Hong-Kong traded Chinese stocks with dual-listings in London barely have any trading volume in the City. But if we flip the coin, we will find that companies listed on the FTSE 100 Index such as HSBC are a big name in China and it is likely that it’s CDRs would be immediately gobbled up by retail and institutional investors in the Mainland. Economics is a game of incentives, and if Chinese investors perceive an advantage in purchasing British CDRs but British investors don’t hold the same attraction to Chinese-issued GDRs, this scheme may easily become a zero-sum game.
4. FUNGIBILITY OF DRs
When something is “fungible” it means it can be exchanged with something else of the same value, and technically allows investors to cash out their investment, which they like. So for example, if I am a GDR holder in the UK I want to be able to redeem the A shares attached to that GDR and trade them on the SSE to then deliver me the cash proceeds. Similarly, if I am a CDR holder in China I want to be able to redeem the UK shares and trade them on the LSE to get cash. However this is where it gets a bit complicated because in order to do this I need to use a “designated broker” who is licensed to trade in both markets and convert GDRs and A shares or CDRs and UK shares. Supposedly being able to do this is a good thing for investors. However because the process is quite complex some actually question how far this “fungibility” principle goes. Some have speculated that “the conversion rate of CDRs is likely to be almost zero” and have renamed CDRs “depositaries with Chinese characteristics”. Ba Shusong, chief economist of the Hong Kong Exchanges and Clearing, claimed that inability to convert the CDRs would make these receipts “pointless”.
5. INABILITY FOR LONDON-LISTED COMPANIES TO ISSUE NEW SHARES
London-listed companies will initially only be able to offer existing shares and not new shares. This means they will give the Chinese market access only to shares that are already traded in London. On the other hand, SSE firms listing in London through GDRs are not constrained by this requirement and can raise capital. This will inevitably be a massive disincentive for UK-listed companies who would not be able to raise fresh capital .
6. TRADE WAR
The last, but definitely not least, potential backstop to the London Connect is the on-going trade war being fought by China and the US. The recent escalation of events have forced Chinese regulators like the CSRC to reconsider the risks facing the mainland stock market and might delay the project.
Now that I have given a full breakdown of the initiative, its pros and its cons, comes the part that all of you have been waiting for:
V. WHY SHOULD WE CARE? WHAT IS THE IMPACT ON LAW FIRMS?
This project will no doubt be welcomed by law firms with a strong capital markets practice and a strong China presence.
Linklaters
One firm which perfectly fits this description is Linklaters. Backed by its No 1 ranking in the Bloomberg league tables for IPOs both globally and across EMEA regions, the firm can safely call itself market-leading for what regards global IPO experience and expertise. Being finance heavy, the firm’s London office has also worked on some of the most high-profile deals involving GDR offerings and has developed considerable expertise in the area. Links will also be familiar with this project as it was directly involved in designing and advising on regulatory and legal issues around the launch of the other two existing Stock Connects and is currently involved in similar discussions regarding the new London connect. By virtue of its collection of market-leading lawyers which span Shanghai Beijing, Hong-Kong and London and who can advise clients in both English and Mandarin, the firm will no doubt be first pick for both Chinese and international companies seeking to cross-list through this program.
Allen & Overy
With over 25 years of on-the-ground experience in the China region and extensive knowledge of practical and legal issues that foreign investors and local clients face, Allen & Overy has been and will continue to be one of the top choices when it comes to Chinese firms wanting to “go global” who are seeking advice on outbound investments and related financings. The firm has been praised time and time over for its “in-depth knowledge of both PRC laws, regulations and Chinese culture”. Furthermore, the firm’s China group offers lawyers based in Mainland China, HK, London, New York, Sydney, South Africa and Continental Europe, enabling clients to use A&O as a “one-stop-shop” across different practice areas and jurisdictions.
Clifford Chance
Clifford Chance is another member of the magic 5 who would no doubt see a lot of work coming its way as a result of the London-Shanghai Stock Connect. With China being key to the firm’s global expansion strategy, CC offers offices in Beijing and Shanghai with international and local, dually-trained lawyers. Like A&O the firm has been operating in the country since the mid 1980s and has developed notable expertise in the area of equity capital markets. Evidence of its standing in the region is reflected by the leading role the firm held in Xiaomi’s lPO on the Hong Kong Stock Exchange this July, following the introduction of the new dual-class share regime being allowed. This operation represented the fourth largest global tech IPO after Alibaba, Facebook and Infineon.
There are heaps of firms I could mention which are also very well-poised to take advantage of the situation, but you get the gist. In terms of what specifically lawyers in such firms will help with, their jobs would include:
Drafting of prospectus.
In finance, a prospectus is a disclosure document that describes a financial security for potential buyer. This means that through the prospectus investors need to get all the necessary information they need in order to make an informed judgement on the security and whether it’s worth purchasing. This includes assets and liabilities, profits and losses, prospects of the issuer as well as the specific rights attached to the securities (in this case the rights attached to GDRs and CDRs). Usually, lawyers will be the ones drafting prospectus’ for clients (ie companies wishing to issue securities). For securitization, a prospectus can range from 15 to more than 500 pages! So I’ll leave it to you to figure out the hours that lawyers will have to put into this.
Negotiating contracts
If we consider this particular project, there are a lot of contracts which will need to be signed off by a lot of parties, and each one is of utmost importance for the completion of a deal. So for example, when listing on a stock exchange, a company will want best terms. On the other hand, banks holding the securities will push for terms which will make the security an optimal product to sell to investors.
Regulatory and other approvals
Lawyers will also need to liaise with entities such as rating agencies (Moody’s, S&P, and Fitch) who need legal counsel when determining what the adequate rating of a certain product should be. We have seen that in this particular project, only the most profitable and valuable companies will be able to issue GDRs and CDrs to investors, so this shouldn’t be too much of a problem. Lawyers will also need to instruct London-based clients wishing to issue securities about their duty to comply with the EU Market Abuse Regulation.
Litigation
Arguably, from the moment a foreign company chooses to sell securities to retail and institutional investors it makes itself vulnerable to lawsuits. This is because there are so many rules and regulations to satisfy that this increases the chances of something going wrong and investors complaining about it. There is evidence that in recent years, the amount of class action lawsuits regarding securities has increased.
Conclusion
Although the outcome of this project is arguably a big question mark, the initiative no-doubt signals China’s willingness to further open up its equity markets and is a stepping stone for Shanghai who aims to become one of the top global financial centres by 2020. More importantly, we are faced with a disturbing reality: as Xi gradually opens up his country’s markets and propels the renminbi to have a greater international role, those who have been criticizing China for its protectionist policies and isolationist character will find that, currently, these accusations more accurately describe Trump’s USA. Indeed, a country which was once understood to be the pillar of freedom, fairness and capitalism is seeing the gradual erosion of these principles as the president shows no sign of abandoning his “America First” policy. This situation threatens to shake up the geopolitical paradigms that govern world order as we know them, making us wonder: is the next Sino-US war is really going to be over trade, or will it be one which pits the US dollar against the Chinese renminbi in a fight for global dominance?
