The highly expected new QFII regulation came into effect on 1st November 2020. What kind of investors and managers can benefit most from this significant policy change?
11 November 2020
The new Qualified Foreign Institutional Investor (“QFII”) regime came into effect on 1st November 2020. The 18-year-old China capital market access scheme now has a quite different appearance that deserves attention from global investors.
What are the most significant changes in the regulation? Depending on what kind of investor/manager you are, the answer may vary. But three aspects are very noticeable:
- by lowering and simplifying the QFII qualification requirements, the new regulation enables smaller investors/managers to access the market;
- by substantially increasing the QFII investment scope, the new regulation enables global investors/managers to carry out new investment strategies in the China market. Such investment scope breakthroughs include financial and commodity futures, bond repo, the technology third-board (NEEQ), ABS, IPO participation, etc;
- by including both private funds and public funds in the QFII investment scope, the regulation enables global investors to tap into local management capabilities.
To help global investors to better leverage the facilities offered by the new QFII regime, we conducted a further interview with Eugenie Shen, Managing Director and Head of Asset Management Group, Asia Securities Industry & Financial Markets Association (ASIFMA), and Melody Yang, Partner of Simmons & Simmons Law Firm, both of whom have abundant first-hand experience working with Chinese regulators and global investors. They gave a detailed review of some of the key aspects of the new regulation.
Other interviews in our ViewPoints Series
Q: In a nutshell, what are the most significant highlights in the new QFII Measures?
- We believe the most exciting highlights to global asset managers include (i) the ability to invest into China’s futures market; (ii) the ability to short when trading Chinese equities and (iii) the ability to invest into China’s PFM funds.
- Firstly, rather than trading on stock index futures only, QFII/RQFIIs will be able to trade on a wider range of financial futures as well as commodity futures, which we believe will bring in significant diversification benefits for the QFII/RQFII investors.
- Secondly, it is the first time in history for QFII/RQFII to be able to do short sales against the traditional constraints on long-only strategies. QFII/RQFII managers will be able to gain from their insights on the short side.
- Thirdly, allowing QFII/RQFIIs to invest in China’s onshore PFM funds will internationalize the PFM funds. More significantly, PFM funds will be able to do capital raising not only within China but also globally.
Q: The New QFII Measures amended the previous eligibility requirements and simplify the application process. Can you give us some details and what are the opportunities for global investors who are willing to apply for QFII licenses?
- Firstly, simplify the QFII qualification requirements is really helpful. In the past, QFIIs have to be one of these categories, like asset managers, commercial banks, etc. Within these categories, QFII has to have a certain number of years of operation and meet certain AUM requirements, the original QFII program is really designed for long-term and large investors. In the new QFII measures, by getting rid of these qualification requirements, it allows smaller investors to participate and opens the QFII scheme for a larger group of investors, like hedge funds.
- Secondly, the new QFII measures also simplify the application process, meaning investors no longer have to separately apply for QFII and RQFII, and investors can also do the application online, although the backed-up documents have to be submitted by the custodian.
- Thirdly, QFIIs also don’t need to apply for a quota.
- All these simplifications will make the QFII program more attractive and this will be a great opportunity for smaller types of investors.
Q: One of the most important aspects of the new QFII measures is to expand the investment scope, can you give us some details about the investment scope changes?
- Compared with the original QFII rules, the new investment scope is certainly much broader.
- On the stock exchange-traded securities, originally QFII can trade stocks, bonds and warrants, under the new measures, depositary receipts, repos and ABS and shares transferred on NEEQ are included.
- On the interbank bond market, originally QFII can only trade fixed income products (cash bonds), now bond repos, derivatives on bonds, interest rates and foreign exchange can also be traded by QFIIs.
- In terms of funds, originally QFIIs can only invest public funds, now QFIIs can invest both public and private funds. Private funds include two types of funds: one is private fund issued by Private Fund Managers and one is asset management product issued by securities companies, FMCs and futures companies. But all these funds need to be securities investment funds.
