Gearing up for ETF Connect
Listing an ETF in Hong Kong can take up to six months depending on the complexity of the product
TO further open up its exchange-traded funds (ETFs) market to the world, China is looking to launch an ETF trading link with Hong Kong. The strong growth in the volume of these financial products, and the success of cross-border access schemes between the mainland and Hong Kong, particularly the Stock Connect, have added to the excitement around ETF Connect – a proposed cross-border scheme exclusively for ETFs.
While, the China Securities Regulatory Commission (CSRC) has given no indication as to how the ETF Connect will look like in terms of structure and products, the general expectation is that the ETF Connect will be launched in the second half of this year.
There are suggestions, particularly from the Hong Kong Investment Funds Association (HKIFA), the powerful lobby group for the fund management industry, that the ETF Connect should follow the Stock Connect model.
If this happens, it would mean that the ETF Connect would have no limits on the purchase of ETFs although the total trading volume may be subject to a daily quota. Under the HKIFA proposal, the quota for the ETF Connect should also be separate from the aggregated quota of the Stock Connect.
In any case, the only thing that is clear so far is that the ETF Connect will allow investors in Hong Kong to access Shanghai and Shenzhen listed ETFs, and mainland investors can trade Hong Kong ETFs.
For ETF providers, the impending launch of the ETF Connect means they have to be ready with their products as soon as the cross border access scheme is launched.
In Hong Kong, one particular issue is whether the ETF Connect will require only locally domiciled or Hong Kong-listed ETFs to qualify for the scheme. Although this issue is not yet resolved ETF providers, particularly the offshore fund managers, are already thinking of preparing their products so they will be ready the moment the ETF Connect is launched.
As of April 13 2018, there are 107 ETFs listed in the Hong Kong Exchange. There are also 27 leveraged and inverse (L&I) products. In addition, 34 ETFs have been delisted in 2017.
“Because the ETF Connect will hopefully be launched before the end of this year, a number of foreign fund managers are already thinking about listing and launching an ETF in Hong Kong,” says Eva Chan, partner at Simmons & Simmons, a law firm which has worked on 80% of the ETFs listed in Hong Kong. Chan, herself, has 15 years of experience working on fund services particularly ETFs.
The latest ETF that Chan’s team has worked on involves the CICC KraneShares CSI China Internet Index ETF that was launched by the China International Capital Corp (CICC), a Hong Kong-based mainland asset manager and Krane Funds, a US-based fund manager specializing in China ETFs.
Launched on April 10, the CICC KraneShares CSI China Internet Index ETF is an innovative technology-focused ETF that tracks the CSI Overseas China Internet Index. It matches the benchmark and strategy of the New York-listed KraneShares CSI China Internet ETF (KWEB) which was launched in 2013 and now has US$1.7 billion in assets under management.
“The newly launched CICC KraneShares CSI China Internet Index ETF will provide investors with exposure to Chinese internet companies that benefit from the increasing domestic consumption within China. Key constituents include Tencent, Alibaba, Baidu, JD, Weibo, and others,” says Jonathan Krane, CEO of KraneShares.
The CICC KraneShares CSI China Internet Index ETF is just an example of the type of ETFs that is expected to be listed in Hong Kong in preparation for the ETF Connect.
In any case, listing an ETF in Hong Kong involves a lot of legal work that can take many months.
According to Chan, the process of listing an ETF actually begins the moment an ETF sponsor goes to a law firm like Simmons & Simmons and provides information on the investment strategy and structure of the ETF. The lawyers will then offer the ETF sponsor their legal opinion.
“We will consider it and check against whether it will comply with the current provisions under the SFC (Securities and Futures Commission) Code on Unit Trust and Mutual Funds. For innovative products, we always advise clients to have a preliminary meeting with the SFC to discuss the unique features of the product first. For this, we’ll assist them by preparing a document, listing out the issues and exemption requests that may be sought in order to seek the authorization of the SFC, and setting out the rationale, justification and proposal in seeking a waiver,” Chan says.
An example would be back in 2015 when Samsung Asset Management launched the first futures based ETFs in Hong Kong that relied on a full replication strategy by investing directly in HSI futures contracts, in order to give the ETF the performance of a futures-based index.
“I remember when Samsung first launched the first batch of futures-based ETFs in Hong Kong, we needed to obtain a waiver from the SFC because that was an index tracking futures fund which may not have been able to fulfill the margin requirement set by the SFC for futures-based funds. We needed to provide some supporting data and to explain to the SFC why they are unable to comply with this requirement and to explain what safeguards can be provided to the investors,” Chan says. The Samsung Futures ETFs were delisted on July 31 2017 as part of Samsung’s rationalization of its product offering in Hong Kong.
In contrast, the new Kranshares ETF has a more straightforward structure and its underlying assets are A-shares. It is also traded on the Stock Connect.
The SFC basically looks at the structure, investment strategy and underlying assets of the ETF. The less complicated the structure and underlying assets, the fewer issues there will be from the perspective of the SFC.
Once the SFC is happy with the structure, investment strategy, underlying assets, and other salient features of the ETF, the ETF manager can formally submit the application. In preparing the submission they get help from legal experts.
“We will assist them by preparing the draft offering document, which is usually the most heavily negotiated document. The negotiations usually focused on disclosure, for example, like what is the underlying index, and if there are any related risk factors,” Chan says.
The negotiations usually involved a few rounds of comments as well as back and forth between the ETF manager with their lawyers and the SFC.
After the SFC has formally taken up the application, the six-month period during which the application is processed kicks in. In respect of a new umbrella fund, the application is processed within three months during which the SFC gives the “conditional authorization” for the ETF.
“Six months is the maximum period. If you still fail to get the SFC conditional authorization within six months then the applications lapses and you have to redo everything,” Chan says.
However, it is quite rare that the processing period reaches the maximum of six months as the SFC is quite efficient and most of the ETF managers are responsive to requests from the SFC, says Chan citing her previous experiences.
“It really depends on how responsive clients are as well as the relevant service providers, or how complicated the product is. For a very straightforward product, we can get a conditional authorization sometimes within two to three months,” Chan says.
Even leveraged ETFs, a rather complex and high-risk product that involves the use of financial derivatives and debt to amplify the returns of an underlying index, took less than six months to gain SFC approval when it was launched in June 2016.
After securing the “conditional authorization” the ETF manager must apply to the Stock Exchange of Hong Kong (SEHK) for the listing of the ETF.
Compared to the SFC processing, the listing process is straightforward, involving the completion of some standard forms and submission of documents such as the annual report. If the fund is already established, reports of the manager and trustee, listing agreement, and admission to the Central Clearing and Settlement System (CCASS) are required.
“When you get the stock exchange listing approval then you go back to the SFC to submit the finalized offering document and other required documents, and then it’s complete. When the ETF’s name is listed on the SFC website then you know it has been granted the final authorization by the SFC,” Chan says. "The ETF Connect has not yet been launched so we don’t know yet whether a Hong Kong domicile will be required for an ETF to qualify for the ETF Connect. Nevertheless, many fund managers, just to play it safe, are deciding they might as well domicile the product in Hong Kong,” Chan adds.