This article was written by KWM cross-border regulatory and debt capital markets team
(Minny Siu, Molly Su, Richard Mazzochi, Hao Zhou, Michael Lu and Song Yue)
1. Debut launch of Southbound Bond Connect on 24 September 2021
Bond Connect is a mutual market access scheme launched in 2017 that facilitates cross-border bond trading and settlement. Northbound Bond Connect commenced trading in July 2017 and allowed Hong Kong SAR and other offshore investors to access China’s Interbank Bond Market (“CIBM”).
Southbound Bond Connect is the “southbound” version of Northbound Bond Connect. Please refer to our previous client alert for further information on the Northbound Bond Connect scheme.
Southbound Bond Connect is the “southbound” mirror image of the Northbound scheme and allows eligible China Mainland institutional investors (“China Mainland Investors”) to access the offshore bond market in Hong Kong SAR. Southbound Bond Connect is operated and supported through cooperation between the relevant bond trading, custody and settlement infrastructure institutions (“Financial Infrastructure Services Institutions”) in Hong Kong SAR and China Mainland. The People’s Bank of China (“PBOC”) and Hong Kong Monetary Authority (“HKMA”) approved the collaboration of the Financial Infrastructure Services Institutions on 15 September 2021 for the purposes of establishing Southbound Bond Connect.
According to data from the HKMA and the PBOC, the first batch of trading under Southbound Bond Connect on 24 September 2021 recorded more than 150 transactions in bonds commonly traded on the Hong Kong SAR market with participation from over 40 China Mainland Investors and 11 Offshore Market Makers.
According to the Joint Announcement, Southbound Bond Connect supports the continued development of Hong Kong SAR and enhances cooperation between China Mainland and Hong Kong SAR, and is “conducive to the diversification of investment channels for Mainland institutional investors, to the steady and progressive two-way opening up of the Mainland financial markets, to the enhancement of Hong Kong’s competitive advantages and consolidation of Hong Kong’s status as an international financial centre, and to the upholding of long-term prosperity and stability of Hong Kong”.
In this article, references to “PRC” or “China Mainland” means the People’s Republic of China, excluding the Hong Kong Special Administrative Region (“Hong Kong SAR”), Macau Special Administrative Region and Taiwan region, and the term “onshore” refers to China Mainland, and “offshore” refers to jurisdictions outside China Mainland (such as Hong Kong SAR).
2. Key features of Southbound Bond Connect
Infrastructure of Southbound Bond Connect – key participants
The key Financial Infrastructure Services Institutions and their respective roles under Southbound Bond Connect are summarised in this table:
|PRC Financial Infrastructure Services Institutions
|China Foreign Exchange Trade System (“CFETS”) – the PBOC approved trading system for bonds traded on the CIBM
|Provide market participants with bond trading related services including providing Offshore Trading Platforms (as defined below) with information relating to the relevant bonds, facilitating with requests for quotations and providing information on completed transactions
|China Central Depository & Clearing Co., Ltd. (“CCDC”) – one of the designated central securities depositories of the CIBM
|Through collaboration with the CMU (as defined below), open nominee accounts for China Mainland Investors
|Interbank Market Clearing House Co., Ltd. (“SHCH”) – one of the designated central securities depositories of the CIBM
|Through collaboration with the CMU (as defined below), open nominee accounts for China Mainland Investors
|Onshore custody and settlement banks
|Through connection with CMU (as defined below) and/or Hong Kong SAR custodian banks, provide bond custody and settlement services to China Mainland Investors
|Cross-Border Interbank Payment System (“CIPS”)
|Offer clearing and settlement services for cross-border RMB payments and trade
| Hong Kong SAR Financial Infrastructure Services Institutions
|Hong Kong Exchanges and Clearing Co., Ltd. (“HKEX”) – part operator of Bond Connect Company Limited (“BCCL”) and owner of The Stock Exchange of Hong Kong (“SEHK”)
|BCCL is a joint venture established by CFETS and the HKEX to support Bond Connect trading services.
Most bonds available to investors in Hong Kong SAR are not listed or traded on the SEHK.
|Central Moneymarkets Unit (“CMU”) – the debt securities clearing and settlement system in Hong Kong SAR owned and operated by the HKMA
|Provide clearing, settlement and custodian services for debt securities issued by both public and private sector entities in Hong Kong SAR
|Hong Kong custodian banks
|China Mainland Investors that choose to hold bonds with an onshore custody and settlement bank can do so through a settlement link between such onshore custody and settlement bank and CMU or a Hong Kong custodian bank (although the implementation details of this settlement link are pending clarification)
Eligible China Mainland Investors
The following China Mainland Investors are now permitted to trade under Southbound Bond Connect:
- the 41 banking financial institutions (excluding non-bank financial institutions and rural financial institutions) that are designated by the PBOC as Tier 1 dealers for open market business in 2020 – a complete list of such dealers (including the excluded non-bank financial institutions and rural financial institutions) as listed in Appendix A of this article; and
- Qualified Domestic Institutional Investors (“QDIIs”) and Renminbi Qualified Domestic Institutional Investors (“RQDIIs” and together with QDIIs, “(R)QDIIs”) (although their investments do not count towards the quota usage, as set out below).
