Prime brokers set to increase revenues from stock connect

Market divided over whether long-only mangers can access China via the initiative with some broker-dealers saying the integrated bank model offers a solution

A divide has emerged over whether long-only managers will be able to access the Hong Kong stock connect when it goes live but a consensus has been reached that prime brokers will see an increase in revenue as hedge funds which have been excluded from the qualified foreign institutional investor (QFII) process look to ramp up their China exposure.

The Hong Kong stock connect is due to go live in October but so far long-only asset managers have expressed reservations over a number of technical issues that may deter them from joining the first wave of investors. The primary issue relates to the need for fund mangers to pre-deliver stock to their brokers the day before sale due to the varying settlement cycles each side of the border.

Additionally, long-only asset managers have been granted access to the QFII scheme while hedge funds have been excluded, which means there is strong pent-up demand for China stocks from hedge funds – particularly on the back of improving sentiment on the country's economic fundamentals.

"The hedge funds are in prime position to benefit from the stock connect," says Emma Quinn, head of Asia-Pacific trading at fund manager AllianceBernstein. "If you have set up a prime broking relationship, all you need to do is set up a swap to transact. Unlike the long-only managers, hedge funds haven't had access to QFII and RQFII so far and this is a fantastic way for them to get into China. Long-only managers won't stay out of the stock connect – but it will be a difficult process."

A number of prime brokers active in Hong Kong back Quinn's view on the potential to see increased revenue from hedge fund clients in the early stages of the connect, particularly as a result of some of the operational problems faced in accessing the market.

Carl Davey, head of hedge fund sales, Asia for Citi's investor services division, points to the history of the prime brokerage industry which originally emerged as a means to streamline access to markets.

"In the earlier stages of stock connect the greater opportunity for prime brokers will come from synthetic financing. The whole prime broking sector evolved from the need to simplify operational requirements for hedge funds – the easiest way to do this will be via synthetic access or swaps. And there will be an increasing demand from hedge funds for China – this is a transformational moment for the market."

The current structure of the stock connect prohibits margin lending, one of the usual revenue drivers for prime brokers. However, according to one Hong Kong-based head of prime broking for a global bank, firms will also see an additional benefit from subsequently providing financing against synthetic China assets. But he cautions that synthetic structures are very capital intensive under Basel III, and that firms' ability to write large amounts of this business depends on the approach of their internal treasury.

"I agree that synthetic access products will be a revenue opportunity for prime brokers; however, synthetics are an on-balance-sheet structure and this is going to be constrained in future as a result of Basel III. So on the one hand you will get more synthetics but the more of these that you park on your balance sheet the greater capital cost. How your treasury department charges using this will ultimately determine the costs prime brokers face and they will need to look at the potential revenue in a holistic way," he says.

Similarly, while Nathan Davison, Hong Kong-based head of prime sales Asia at Barclays, is positive about the potential for the stock connect to drive up earnings for firms' prime broking arms, he warns this doesn't mean the entire wallet will increase across the Street. Indeed those banks currently providing synthetic access via their QFII quotas are likely to see a drop in business.

Currently just 14 banks have access to a QFII quota, a significant portion of which then sell access to third-party investors. Due to the scarcity value of this access, commissions on such trades are typically quite high – but if the China market becomes easier to access Davison says he expects the premium to fall.

"We anticipate both hedge funds and long-only clients using the stock connect and prime brokerage units will be able to capture additional revenue streams through provision of equity swaps to hedge fund clients and P-notes to long-only clients.

"There will be potentially be a smaller revenue pool across the Street on legacy QFII access products for those banks that are active in this area. Firms with the largest legacy access books may even be net down on revenue once the stock connect is up and running depending on where commission and financing rates end up for both QFII access and connect access."

However, a Hong Kong-based chief operating officer for a bank's cash equity division cautions that it isn't clear if derivative trades would be permitted by the Chinese authorities given that regulators explicitly banned QFII holders from conducting derivative trades when the quotas were expanded in 2013.

"It's not formally given from today that derivatives are permitted via the stock connect. It would be advisable for investors to keep their options open. If all the activities that go across the link are derivative based, will the Chinese authorities consider the project has been a success?"

Citi's Davey also questions whether long-only funds will find it difficult to access the China cash market, saying that a number of banks in Hong Kong have an integrated model which will enable them to overcome the delivery issue.

"I'm surprised that some may think that the scheme would be inaccessible with current operational proposals to long-only fund managers – it really comes down to what services their custodian banks provide. If the bank has a custody offering in the Hong Kong market – as Citi does – these operational challenges are mitigated because we can act as both custodian and executing broker. The execution to custody model that our bank offers lends itself well to the proposed stock connect scheme."

Davey adds, though, that such an approach requires long-only mangers to be comfortable channelling a significant part of their trading through one counterparty – a point which Quinn says could be problematic for the sector. She also expresses concern that it could result in transactions being channelled through a small number of brokers – or even just one.

"It's possible to get around the whole delivery of stock issue by leaving your stock with a sub-custodian that has a broker operation attached – which is great if you are HSBC, Citi or JP Morgan but not so good for a long-only manager. This is because they have to trade with a sub-custodian appointed by the global custodians, forcing you to trade through one broker. This means best execution is not driven by which broker is best at China business but purely who the relevant global custodian happens to have as a sub-custodian in Hong Kong.

"So you probably have five firms which can transact in this market and my view is that one of them will get 80% of the business and that's not good for any market to be so concentrated in one counterparty."