October 22, 2013
Practice Group:
Investment
Management, Hedge
Funds and
Alternative
Investments
By Choo Lye Tan
The Hong Kong funds industry has faced significant challenges in recent years, having had to deal with the fallout from several financial scandals and a securities regulator that has become more aggressive in an effort to minimize the possibility of future scandals. Hong
Kong also faces increasing competition from Singapore and Taiwan, which have been trying to attract financial business from Hong Kong. However, in 2013, the securities regulators in the People’s Republic of China (PRC) announced revisions to the RQFII pilot scheme that it had already introduced in Hong Kong two years ago, as well as an unprecedented mutual funds recognition platform between the PRC and Hong Kong fund market that will insure
Hong Kong’s funds market for the immediate future and help it maintain its position at the forefront of Asian investment centres.
The Renmimbi (RMB) Qualified Foreign Institutional Investor (RQFII) pilot scheme, announced in December 2011, was intended to be an expansion of the Qualified Foreign
Institutional Investor (QFII) program, the key difference being that, whereas QFII quotaholders had to convert foreign currency into RMB in order to invest in PRC securities, RQFII quota-holders could invest directly into PRC domestic capital markets with offshore RMB.
The RQFII pilot scheme also allows institutional investors outside the PRC to facilitate investments of offshore RMB deposits back into Chinese capital markets, by enabling them to establish RMB-denominated funds and/or public or private funds or other investment products outside of the PRC and utilising the RMB thereby raised to invest in PRC domestic assets.
The initial response to the RQFII pilot scheme was admittedly muted, but, as market knowledge increased and the general market outlook for the PRC improved, interest began to warm up, and many of the early RQFII funds that launched below expectations are now sold out as a result of the increased demand and enthusiasm.
In April 2012, the initial RQFII quota was increased by a further RMB50 billion, from RMB20 billion to RMB70 billion, to enable exchange-traded funds to invest in the domestic A-share market. In November 2012, the quota was increased again to RMB270 billion, with Guo
Shuqing, the chairman of the China Securities Regulatory Commission (CSRC), indicating that this was at the request of “Hong Kong officials.” On 14 January, 2013, he indicated that the ceiling could be raised by 10 times, if necessary.
However, the biggest boost to the RQFII pilot scheme came on 6 March, 2013 when the
CSRC announced that, effective immediately, it was relaxing the RQFII rules to, among other things, 1) remove the investment restrictions allowing asset managers full discretion to determine the asset mix of their investments and permitting index futures, and 2) allow participation by Hong Kong subsidiaries of Chinese banks and Chinese insurance

2013 Recent Developments in Hong Kong Funds Market companies, as well as Hong Kong-registered financial institutions that have major businesses in the territory. Including the latter category of new participants caused the most excitement, since it enabled non-Chinese fund managers with no Chinese shareholders, so long as they operated in Hong Kong, to apply for an RQFII quota and license. This was an unexpected but very welcome surprise to many industry participants who had expected a more gradual easing of the restrictions. To demonstrate how committed they were to the program, the CSRC pledged that the application process would be streamlined and shortened to a maximum of 60 days.
On 12 July 2013, the CSRC announced that it will extend the RQFII pilot scheme to Taiwan,
London, Singapore and other “unnamed destinations.” However, for the moment, Hong Kong remains the only jurisdiction in which the RQFII pilot scheme has officially been launched and which has implemented regulations for, and successfully launched and offered, RQFIIlinked products.
In order for foreign non-Chinese asset managers to take advantage of this program in Hong
Kong and to launch and offer such RQFII-linked products like RQFII retail funds and exchange-traded funds (“ETFs”), applicants must comply with the criteria set out under the
Code of Unit Trusts and Mutual Funds of the Securities and Futures Commission of Hong
Kong (SFC). The release of those new criteria on the SFC website was a clear indication that mainland and Hong Kong regulators were following through on the CSRC’s promise in
November 2012 to widen participation in the program beyond mainland subsidiaries and joint ventures.