We understand that unincorporated investment vehicles launched in China Mainland are permitted to invest through Southbound Bond Connect (although the specific product types that can be accessed through Southbound Bond Connect remain to be clarified).
Registration requirements: China Mainland Investors are required to submit certain information to CFETS before commencing its Southbound Bond Connect business and comply with other procedural requirements stipulated by the relevant regulators.
Eligible market makers (trade counterparty)
An eligible China Mainland Investor can only trade under Southbound Bond Connect with a financial institution in Hong Kong SAR that is a designated market maker for Southbound Bond Connect by the HKMA (“Offshore Market Makers”). There are currently 13 approved Offshore Market Makers (as listed in Appendix B of this article).
Selection criteria: The Offshore Market Makers were selected pursuant to the HKMA’s internal evaluation process based on several criteria “including certain basic conditions such as licenses for carrying on relevant activities, adequate internal control systems, and regulatory compliance; and other factors including the financial institutions’ activities in the Hong Kong bond market, their business presence in Hong Kong, counterparty network with Mainland financial institutions”.
Registration requirements: Offshore Market Makers must submit certain information to CFETS prior to commencing any Southbound Bond Connect trades and must comply with other procedural requirements stipulated by the relevant regulators.
Eligible bond products
Eligible China Mainland Investors may access all bonds that are (i) issued offshore and (ii) traded in the Hong Kong SAR market with liquidity under Southbound Bond Connect. It remains to be seen whether the regulators will stipulate further eligibility requirements to narrow the eligible bond product scope, for example, by qualifying what constitutes “with liquidity”, and stipulating the required product features of the bonds.
We understand CFETS intends to publish a list of the eligible bonds for trading on its platform. This list will be updated from time to time in response to market conditions and investor needs.
Annual and daily quota
The cross-border capital net outflow for Southbound Bond Connect is subject to an annual quota limit, as well as a daily quota limit.
|Annual total quota
Investments made by (R)QDIIs under Southbound Bond Connect will not be included in calculating quota usage of Southbound Bond Connect.
CFETS will monitor the quota usage on a real-time basis. Once exceeded, CFETS will not accept further buy orders under Southbound Bond Connect.
Southbound Bond Connect trades adopt the trading days and trading hours of the CIBM (i.e., Beijing time 9.00am – 12.00pm and 1.30pm – 8.00pm on a trading day). The SHCH provides gross settlement services and supports Southbound Bond Connect transactions with a settlement cycle of T+1 to T+3.
A transaction executed under Southbound Bond Connect must be settled only on a day which is a working day on both the CIBM and the Hong Kong SAR bond market.
Foreign exchange conversion and cross-border funds under Southbound Bond Connect
The quoting, transaction and settlement currency of trades conducted under Southbound Bond Connect are governed by the terms of the underlying bond.
A China Mainland Investor intending to trade in foreign currency denominated bonds under Southbound Bond Connect may exchange its RMB for the relevant foreign currency in China’s interbank foreign exchange market and hedge its foreign currency risks through foreign exchange derivatives.
Capital flow under Southbound Bond Connect will be kept in a close-loop – that is, any sales proceeds derived by a China Mainland Investor must be remitted back to China Mainland and exchanged back into RMB.
3. Trading link
General trading flow – RFQ
Trades under Southbound Bond Connect are conducted by way of the placement of a Request-for-Quote (“RFQ”) by a China Mainland Investor with an Offshore Market Maker. The key steps involved in a trade execution are:
A China Mainland Investor sends a RFQ through CFETS to the Offshore Market Maker(s).
- may be sent to one or more Offshore Market Makers;
- should stipulate the trading parameters such as direction (bid or offer), bond code, total face value, settlement date, etc.;
- may include a validity period, upon the expiry of which the RFQ automatically lapses; and
should follow the minimum nominal amount and tick size of the underlying bond.
An Offshore Market Maker responds to the RFQs through CFETS or Offshore Trading Platforms.
The Offshore Market Maker may choose not to respond to an RFQ.
