Stock Connect set to buoy use of more financial instruments

Apart from OTC derivatives targeting private banks, synthetic securities such as participatory notes and equity swaps will also find clients among global funds, said CLSA Ltd, a local securities house focusing on institutional business.

"P-notes are probably going to be the biggest derivative arrangement written from the sell side to the buy side on the back of Stock Connect," said Andrew Maynard, global head of trading and execution at CLSA.

Synthetic securities are combinations of securities that represent the properties of yet another security, which may not itself exist.

P-notes are synthetic structures that brokers write to allocate some of their quota to clients such as investment funds that are finding it difficult to acquire their own quotas. P-notes can also be used to bypass regulatory restrictions and avoid settlement problems.

Though Stock Connect will provide much easier access to Shanghai-listed stocks than the QFII and RQFII programs, P-notes are expected to be in demand, because global investors are wary of Chinese settlement rules and often unfamiliar with currency controls, said Maynard.

Northbound trading through Stock Connect is to be settled in offshore yuan, which are known as CNH in the currency markets.

"The problem is a lot of global custodians are not able to settle or hold securities denominated in CNH. It's not a convertible currency and there are only five offshore centers for it," he said.

"Equity investors are not familiar with the Chinese capital market, which is relatively new. The system has not been set up and due diligence has never been done properly. Besides, when you add the settlement scenario, pre-delivery requirements and different time zones, people would find Stock Connect too complicated."

Many investors are requesting P-notes, Maynard said. "I imagine swaps and P-notes would probably make up one-third of foreign activity going in (through Stock Connect). That's the same ratio of people using their own QFII quotas versus using our firm's QFII quota to invest in the mainland market right now.

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