The latest RQFII product to be launched is the RQFII physical A-Share ETF, which is the first
RMB physical A-share ETF issued outside mainland China that seeks to track an A-share index by channelling the RMB raised outside mainland China through the RQFII quota to directly invest in a portfolio of A-shares in the PRC market that replicates the performance of the underlying A-share index. Under current PRC rules and regulations, only those SFClicensed management companies who have RQFII licences and quotas are eligible to launch
RQFII physical A-share ETFs in Hong Kong.
The SFC’s Code of Unit Trusts and Mutual Funds provides that an eligible RQFII fund manager lacking a mainland parent must have at least one key person with at least two years of physical A-share ETF portfolio management experience, and its RQFII ETF must adopt a full physical replication strategy, with no representative sampling.
The participant is also required to retain a “reputable” mainland, Hong Kong or international firm “acceptable to the SFC” as its investment advisor for at least a year after listing the
RQFII ETF. The investment advisor must have at least three years of "solid" experience and a "good track record" in managing ETFs in the mainland, Hong Kong or other major ETF markets, and it has to provide support for the ETF’s cash management, the handling of corporate and other special events, portfolio composition file generation and checking, reference underlying portfolio value or estimated net asset value checking and monitoring, tracking error management and any other duties the SFC deems appropriate. However, the
Code accords overriding discretion to the SFC “where the management company has a proven track record in managing ETFs in reputable markets” to consider “modifying and/or not requiring strict compliance with any of the above requirements, on a case-by-case basis, where it considers appropriate.” Global fund managers that wish to participate in the scheme cannot simply set up an office in Hong Kong, but must also establish a meaningful presence
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2013 Recent Developments in Hong Kong Funds Market in the form of investment analysts and portfolio managers, and must carry out actual trading in Hong Kong.
The RQFII pilot scheme has provided a new avenue for utilising the huge amount of offshore
RMB floating outside the PRC. Hong Kong is, by far, the largest offshore RMB centre, with offshore RMB deposits of almost RMB700 billion as at the end of 2012. Until the launch of the RQFII, these offshore RMB deposits would have remained offshore, available only for offshore purposes, but the RQFII pilot scheme has provided a way of bringing that RMB back onshore without the more cumbersome process of obtaining regulatory approvals each time
(up to the upper limit of the quota, of course). Among other things, this has led to greater access to onshore buyers and suppliers, a more diversified range of investments, reduced foreign exchange costs and new hedging opportunities. Borrowing costs on the offshore bond market are considerably lower than the official interest rates for onshore loans set by the People’s Bank of China, and utilising the proceeds of a dim sum bond to invest in PRC domestic securities is an attractive proposition.
As demonstrated by the performance of the RQFII funds in their early days, investor education and familiarity with a product are important factors in their success. Hong Kong and the SFC are currently the only jurisdiction and regulator that have officially implemented the RQFII pilot scheme and, consequently, the only ones with any experience with such
RQFII funds. Hong Kong has the longest history and track record of the offshore RMB centres and, therefore, service providers familiar with and capable of dealing with RMB and the RQFII process, such as lawyers and other fund managers and investment advisers.
Further, the relationship between the CSRC and the SFC is long, co-operative and amicable, stemming from Hong Kong’s unique position as a special administrative region of China and the Mainland and Hong Kong Closer Economic Partnership Arrangement, more commonlyreferred to as CEPA, which has been in place since 2003. In addition, because of its sophisticated and highly-developed financial market and common laws and regulations from its former days as a British colony, the CSRC has tended to look to Hong Kong for guidance on more complex securities issues and products. Hong Kong has, historically, been the market where the PRC has launched new products, and Hong Kong and China have had the time to build up a sufficiently comfortable and trusting relationship. Even before 1997, Hong
Kong played a key role in relation to market-opening reforms in China, going all the way back to the early 1990’s when China required capital investment and was aided through the listing of H-shares companies on the Hong Kong stock market.
The PRC onshore bond market can be a minefield, and investors keen to have a finger in the PRC pie may now access a safer route through the RQFII fund, which minimises that risk by providing investors with the protection, comfort and security of a Hong Kong-approved and regulated fund.