- should quote a price and include the trading parameters such as the amount of tradable bonds, net price and yield at maturity; and
- may be subject to a validity period, upon the expiry of which the quote automatically lapses if it is not accepted.
||The China Mainland Investor decides whether to accept any given quote.
Types of trading links
Unlike Northbound Bond Connect, Offshore Market Makers are offered two types of trading links for connection to CFETS’ trading platform:
- Trading Link A (described further below) - the trading link is between CFETS’ trading platform and the designated Offshore Trading Platform (such that the Offshore Market Makers may simply connect their systems with the Offshore Trading Platform); and
- Trading Link B (described further below) - the trading link is between CFETS’ trading platform and the Offshore Market Makers (i.e., no Offshore Trading Platform is involved).
Both variations adopt (broadly speaking) the RFQ trading flow described above.
The trading links are illustrated in this diagram:
Trading Link A – Trading link between CFETS’ trading platform and Offshore Trading Platforms
This model allows Offshore Market Makers to conduct the RFQ process on an Offshore Trading Platform, which allows market makers to avoid the need to connect to CFETS, thereby reducing their pre-trade system connection costs and administrative burden.
Under this model, a trade completes when:
- the China Mainland Investor accepts a quote provided by an Offshore Market Maker in response to the investor’s RFQ; or
- if the Offshore Trading Platform offers a “last look” function and the function is adopted by an Offshore Market Maker, (i) a quote is accepted by a China Mainland Investor and (ii) the acceptance by the investor is confirmed by the relevant Offshore Market Maker.
Trading Link B – Direct trading link between CFETS’ trading platform and Offshore Market Makers
Under this model, Offshore Market Makers are linked to, and trade directly on, the CFETS platform. A trade completes when the China Mainland Investor accepts a quote provided by an Offshore Market Maker in response to the investor’s RFQ.
(R)QDIIs trading through Southbound Bond Connect may also use trading routes permitted for their offshore bond trading.
4. Settlement and custody link
Nominee holding structure
Again, similar to Northbound Bond Connect, bonds traded under Southbound Bond Connect are held and settled under the nominee holding structure. However, under Southbound Bond Connect, China Mainland Investors may choose to hold their Southbound Bond Connect bonds through:
- onshore bond registration and settlement institutions recognised by the PBOC (i.e., CCDC/SHCH) (“Onshore CSD Settlement Route”) – trades under this route are settled via a settlement link between the bond registration and settlement institutions recognised by the PBOC (i.e., CCDC and SHCH) in China Mainland and CMU; or
- an onshore custody and settlement bank (“Onshore Settlement Bank Route”) – pending detailed rules on the settlement structure for this route, trades under this route are settled via a settlement link between the onshore custody and settlement bank and CMU or Hong Kong SAR custodian banks.
Although the rules and regulations have not provided extensive details for the Onshore Settlement Bank Route, the key differences between these routes are as follows:
||Northbound Bond Connect
|Onshore Settlement Bank Route
China Mainland Investor or its custodian bank opens a “Southbound Bond Connect” account with CCDC or SHCH to record its bond holdings at CCDC or SHCH (as applicable).
CCDC/SHCH opens segregated nominee sub-account(s) with CMU to record its bond holdings on behalf of China Mainland Investors (at individual investor level).
The bond holdings recorded in the Southbound Bond Connect account opened at CCDC/SHCH should match the holding as recorded in each nominee holder account opened by CMU for CCDC/SHCH.
The operational details for this route have yet to be clarified. Pursuant to the PBOC Notice, where a China Mainland Investor opts for this route, the Onshore Settlement Banks should establish a settlement link with CMU or Hong Kong SAR custodian banks in order to provide China Mainland Investors with services such as bond custody and settlement but no further details are provided.
We believe this route is intended to allow China Mainland Investors to directly invest in bonds denominated in non-Renminbi currencies after purchasing foreign exchange in China Mainland. We anticipate that the settlement mechanism under this route will be similar to the settlement mechanism for bonds traded via the CIBM direct access regime.
|Settled via CIPS.
This diagram illustrates the Onshore CSD Settlement Route and Onshore Settlement Bank Route:
Only SHCH has published guidelines on Southbound Bond Connect as of the date of this article. According to the SHCH’s rules, China Mainland Investors are entitled to rights and interests in the bonds in accordance with the law. SHCH must act in accordance with the investors’ instructions.
Settlement on delivery versus payment (“DVP”) basis
Under Southbound Bond Connect, transactions are settled on a DVP basis. Taking SHCH as an example, it provides gross settlement services and supports transactions under Southbound Bond Connect with a settlement cycle of T+1 to T+3.
