This article was written by Minny Siu, Jack Wang, Molly Su, Jia Zhihang, Xi Suodi, Jessie Ng.
After MSCI’s recent announcement on the inclusion of China A-Shares in its Emerging Markets Index and other major global indexes in 2017, the inaugurated launch of the long-awaited Bond Connect scheme in July 2017 has marked another significant breakthrough in China’s capital market development, coinciding with the celebration of the twentieth anniversary of the formal establishment of the Hong Kong Special Administrative Region (“Hong Kong SAR”).
Bond Connect is a new mutual access scheme for offshore investors to access the mainland China bond market (“Northbound Trading”) and for onshore investors to access the Hong Kong bond market (“Southbound Trading”) through a market infrastructure linkage between the mainland China and Hong Kong SAR.
The initial phase of Bond Connect only supports Northbound Trading. Southbound Trading will be explored at a later stage. This article will primarily examine and recap the key features and legal issues relating to Northbound Trading.
King & Wood Mallesons had the honour of acting as the legal adviser to the China Foreign Exchange Trade System & National Interbank Funding Centre (“CFETS”) in developing this ground-breaking initiative. If your institution is considering investing through, or offering services relating to, Bond Connect, we would be delighted to advise on the key legal issues and/or assist with the relevant documentation.
According to data published by BCCL, as of 3 December 2018, the total trading volume of Bond Connect reached RMB 74.3 billion with an average daily turnover of RMB 3.38 billion in November 2018. Bond Connect has now expanded its coverage to 23 jurisdictions and 467 international institutional investors across the globe, with a total of 450 international institutional investors having joined Bond Connect .
※ A list of the key rules and regulations relating to Bond Connect are set out at the end of this article.
Ⅱ.Recap on the current state of the China bond market
1. Market size and structure
The mainland China bond market is the third-largest in the world after the US and Japan, comprising the China interbank bond market (commonly referred to as “CIBM”) and an exchange-traded bond market. As of June 2018, the total amount of bonds outstanding in China’s bond market was RMB 79.4 trillion. According to PBOC data, China issued bonds worth RMB 40.8 trillion in 2017, up 12.9 percent from the previous year..
(1) CIBM (CFETS)
CIBM is an over-the-counter wholesale market, which accounts for over 90% of outstanding value and 80% of trading settlement of the mainland China’s overall bond market. Participants in CIBM include mainly financial institutions and also various investment vehicles, including pension funds, mutual funds and private equity funds.
(2) Exchange-traded bond market (Shanghai Stock Exchange and Shenzhen Stock Exchange)
The exchange-traded bond market is retail-oriented, and accounts for less than 10% of the mainland China’s overall bond market.
2. Potential for foreign participation in China's bond market
Over the past decade, China has made significant progress in developing its bond market, with measures ranging from steadily liberalising interest rates to gradually easing capital controls. As of the end 2016, foreign holdings of China’s domestic bonds have reached a new high of RMB852.6 billion (approximately USD125.7 billion), 13% higher than the previous year.
3. Clearing and settlement for mainland China bonds
There are three central securities depositories for the mainland China’s bond market as below:
- China Central Depository & Clearing Co., Ltd (“CCDC”) and Shanghai Clearing House (“SCH”) are responsible for custody and settlement for the CIBM; and
- China Securities Depository and Clearing Corporation (“CSDC”) is the custodian, settlement and clearing house for the exchange-traded bond market.
Ⅲ. Snapshot of the infrastructure and key participants of Bond Connect
This diagram illustrates the infrastructure, and interaction between the key participants, of Bond Connect. We have included a brief explanation of the key roles and functions of each party involved in Bond Connect below.
|| The “settlement link” facilitates to the settlement and custody of CIBM securities conducted under Bond Connect through a clearing and settlement linkage between CMU in Hong Kong SAR (as the offshore custodian and settlement agent for eligible offshore investors) and CCDC and SCH (as the onshore custodian and clearing institutions in the mainland China).
|| The “trading link” refers to the trading platform located outside China and which is connected to CFETS for eligible offshore investors to input trading orders for Bond Connect transactions. HKEx and CFETS will cooperate with international bond trading platform(s) to provide electronic trading services and platforms (“Access Platforms”) to enable direct trading between eligible offshore investors and market makers providing quotations in the mainland China from the CFETS system.
|| HKEx and Bond Connect Company will provide administrative services to eligible offshore investors (such as passing on the eligible offshore investors’ applications to CFETS).
|| Offshore eligible investors will input trade orders and instructions through the trading link provided by Access Platform located outside China to CFETS’ trading system in China.