- On the range of the derivatives, in addition to stock index futures, financial futures traded on CFFEX, commodity futures traded in three commodity futures exchanges, options listed in the exchanges and foreign exchange derivatives traded for hedging purposes are approved by CSRC (but the details need to be confirmed by the exchanges themselves).
- On the IPO side, QFII can participate in the issuance of stocks, bonds and also ABS.
- New QFII measures even include margin trading and securities financing and securities lending on the stock exchange.
Q: Can you give us a bit of colour on the structure of PFM funds. How do you compare that to an offshore hedge fund or long-only fund?
- As we have mentioned, the PFM fund represents private securities investment fund. Under Chinese securities law, “securities” is quite narrowly defined to cover those more liquid securities and futures products in China.
- What is quite unique about the PFM fund is its contractual characteristics, in other words, the PFM fund is a contract entered into by and among the manager, the fund custodian and the end investors. It is not an incorporated entity and of course, it doesn’t have the legal person status.
- Under Chinese law, the manager and the custodian are appointed as the co-trustees. In addition to the usual duties of the custodians of PFM funds, the custodians have the legal duties to check and balance the action or inaction of the manager.
- Given the fund itself is not an incorporated entity, the manager will sign most of the service provider agreements and trading documents with the relevant counterparties. The manager is advised to have to ensure there are a clear division and robust indemnification mechanism to protect itself from the relevant exposures when acting on behalf of the fund.
- Finally, the PFM funds in China are unitized and they will issue fund units which function like shares. This enables fund investors to subscribe for redeem and transfer their interest in such open-ended funds.
Q: In terms of investing in private funds, for different types of QFII licence holders what do they need to consider?
- Firstly, QFII/RQFII investors who wish to make investments into the PFM funds would have to amend their investment plans. As the new QFII Measures have just taken into effect from the beginning of November, QFII’s original business plan would require an expansion of the business scope of cover PFM funds. Hence QFII/RQFIIs who wish to invest in PFM funds will have to file the updated investment plans with CSRC and the foreign exchange authorities through their custodian banks.
- Secondly, it is worth noting the scope of the PFM funds has to be fully aligned with that of QFII/RQFII investors. For example, according to the recent exchange rule, QFII/RQFIIs can only invest in China stock index futures for hedging purposes, not for speculation purposes. If the PFM funds wish to accept funding from QFII/RQFIIs, they themselves i.e. the PFM funds, will also have to align their own investments scope with that of the QFII/RQFIIs.
- Comparing the existing investment scope of PFM funds and with the investment scope of QFII/RQFIIs in respect of futures trading or derivatives trading, I believe the current scope for the PFM funds is slightly wider than that of QFII/RQFIIs. For example, when PFM funds invest in Chinese futures, they can act as both hedgers and speculators. PFM funds can also invest into all of the OTC derivatives available via China’s interbank bond market as well as products such as total return swaps.
- We understand some PFM funds when trying to accept funding from QFII/RQFIIs may need to set up separate PFM funds which can avoid getting their existing PFM funds “tainted” in terms of the alignment with the investment scope.
- Thirdly, we believe at the QFII/RQFII offshore product level may require certain changes. Currently, there are broadly three ways to make a QFII/RQFII investment as a QFII/RQFII license holder: (i) using its proprietary funding; (ii) to manage an alternative investment fund or a managed account to make QFII/RQFII investment and (iii) to launch a UCITS or registered fund to make QFII/RQFII investment.
- In terms of using offshore funds to invest in China’s security and futures market under QFII/RQFIIs at the product level,
- The QFII/RQFII license holders need to ensure the targeted investments are aligned with the permitted investment scope and investment strategies of their offshore products.
- Additionally, UCITS funds may also need to determine on whether the interest in the PFM fund is covered by the definition of the “transferable securities”, albeit as we understand, it would be very difficult to achieve.
- On the other hand, we believe it is relatively easier for alternative funds to make the changes at the product level.
Q: Can QFII license holders invest in Chinese PFM funds that have HK stocks in their portfolios?