This table summarises the operation of settlement through SHCH on a DVP basis:
|CIBM trading day immediately preceding settlement date
||China Mainland Investors confirm settlement instructions through SHCH.
| During the day
||SHCH submits settlement instructions to CMU following CMU’s requirements.
||After confirming that the seller has sufficient bonds for settlement, CMU locks up the relevant bond position in the seller’s account and sends a CIPS135 message to CIPS. CIPS forwards the CIPS135 message to the buying and selling CIPS participant.
||China Mainland Investor or its entrusted CIPS participant sends a CIPS136 message to CIPS notifying CIPS of the investor’s consent on the transfer of funds.
CIPS transfers the funds pursuant to the CIPS136 message and sends a CIPS601 message to update CMU on the status of the transfer, based on which CMU completes the distribution of bond.
If the seller has insufficient holding positions in its account, or if the buyer has not transferred the funds required, SHCH will submit a cancellation request to the CMU to terminate settlement for that transaction.
||When a DVP settlement is completed by CMU, SHCH will generate individual internal settlement instructions to credit or debit the balance of the respective Southbound Bond Connect accounts.
||China Mainland Investors may enquire settlement results through the SHCH’s system.
5. Key legal and regulatory issues
Applicable laws and regulations
Southbound Bond Connect is subject to the laws and regulations in Hong Kong SAR and China Mainland. The settlement of a transaction under Southbound Bond Connect must comply with the regulatory requirements and business rules of the jurisdiction in which the settlement takes place.
All China Mainland Investors participating in Southbound Bond Connect are subject to the following rules and regulatory bodies:
Rules and regulations of the PBOC and CFETS (for example, China Mainland Investors must use any Southbound Bond Connect market data obtained via CFETS’ trading platform for trading purposes only and are strictly prohibited from downloading, recording or providing such data or using such market data for index compilation or provision of derivatives without authorisation)
Applicable trading rules of the interbank market
|Fund remittance and cross-border payment activities
|Supervision by the PBOC and the State Administration of Foreign Exchange
|Custody and settlement of bonds
|Comply with the relevant rules of the CCDC, SHCH and CMU
|Legal relationship with bond issuer
|Determined in accordance with the legal documentation underlying the bond issuance
Contravention of the applicable laws and regulations
Where CFETS has reasonable grounds to believe that any Southbound Bond Connect participant has violated the relevant laws and regulations or otherwise engaged in activity which affects the operations of Southbound Bond Connect in a material adverse way, it may suspend the participant’s use of the system and report the same to the PBOC.
The SHCH Guide clarifies that the China Mainland Investor bears all (onshore and offshore) tax labilities arising from its Southbound Bond Connect investments.
6. Benefits of Southbound Bond Connect compared with (R)QDII
Flexibility of asset allocation
Prior to the launch of Southbound Bond Connect, the (R)QDII regime was the main channel through which China Mainland Investors invested in the offshore bond market. However, as a general rule under the (R)QDII regime, any instruments in the form of securities (including bonds) issued by an offshore entity and sold to a (R)QDII counterparty cannot be distributed to PRC investors directly or on-sold by a (R)QDII counterparty. Rather, the products must be repackaged or “wrapped” by the (R)QDII counterparty as its own product and then sold to PRC investors. (R)QDIIs did not have the flexibility to adjust their positions and allocate their assets according to market conditions.
Under Southbound Bond Connect, a China Mainland Investor may trade any eligible bond via the trading link with Offshore Market Makers directly, greatly enhancing the flexibility for asset allocation.
Focus on bonds products with larger quota
Apart from bonds, the range of (R)QDII products also includes stocks, structured products, financial derivatives and funds. As the quota for (R)QDII is relatively scarce, a large proportion of the (R)QDII quota is allocated to investment in other offshore asset classes, thereby restricting the quota for bond investment.
The annual quota limit and daily quota limit for Southbound Bond Connect are higher than the quotas for the Shanghai-Hong Kong Stock Connect when it launched (the aggregate quota limit for the Shanghai-Hong Kong Stock Connect was RMB250 billion and the daily quota was RMB10.5 billion in 2014). At present, there is no aggregate quota for the Shanghai-Hong Kong Stock Connect or Shenzhen-Hong Kong Stock Connect, and the southbound daily quota for each of the Stock Connect schemes is RMB42 billion.
Potential range of bond varieties
Different types of (R)QDIIs are subject to different restrictions on their scope of bond investment. For instance, bank (R)QDIIs are subject to certain requirements on bond rating (i.e., BBB above) and on the issuing entity. Under Southbound Bond Connect, however, there is currently no specific requirement on the rating of the target bonds nor the issuing entity. Therefore, Southbound Bond Connect may provide China Mainland Investors with a broader range of offshore bond investments.