Tradeweb was the first Access Platform to grant Bond Connect investors with access to the Bond Connect trading link. Bloomberg has been approved very recently as the second Access Platform since November 2018.
|| CMU (as the offshore clearing system for Northbound Trading) will provide bond registration, custody and clearing/settlement services to CMU members in Hong Kong SAR.
|| CFETS will match and execute trade orders from eligible offshore investors routed through the Access Platform.
|| CCDC/SCH (as the onshore clearing systems for Northbound Trading) will provide bond registration, custody and clearing/settlement services to CMU in China, as the onshore clearing system.
|| CNAPS/ CIPS/ RCPMIS are the RMB payment systems for remittance of cross border RMB between CMU and SCH/CCDC and reporting of RMB payments.
||Hong Kong Settlement Banks will offer FX/RMB conversion services to eligible offshore investors who intend to use FX for Northbound Trading.
As at the date of this article, the Hong Kong settlement banks appointed to offer RMB clearing and conversion services for Bond Connect are: Industrial and Commercial Bank of China (Asia) Limited, China Merchants Bank Hong Kong Branch, Standard Chartered Bank (Hong Kong) Limited, Citibank Hong Kong Branch, Hang Seng Bank Limited, Agricultural Bank of China Limited Hong Kong Branch, China Construction Bank (Asia) Co., Ltd, Wing Fung Commercial Bank Co., Ltd. Hong Kong Branch, CITIC Bank (International) Limited, Hongkong and Shanghai Banking Corporation Limited.
Ⅳ. Trading and settlement of bonds under Bond Connect – what do market participants need to know?
1. Home rules principle
Bond Connect will abide by the relevant laws and regulations of the bond markets of Hong Kong SAR and the mainland China. Foreign investors investing in the CIBM through Northbound Trading will be subject to the CIBM bond market regulations in China. This is similar to the principles applicable to foreign investors investing in CIBM through the existing QFII/RQFII regimes.
2. Eligible investors
According to the Bond Connect Interim Trading Rules, CFETS will determine the eligibility of offshore investors according to the criteria set out in PBOC Notice No. 3 of 2016 and PBOC Notice No. 220 of 2015 (please refer to our previous article for more information).
Offshore investors eligible to trade through Bond Connect include:
| Institutional investors
|| Financial institutions such as commercial banks, insurance companies, securities companies, fund management companies or asset management companies incorporated outside of mainland China
Investment products lawfully sold by the above-mentioned financial institutions to their clients
Medium and long term institutional investors recognized by the PBOC including senior funds, charity funds and donation funds
QFIIs and RQFIIs
Institutional investors based in Hong Kong SAR, Macao SAR and Taiwan Region
|Central bank institutions
|Foreign Central Banks
International Financial Organisations
Sovereign Wealth Funds
3. Eligible bonds under Northbound Trading
Eligible offshore investors under Northbound Trading may conduct spot trading of all cash bonds currently traded in the CIBM (for example, national bond, local-government debt, central bank bond, financial bond, corporate credit bond, inter-bank deposit receipt and asset-backed securities). Based on the published rules, eligible offshore investors will have access to the primary and secondary bond market through Northbound Trading.
It is expected that the scope of eligible products may expand to include transactions such as bond repurchasing, bond lending, bond forwards, interest rate swap and forward rate agreements in the future, although these products are not permitted under the existing scope of Northbound Trading.
4. No specific investment quota limit
According to the rules and regulations published to-date, there is no investment quota limit for Northbound Trading.
5. Application procedure
Eligible offshore investors are required to comply with the following filing procedure with the PBOC Shanghai headquarters to trade through Bond Connect:
- an eligible applicant may file an application through a qualified institution with PBOC;
- PBOC will issue a filing notice within 3 working days upon PBOC’s acceptance of the filing application; and
- upon receipt of the PBOC filing notice, the approved offshore investor can apply to CFETS for trading account opening.
6. What are the trading days and hours for Northbound Trading?
- Trading days: CIBM trading days in mainland China (regardless of whether it is public holiday in Hong Kong SAR)
- Trading hours: 9:00 am to 12:00 pm and 13:30 pm to 16:30 pm (Beijing time)
7. How is a spot bond trade concluded under Northbound Trading?
Trades under Northbound Trading will be executed through a “request for quotation” mechanism between an eligible offshore investor and an onshore market maker at CFETS, subject to a minimum order size of RMB1 million (approximately USD147,520). Broadly speaking, the procedure for concluding a spot bond trade under Northbound Trading is as follows:
At the Bond Connect Anniversary Summit held on 3 July 2018, Pan Gongsheng, the Deputy Governor of the PBOC and the Director of the State Administration of Foreign Exchange, expressed that pre-trade allocations for Bond Connect would be launched in the foreseeable future.
