China’s Capital Markets – Developed World Flows, Emerging Market Costs

The rise in international appetite for China’s bond and equity markets over the last three years has been meteoric. So far this year foreign investors on the ‘Connect’ schemes alone have bought more than $75bn of domestic Chinese bonds (up 50% on last year) and a net $35.3bn of Chinese stocks. In total, $800bn of net capital has been invested via the Hong Kong based ‘Connect’ schemes since their inception.


In part, this has been triggered by bonds and equities joining global indices with the intention of China becoming the third largest constituent after a scale-in period.

Foreign Holdings of Domestic Chinese Bonds

Foreign-owned CNY Bond Holdings have doubled in the last 2 years to $580bn.

(Source: Bond Connect)

But despite the large size and appetite to invest in China, the costs of participating in this market still resemble those of smaller, emerging market countries.

FX Exposure


One often overlooked cost of investing in China relates to the management of FX for settlement and hedging.

The domestic RMB (CNY) remains a “restricted currency” and therefore comes with strings attached.




Tracking Risk


Due to the capital account restrictions imposed on the CNY, over 70% of participants in China’s markets via the Connect schemes take advantage of the HKMA facility to settle and hedge their China exposures in the offshore RMB, CNH.

As asset managers have rarely used the domestic RMB, CNY, as a currency, this has been a great way to enter the market with minimal friction.

However, it introduces basis risk to the investment process, particularly for tracker funds. Over the last two years, CNH-CNY has moved within an 800-basis point range.

Nomura’s analysts believe that China’s imminent inclusion in the FTSE Russell World Government Bond Index will funnel $130bn into Chinese treasuries. If that exposure were all in CNH, it would potentially be subject to $1.6bn of tracking risk. In this way, and as volumes build, more and more funds will need to move their exposure from CNH to CNY.




Custody FX


As is typical of restricted currencies, CNY execution is currently the domain of the custodian bank. The systems, process and compliance requirements to actively manage smaller EM currencies justify the higher costs of custody FX. The question is, for how long should this remain the case with China?


Despite a rule change in September to allow for price competition, operational practicalities have made this virtually impossible. This must and will change.

As a captive market, there is little incentive for the Custodian to price competitively. With $580bn currently invested in Chinese bonds and approximately the same again in Chinese equities, each currency basis point is worth almost ~$18m. That’s a lot of lost return for every ‘pip’ that trades away from best price. And with trading taking place across capital going into and out of China, frequent portfolio adjustments and the need for portfolio hedging, there can be a lot of currency trades.


Unfortunately, custody FX markups can be significant: reconciling and reporting currency trades with portfolio positions to ensure compliance is a fiddly process that comes with regulatory risk. For a typical emerging market, relatively high margins and low volumes have not justified asset managers enduring the pain of seeking to bring those operational costs and compliance risks in-house.


However, in the case of China, the cost/benefit analysis starts to look different. Especially, if there are tools available to take much of that pain away.




The ChinaFICC Solution


ChinaFICC is building a highly agile and fully interoperable platform that makes it easy for asset managers to bring RMB execution in house.

The platform features:


  • Tools to help manage the basis between CNH and CNY
  • Price competition to ensure that asset managers get best price
  • Validation tools to ensure that each trade meets rules required to trade CNY
  • Transaction report generation to demonstrate adherence to currency controls
  • Routing tools to ensure that counterparty relationship rules are managed across multiple funds
  • Better access to and use of FX Swaps, trade aggregation and netting, and tools to manage the re-allocation of currency balances – all to reduce the number of trades and spreads to cross
  • Operational reports to manage efficiency and evaluate performance


If you are an asset manager with exposure to China, we would love to help you analyse how much your firm could save by using the ChinaFICC solution.


Please reach out to me at or via LinkedIn.

Peter Best