7. Comparison table of Northbound and Southbound Bond Connect
||Onshore CSD Settlement Route
||Southbound Bond Connect
|China Mainland institutional
||Offshore account opening with CMU
|Onshore account opening with CCDC or SHCH
|Eligible product scope
|All cash bonds in CIBM
|All bonds issued offshore and traded with liquidity in Hong Kong SAR (subject to any further rules or guidelines published by the regulators to further refine the scope)
|All trades are executed on the CFETS RMB Trading System, which is accessible by offshore investors through Offshore Trading Platforms
|Pending further clarification, all trades are executed on CFETS’ electronic trading platform
|RFQs (with minor variations)
||Subject to daily and aggregate quotas
|Offshore investors may hedge foreign exchange exposure with foreign exchange settlement banks
|China Mainland Investors may hedge their foreign currency risks through foreign exchange derivatives in China’s interbank foreign exchange market
|Adopts multi-tier custody structure - CMU acts as the single nominee of all offshore investors and holds one omnibus bond account with CCDC and SHCH.
Offshore investors can open subaccounts with the CMU through a Hong Kong SAR custodian that holds CMU membership, or through their global custodian, who then appoints a Hong Kong SAR custodian for subaccounts handling.
Cross-border cash settlement is completed through CIPS.
|China Mainland Investors may hold and settle their Southbound Bond Connect trades through the Onshore CSD Settlement Route (using the settlement link between CMU and CCDC/SHCH) or Onshore Settlement Bank Route (the settlement structure under this route awaits further clarification but we expect it to be similar to the structure under the CIBM direct access regime).
Southbound trading under the Onshore CSD Settlement Route is settled through CIPS.
Certain aspects of Southbound Bond Connect, such as the initial range of eligible bonds and the detailed trading, custody and settlement rules, await further clarification. In particular, we understand that the CCDC has yet to publish its implementation rules for Southbound Bond Connect. We will continue to work closely with the regulatory authorities and the relevant Financial Infrastructure Services Institutions and keep an eye on any regulatory updates. We expect to see further developments and innovations in China-Hong Kong SAR southbound investment brought about by Southbound Bond Connect.
Role of King & Wood Mallesons
King & Wood Mallesons has been providing the CFETS with critical legal support for its Bond Connect related initiatives since 2017, most notably assisting CFETS with the implementation of Northbound trading under Bond Connect when it launched in 2017. King & Wood Mallesons was again honoured to act as the legal counsel to the CFETS with the implementation of Southbound Bond Connect. As a critical financial infrastructure for Southbound Bond Connect, CFETS provides one-stop, multi-currency and multi-mechanism services for China Mainland institutions to invest in and trade in global bonds.
In addition to advising CFETS on the establishment and launch of Southbound Bond Connect, Kind & Wood Mallesons has advised and continues to advise Southbound Bond Connect participants to take advantage of this latest Connect and GBA initiative. Please contact us if you have any questions.
Appendix A: List of Bond Connect dealers (including the excluded non-bank financial institutions and rural financial institutions)
Appendix B: List of Offshore Market Makers (in alphabetical order)
 According to the HKMA’s data, Northbound Bond Connect has attracted over 2,400 global institutional investors and has facilitated Chinese sovereign bonds to be included into various major global bond indices such as Bloomberg-Barclays Global Aggregate Index and J.P. Morgan Government Bond Index – Emerging Markets. In 2020, the scheme recorded an average daily turnover of nearly RMB20 billion, accounting for 52% of foreign investors’ total turnover in the CIBM.
 http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/4348768/index.html and https://www.hkma.gov.hk/eng/news-and-media/press-releases/2021/09/20210924-5/
 The SFC approved CFETS to provide automated trading services for the purposes of facilitating the conduct of trading under Bond Connect in September 2021.
 Listing of bonds on the SEHK mainly provides a listing status to meet the investment mandates for certain types of investors such as mutual funds and unit trusts, but typically, those bonds listed on the SEHK are not traded on the SEHK.
 “Rural financial institutions” primarily comprise of rural commercial banks in China Mainland.
 Please refer to https://www.hkma.gov.hk/eng/news-and-media/press-releases/2021/09/20210917-6/
 The onshore custody and settlement banks currently recognised by the PBOC are Industrial and Commercial Bank of China, Bank of China and China CITIC Bank.
 That is, investors will need to entrust a bond settlement agent onshore to engage in trading and settlement for them.
 CFETS Trading Rules.