- If PFM funds are already making investments into Hong Kong stocks through the southbound stock connect, whether they can still accept the funding from the QFII/RQFII investors would require the joint opinion from CSRC and SAFE (China’s foreign exchange authorities).
- Given the systemic risk is very little, the CSRC has taken out the previous requirement on the underlying asset classes for the QFII/RQFIIs to be “RMB denominated” financial instruments. Given the current position, we believe CSRC and SAFE would be more relaxed, in other words, we are inclined to believe CSRC and SAFE will allow QFII/RQFIIs to invest into the PFM funds that are currently trading Hong Kong stocks. Nonetheless, we need to wait for further guidance given by Chinese regulators.
Q: Is it true that a QFII licence holder can only trade derivatives for hedging purposes?
- There is not a definitive answer for this question and regulators are developing a view on this matter.
- During the consultation stage of the draft QFII/RQFII measures, it was clearly specified that any investment into China’s derivatives has to be done for hedging purpose, not for speculation purpose. However, there are some evolvements in terms of QFII/RQFII’s ability to invest in China’s derivatives.
- Firstly, we can look at those exchange-traded derivatives i.e. the futures and options. Currently, the CSRC has delegated the power to the relevant futures exchanges for them to opine. For example, in the recent rule issued several days ago, it is clear that QFII/RQFIIs can only trade stock index futures for hedging purposes, not for speculation purposes. However, it should be noted that the relevant exchanges are still silent on whether QFII/RQFIIs can trade other financial futures, i.e., the state bond futures and whether they can be traded for speculation purposes. We will wait for further guidance given by the exchanges.
- In terms of the QFII/RQFIIs’ abilities to trade commodity futures, so given the volume, we don’t believe the QFII/RQFIIs has to be the hedgers only. However, further clarification would be needed from the exchanges.
- Further, as one may have noticed, QFII/RQFIIs can also trade certain OTC derivatives available on China’s interbank bond market such as those currencies, interest rates forwards and swaps. It should be noted that the purpose of acquiring those OTC derivatives has to be hedging and not speculating.
Q: Since more asset managers may start to trade Chinese securities and futures on cash through the reformed regimes (as compared to trading on swaps), can you let us know what are the increased regulatory exposures for them?
- In the past, we have seen those non-QFII/RFII investors, for example, hedge funds when gaining access to China securities and futures had to trade on swap rather than trade on cash. Now, since QFII/RQFIIs are made available to more types of applicants including those hedge fund managers, they are given more choices in terms of the means through which they can access to Chinese securities and futures including trading those products on cash.
- The relevant QFII/RQFII investors need to consider the relevant rules to regulate their market conducts available in China, such as rules to prevent insider trading and to prevent manipulations in the market.
- Among others, when one wishes to trade China stock traded equities and fixed income products, they need to consider the relevant disclosure requirements. For example, under Chinese securities law, there is a very robust definition of parties acting in concert e.g. if a QFII/RQFII invest into China’s A-shares and its Chinese subsidiary which is a PFM WFOE also manages fund products that invest into China’s A-shares unless there is evidence that shows otherwise, their relevant exposures in terms of the A-shares trading have to be aggregated for disclosure purposes.
- On the other hand, when one wishes to trade China’s futures, there are also various requirements such as large position reporting requirements and also relevant trading limits that vary on the product by product level.
- As it is the first time for many QFII/RQFIIs to enter into China’s futures market, they may also wish to know in terms of futures trading, what are the unique requirements in China compared to a market they are already familiar with.
- In relation to that, it is important to note the relationship among the exchange, the investor, and also the broker is agency relationship rather principal-to-principal relationship. The brokers are acting as the agents of their QFII/RQFII clients to deal with the exchanges. The exchanges are the central clearing counterparty and direct trading party so in that sense the counterparty risks are very small in such a context.
- The second difference relates to China’s margin requirements with respect to futures trading. Rather than using the excessive margin for settlement purposes, Chinese margin will always be used for collateral purposes. In other words, the investor has to be posted with the relevant exchange and broker sufficient margin every time before they start to trade.