On 31 August 2018, Bond Connect launched the service of block trade allocations, which allows asset managers to allocate block trades to multiple client accounts prior to the trades. With the pre-trade allocations function, traders are able to execute a single block trade and allocate specific percentages or amounts of the trade up to 30 individual accounts.
Following the successful launch of the pre-allocation function, Bond Connect further launched the post-allocation function on 29 October 2018.
8. Custody, clearing and settlement arrangement for Northbound Trading
The basic arrangements for the custody, clearing and settlement under for Northbound Trading are as follows:
(a) All registration, custody, clearing and settlement services in respect of Bond Connect trades are provided by:
Central Moneymarkets Unit (“CMU”) and Central Securities Depository (“SCH”) jointly – SCH is the ultimate CSD and CMU is the nominee holder of the Eligible Bonds; and
CMU and CCDC jointly – CCDC is the ultimate CSD and CMU is the nominee holder of the Eligible Bonds.
(b) Gross DvP settlement method
Northbound Trading transactions will be cleared and settled on a gross and delivery versus payment (“DvP”) basis.
On 27 August 2018, Bond Connect upgraded its settlement system to fully implement real-time delivery-versus-payment (RDvP). RDvP allows payment and delivery of securities under Bond Connect to occur simultaneously, reducing investors’ exposure to settlement risk.
(c) Payment mechanics
Payments (including funding for bond trades concluded via Bond Connect and interest accrued from such bonds) are made on a real-time gross basis between CMU and SCH/CCDC through Cross-Border Interbank Payment System (CIPS).
(d) Settlement finality
Both SCH and CCDC have published rules to recognise the finality of settlements made via SCH/CCDC.
9. How do eligible offshore investors fund the purchase price for a bond trade under Northbound Trading?
Eligible offshore investors can either use Offshore RMB (CNH) or FX converted into Onshore RMB (CNY) to purchase a CIBM bond under Northbound Trading.
(a) Using Offshore RMB (CNH)
Eligible offshore investors using their own Offshore RMB to fund its bond investments through Northbound Trading do not need to appoint an RMB Participating Bank or open a segregated RMB capital account.
(b) Using Onshore RMB (CNY) through FX conversion
An eligible offshore investor can use FX (in whole or in part ) to fund its bond investments through Northbound Trading. An eligible offshore investor intending to use FX to fund its purchase of CIBM bonds under Northbound Trading must open a segregated RMB capital account with an eligible RMB Participating Bank in Hong Kong to convert its FX into Onshore RMB.
There are certain restrictions in using Onshore RMB to fund its Northbound Bond Connect trades, including:
all Onshore RMB converted using FX must remain in the segregated RMB capital account and must be used for FX currency conversion and RMB remittance and settlement for the purposes of Northbound Trading; and
all RMB funds resulting from the redemption or sale of bond investments made through Northbound Trading can remain in the segregated RMB capital account for further Northbound Trading investments – otherwise, the Onshore RMB funds must be reconverted to foreign currency through the RMB Participating Bank.
Eligible offshore investors may, through CMU members, conduct FX risk hedging with RMB Participating Banks.
Positions generated by RMB Participating Banks from providing FX/RMB conversion services can be unwound on the onshore interbank foreign exchange market.
11. Who owns the legal and beneficial title to the bonds invested through Bond Connect?
Trading in CIBM bonds through Bond Connect is settled in SCH or CCDC. The holding of CIBM bonds acquired through Bond Connect involves multiple levels of ownership, which arises from the clearing and settlement arrangements for CIBM bonds as summarised below:
after clearing and settlement with SCH or CCDC, the CIBM bonds acquired under Northbound Trading are registered in the name of HKMA and held through the onshore nominee accounts opened by CMU (in the name of HKMA) in the mainland China with SCH and/or CCDC (as the case may); and
CMU members will settle trading in CIBM bonds through CMU on behalf of eligible offshore investors.
HKMA (as the registered holder of the CIBM bonds) is entitled to exercise its rights as against issuers of the bonds (through SCH/CCDC). Prior to exercising a bond holder’s rights against the relevant CIBM bond issuer, HKMA (as the nominee holder for eligible offshore investors under Northbound Trading) will consult with the eligible offshore investors and take actions accordingly.