Another major boost to the Hong Kong funds market from the PRC came when Alexa Lam, the SFC’s deputy CEO and executive director of investment products for policy, China and investment products announced on 24 January, 2013, that the PRC and Hong Kong were in the midst of developing a mutual recognition platform for fund products. While specific details of the platform were not disclosed, Ms Lam shared that “qualified SFC-authorised funds domiciled in and operating from Hong Kong would enjoy the status of recognised Hong Kong funds,” and qualified mainland funds would enjoy the status of “recognised mainland funds",
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2013 Recent Developments in Hong Kong Funds Market which would allow those recognised funds to be sold directly in each other’s market after obtaining authorisation from the host market. No proposed date for the implementation of this proposal was announced. Since then, two further announcements on the status of the program have been disclosed. On 6 June, 2013, during a panel discussion at the FT Asset
Management Summit 2013, Ms Lam disclosed that a working group comprising members of the SFC and the CSRC were conducting a “technical exercise” mapping the regulatory regimes of both jurisdictions to determine the investor protection offered by each other’s regulatory regimes and were “still trying to get a consensus of the minds,” which she called
Stage 1 in a two-stage process. Only after reaching common ground on their “philosophy and thinking” could they move to Stage 2, which involves sitting down and working out the parameters and limits of the platform. Bearing in mind their very different regulatory regimes,
Stage 1 is a substantial process. However, Lam stated that “we believe that at the end of the day we should be able to get to a space where we will be comfortable in terms of investor protection… and that we are broadly on the same page.” On 6 September, 2013 at a panel at the Treasury Markets Summit, she reiterated that there were still “a good number of technical and product detail issues,” and her co-panellist from the CSRC stated that there was no timeline in place for the regime.
What has been confirmed so far is that:
•
Mutual recognition will only be applicable to those funds that are Hong Kong-domiciled and SFC-authorized, which would automatically exclude Undertakings for Collective
Investment in Transferable Securities (UCITS) products.
•
“Hong Kong-domiciled funds” means funds set up by an SFC-licenced fund manager, using a Hong Kong trustee (if necessary) and having their primary place of business in
Hong Kong.
•
SFC authorization of a fund does not restrict management of the assets to management carried out in Hong Kong only, as Hong Kong authorized funds may be set up as fund-offund types as well.
•
SFC-authorised funds in Hong Kong will not receive automatic recognition in the PRC and vice versa. There will still be a review process, and if the relevant fund receives recognised fund status, it may be sold directly in each other’s market after obtaining authorisation from the host market.
Regardless of when this mutual recognition platform is implemented, it is likely to have a sizeable impact on the Hong Kong funds market.
What may not be immediately apparent to most foreign fund managers is that the costs of setting up in Hong Kong are typically lower than in more familiar UCITS jurisdictions such as
Luxembourg, for access to a potentially much larger market. The cost of establishing local funds in Hong Kong may be lower than if the fund were set up in, say, Luxembourg, since service provider expenses are generally lower. The mutual HK-PRC recognition platform would enable funds with the recognised status to access a market of potential investors 100 times larger than the current size of Hong Kong based solely on Chinese investors.
However, because, like the RQFII quota, this mutual recognition would enable investors to directly access the broad range of China funds on the mainland, it will attract investors outside of the PRC eager to invest in the PRC domestic market as well, which increases the pool of investors even more.
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2013 Recent Developments in Hong Kong Funds Market
Prior to this announcement, focus had generally been on the passporting of already-existing
UCITS funds direct into the PRC, which the PRC may not have been in a position to handle, given its unfamiliarity with UCITS. The HK-PRC mutual recognition regime would be a more practical solution because of Hong Kong’s unique “special administrative region” relationship with the PRC in which the two markets have built up a sufficiently trusting relationship.
At the same time, fund managers have been having a difficult time complying with the numerous amendments and restrictions of European fund regulation. The ink has not even dried on UCITS V and already, there is UCITS VI, in addition to the Alternative Investment
Fund Managers’ Directive, Markets in Financial Instruments Directive II, the Retail
Distribution Review. For those fund managers targeting investors from Asia, such directives would be completely irrelevant if they were able to close their funds in Hong Kong through the HK-PRC mutual recognition scheme.
