First, with the launch of the Delivery Versus Payment (DVP) settlement feature on August 24, all Bond Connect trades cleared through China Central Depository and Clearing (CCDC) will be settled on a DVP basis, removing a major hurdle that limited the scheme from attracting more overseas investors to China’s bond market.
This means that payment for bonds will now be due at the time of delivery, substantially reducing settlement risks. It also makes the investment process significantly more efficient, as investors are no longer subjected to the complexity of following different settlement models.
The introduction of the DVP feature was quickly followed by two other significant developments. On August 31, Bond Connect announced the launch of block-trade allocations. This will allow asset managers to allocate block trades to multiple client accounts beforehand, and traders can now execute a single block trade and allocate specific percentages or amounts of the trade to up to 30 individual accounts.
This reform should improve the scheme's operational efficacy, especially for buy-side investors who no longer have to spend extra time managing the blocks. Foreign institutional investors will also be exempt from paying corporate income tax and value-added tax on interest gains from their investments in the onshore bond market for three years.
Both moves are welcome improvements to the Bond Connect scheme, as foreign investors have long called for permission for block trading as well as greater clarity on tax payments.
The introduction of DVP in Bond Connect - a feature to which BNP Paribas Securities Services offers full access - marks an opportunity for overseas investors to participate more deeply in China’s USD 12 trillion bond market, the second largest in the world. There is a precedent here: When BNP Paribas introduced in November 2014 a DVP solution to the Stock Connect programme (18 months ahead of the market’s DVP solution) we experienced an uptick in overseas interest and therefore anticipate a similar scenario for Bond Connect.
Until now, some foreign investors have stayed away as they found the Bond Connect’s lack of a DVP settlement mechanism not in keeping with global standards. And international regulators, such as the Commission de Surveillance du Secteur Financier of Luxembourg and the Central Bank of Ireland, also have expressed concerns, with the latter refusing to allow local funds to invest in the scheme until the issue was resolved.
DVP and block trade allocations were also prerequisites for the inclusion of Chinese onshore bonds into the Bloomberg Barclays Global Aggregate Index. Such inclusion, which is expected to begin in April 2019, will over a 20-month period result in China's bonds representing 5.49% of the index, which in turn could generate extra foreign investor inflows to the tune of as much as USD 350 billion.
While many overseas investors have so far been hesitant, there is no doubting their interest in China’s onshore bond markets. As at the end of June 2018, foreign holdings of Chinese onshore bonds had reached RMB 1.55 trillion (USD 227 billion), up 83% from a year earlier. And, they remain the biggest buyers of Chinese government debt with about 75% of new bond issuances being absorbed by international investors, according to our estimates.
Bond Connect is seen to be a ground-breaking solution to access Chinese investments because it allows investors to use both offshore and onshore CNY, and offers a variety of hedging options, including, for the first time, an offshore solution to hedge using onshore CNY forward FX solutions.
The incorporation of a full DVP solution for settlement, the permission for block trading, and the grace period on taxes are key steps towards attracting greater numbers of international investors who will finally feel ready to take the plunge after months of preparation to enter China’s onshore markets.
As China continues on its path to open up its financial markets, investors shouldn’t expect ‘big bang’ reforms. China will continue to consider a cautious, measured approach that prioritises domestic market stability alongside investors’ needs. As such we expect future enhancements to include a range of hedging solutions offered by Bond Connect and allowing foreign exchange derivatives such as onshore currency repos.
BNP Paribas Asset Management Analysis, July 2018
Bond Connect Opportunity Analysis', BNP Paribas Securities Services