The CMU nominee holding arrangement is similar to the nominee holding arrangement under Stock Connect. To understand the ownership issues regarding CIBM bonds acquired through Bond Connect, we need to look at two levels of holding:
holding by HKMA as the “nominee holder”; and
holding by the eligible offshore investors through CMU members as the “beneficial owners” of the CIBM bonds.
At the SCH/CCDC level in the mainland China, the CIBM bonds traded through Bond Connect are registered in the name of HKMA as the registered holder and legal holder of such bonds under PRC law. The CIBM bonds are held by HKMA in its capacity as the nominee of the eligible offshore investors under Northbound Trading.
At the CMU level, the CIBM bonds acquired through Bond Connect are allocated to, and recorded as separate holdings of, the relevant CMU members (either as their proprietary investment or, as client assets in their custody role).
The diagram below illustrates the nominee holding structure under Northbound Trading:
Ⅴ. Key points to note
1. How does an eligible offshore investor enforce its rights in CIBM bonds invested through Bond Connect?
PBOC has indicated in a recent Bond Connect press conference that an eligible offshore investor could either enforce rights in the bonds through HKMA/CMU or in its own name in accordance with the applicable laws in Hong Kong. The SCH Rules expressly provide that eligible investors “enjoy the rights and interests of the [bonds] according to applicable laws."
Hong Kong law recognises that investors hold the beneficial interest in bonds acquired for them by their custodian (i.e. CMU members and HKMA). Eligible offshore investors (as beneficial owners of the bonds) should be able to exercise their rights in CIBM bonds in accordance with the laws and regulations of Hong Kong SAR regarding nominee holders and custody arrangements.
Under PRC law, the plaintiff to a legal claim is any citizen, legal person or any other organisation with a direct interest in the claim. Subject to an eligible offshore investor providing evidence that it is the ultimate beneficial owner of the relevant CIBM bonds (i.e. certificate/proof provided by CMU and CMU members showing that such eligible offshore investor is the legitimate beneficial owner under Hong Kong law), the offshore investor should be entitled to bring a legal claim in its own name in the PRC courts.
2. What are the consequences if an eligible offshore investor is found to have contravened the relevant Bond Connect rules and regulations?
CFETS may investigate any actual or potential breach by eligible offshore investors of the Bond Connect trading rules and/or other rules and regulations relating to the CIBM.
According to the rules published by CFETS, CFETS will closely monitor certain abnormal bond transactions under Northbound Trading, including repeatedly sending of quotation amounts that do not reflect genuine trading intentions, responses of tradable prices or settlement prices that significantly deviate from fair market value, market disruption activities such as market manipulation and insider trading, and failure to perform settlement obligations according to the concluded trade information leading to repeated failure of settlement.
3. What are the key takeaways for offshore service providers providing custody and settlement services for Bond Connect?
(a) KYC procedures
The rules are clear that RMB Participating Banks providing FX/RMB conversion services to eligible offshore investors are generally expected to conduct the basic know-your-client procedures in respect of eligible offshore investors to whom it provides services to.
We recommend all RMB Participating Banks providing Bond Connect-related FX/RMB conversion services to obtain specific declarations from eligible offshore investors to whom it provides currency conversion services to that all Onshore RMB converted by the RMB Participating Bank must be used for settling Bond Connect trades (failing which must be re-converted to the original foreign currency).
(b) Discrepancy in trading days
If the business days of the offshore service provider are not the same as the CIBM trading days (being the trading days for Bond Connect trades), such offshore service providers should ensure it obtains an acknowledgement from the eligible offshore investors to whom it provides Bond Connect-related services to that the services will only be provided to the eligible offshore investor during the working days and hours of the service provider.
4. What are the tax implications? Are eligible offshore investors required to pay PRC taxes (e.g. stamp duty or capital gain tax) in respect of their Northbound Trading activities?
On 30 August 2018, the Standing Committee of the State Council proposed to apply a three-year exemption from Corporate Income Tax and Value Added Tax on all interest income derived by foreign institutional investors from their investments in China’s bond market. This proposal was confirmed and given effect to by Circular 108 which was jointly published by China’s Ministry of Finance and the State Administration of Taxation on 7 November 2018.
The exemptions apply to:
(a) bond interest income received from 7 November 2018 to 6 November 2021; and
(b) foreign institutional investors that do not have an establishment in China or, if there is an establishment(s) in China, the bond interest is not effectively connected with the establishment(s).