Competition is likely to increase as an increasing number of foreign fund managers set up shop in Hong Kong to take advantage of this mutual recognition between Hong Kong and the
PRC. Currently, the majority of local Hong Kong fund managers are focused on Hong Kong and Taiwanese equities, but mutual recognition will likely encourage foreign fund managers to set up branches in Hong Kong to manage US or European assets. At the same time,
RQFII funds may come under pressure as well. If this competition is carefully-managed, it could lead to innovative products, an increase in skills and knowledge and a sharing of talents – exactly in line with the CSRC’s aims of widening its investor base by encouraging foreign participation, promoting the concept of value investment, increasing knowledge base and allowing its capital markets to grow in line with international standards. As participation grows, this will lead to more liquidity in the markets which will result in more interest in the capital markets since it becomes easier to buy and sell, which will then lead to interest from foreign markets.
Hong Kong entities have taken a back seat to UCITS and foreign companies for a considerable time now. Even when companies appear to be operating “in Hong Kong,” this has usually been through offshore vehicles without a genuine presence in Hong Kong. The regime would bring the focus back to Hong Kong, requiring use of Hong Kong companies and Hong Kong service providers, and enable Hong Kong to directly benefit. Of the 2,200 odd SFC-authorised funds in early 2013, only 300 funds currently qualify for this recognition scheme. The potential, if all of such SFC-authorised funds qualified, would be huge. A
PricewaterhouseCoopers report titled “Transforming Hong Kong into an asset management hub”, calculates that, if all SFC-authorised funds in Hong Kong were locally domiciled, an additional US$3.5 billion in domestic fund administration and support service fees would be injected into Hong Kong’s asset management industry. For every US$1 of assets under management in a fund, usually about 25 basis points would go to service providers, and for any one full-time employee working directly in the asset management industry for a locally domiciled fund, there are 4.6 jobs in the industry for servicing the fund structure. Currently, in
Hong Kong, there are almost 4,000 direct jobs in the asset management industry, according to a recent SFC survey; if all these 4,000 professionals were to service Hong Kong-domiciled funds rather than offshore funds, this would create an additional 18,000 jobs within the local asset management industry. That amount would equate to an extra US$500 of per capita gross domestic product (GDP), or a further 1.5% in GDP growth for Hong Kong, the report says.
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2013 Recent Developments in Hong Kong Funds Market
Meanwhile, perhaps aware of the growing competition from Singapore as a funds centre, the
Hong Kong government pledged in its annual budget in February 2013 to raise the profile of the Hong Kong asset management industry, which includes, among other things, considering legislative amendments to introduce open-end investment companies and introducing tax incentives for private equity funds.
Legislative amendments to the existing companies’ legislation in Hong Kong, the Companies
Ordinance, are necessary as existing provisions do not facilitate share repurchases and rolling redemptions, which are a necessary feature of more traditional mutual and hedge funds.
Tax incentives for private equity funds have been long overdue – since 1996/97, the 100% tax exemption for offshore funds has exempted non-resident persons from profits on
“specified transactions” only, which definition excluded transactions in private companies.
The latest Budget proposes to extend the 100% tax exemption to include transactions in private companies which are incorporated or registered outside Hong Kong and do not hold any Hong Kong properties nor carry out any business in Hong Kong.
Following the normal course of events, the government will first conduct a consultation process on the proposed amendments before any final decision is made. The government has requested the assistance of the SFC in this endeavour as any such amendments will likely affect the securities legislation as well.
With such interesting developments in the space of just a few months in Hong Kong, the question is: “What next?”. Onlookers have been surprised at just how rapid the pace of these changes have been, particularly in the PRC, with some market-makers commenting that it appears likely that we could see a free-floating RMB by as early as 2015. The PRC government has demonstrated that, when it wants to implement a proposal quickly, it will, and with the added arsenal of a developed, sophisticated market like Hong Kong under its wing, it has the means, skillset and ability to do so.
Authors:
Choo Lye Tan choolye.tan@klgates.com
+852.2230.3528
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2013 Recent Developments in Hong Kong Funds Market
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