However, certain issues remain unclear. For example, it remains to be clarified whether the exemption applies to interest arising on 7 November 2018 and thereafter or whether it applies to interest that is due on or after 7 November 2018. In addition, Circular 108 is silent on the tax treatment for the period before the exemption applies.
Foreign participation in China’s bond market has remained at around 2.52% of the PRC onshore market, and 3.93% of the sovereign debt market. This is significantly lower than other countries such as Japan, U.S. and even some emerging markets.
Bond Connect is another breakthrough after the launch of Stock Connect. We believe Bond Connect will play a significant role in:
advancing the level foreign participation in China’s domestic bond market; and
offering an improved and easily accessible market infrastructure to further broaden and deepen China’s bond market for global access.
This is an encouraging development after the recent inclusion of China A-shares in MSCI indexes. We have been working closely with the key parties involved in Bond Connect and expect to see further innovative developments in this ground-breaking programme.
Key rules and regulations applicable to Bond Connect (Up to 2 July 2017)
| Bond Connect Interim Trading Rules
| Interim Trading Rules for Bond Connect as set out in the Circular issued by CFETS and National Inter-Bank Funding Centre on 22 June 2017
| CCDC Implementation Notice
| CCDC Notice of Implementation of PBOC’s Bond Connect Settlement Provisional Operation Instructions
| CCDC Rules
| Rules on Registration of Bond Connect Custodial and Settlement Services issued by CCDC on 26 June 2017
| FAQ on Provisional Measures
| FAQ on the Bond Connect Provisional Measures issued by the PBOC on 22 June 2017
| Joint Announcement (PBOC and HKMA)
| Announcement jointly published by PBOC and HKMA on 16 May 2017 and 2 July 2017 confirming, amongst others, that it has approved the CFETS, HKEX, CCDC, SCH and CMU to collaborate in establishing mutual bond market access between Hong Kong and Mainland China through “Bond Connect”
| Joint Announcement (SCH and HKMA)
| Announcement jointly published by the SCH and HKMA on the Provision of Custodial and Settlement Services for Bond Connect on 19 May 2017
| PBOC Filing Guidelines
| Filing Guidelines for Bond Connect Northbound Foreign Investors circulated by PBOC Shanghai Headquarters on 22 June 2017
| PBOC Notice No. 220 of 2015
| Notice of the People's Bank of China on Issues concerning Investment in the Inter-bank Market with RMB Funds by Foreign Central Banks, International Financial Organizations, and Sovereign Wealth Funds
| PBOC Notice No.3 of 2016
| Notice of the People's Bank of China on Further Handling of Issues Concerning Investment in the Inter-bank Market by Foreign Institutional Investors
| Provisional Measures
| Notice on the Publication of the Bond Connect Provisional Measures issued by the PBOC on 21 June 2017
| SCH Business Guidelines
| SCH Business Guidelines for Northbound Trading of Bond Connect (Trial Implementation) published by the SCH on 28 June 2017
| SCH Rules
| Shanghai Clearing House Detailed Operation Rules for Registration, Custody, Clearing and Settlement of Bond Connect Cooperation between the Mainland and Hong Kong SAR (Trial Implementation) published by the SCH on 23 June 2017
See Articles 6 and 7 of the Provisional Measures and Question 3 of FAQ.
Refer to Filing Guidelines for specific procedures.
Refer to Filing Guidelines for specific procedures.
See Article 4 of SCH Rules.
See Article 4 of CCDC Rules.
See Articles 3 and 4 of Trading Rules, Article 9 of SCH Rules, and Article 12 of CCDC Rules.
See Article 11 of CCDC Rules and Article 12 of SCH Rules.
See Question 14 of FAQ.
 See Question 13 of FAQ.
See Article 5 of the Provisional Measures.
See Article 9 of CCDC Rules and Article 7 of SCH Rules.
See Article 7 of SCH Rules.
Article 119 of the Civil Procedure Law of the People's Republic of China.
See Question 7 of FAQ.
Announcement published by BCCL on 29 November 2018.
Announcement published by the BCCL on 31 August 2018.
Flash Report for Bond Connect – October 2018 published by BCCL.
HKMA Press Release dated 24 August 2018.
Such as Article 5.2 of the Bond Connect Interim Trading Rules.
Circular  108 jointly published by China’s Ministry of Finance and the State Administration of Taxation on 7 November 2018.