Shenzhen-Hong Kong Stock Connect FAQ
December 2016

DEVELOPING ASIAN CAPITAL MARKETSTABLE OF CONTENTS

1. What is the point of Stock Connect? Do other countries use similar schemes to enable offshore
investors to invest in their stock markets? ..................................................................................................... 3
2. Haven’t there been other ways to invest in China for some time? ............................................................ 3
3. How does Shenzhen Connect Change things and how does it compare? .................................................. 4
4. What Shenzhen stocks will be on Connect? ................................................................................................ 7
5. Why are ChiNext stocks restricted? ............................................................................................................ 7
6. What about the quotas? How are they changing and why? ....................................................................... 7
7. What are the implications of the daily quotas and the end of the aggregate quota? ................................ 8
8. Southbound buying has been on an uptrend since November of 2015. Is there a reason for that? ......... 8
9. Are there any other differences in trading from other global markets? .................................................... 9
10. What does the Shenzhen launch mean for A-share inclusion in benchmark indices such as MSCI and
FTSE? ............................................................................................................................................................... 9
11. What are the legal, regulatory, and operational implications of Connect? ............................................ 10
12. Does this complete the rollout of the Stock Connect Program, or will there be further developments
down the road? ............................................................................................................................................. 10
13. What about new Connects with financial centers other than Hong Kong? ............................................ 11
14. How does Stock Connect affect capital outflows? .................................................................................. 11
15. What’s the future of Connect when China’s capital account becomes open? ....................................... 11

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Background: China maintains a “closed” capital account, which means investors can move money into andout of China only subject to strict rules. Over the past 15 years or so Chinese authorities have been
gradually opening its capital markets, via tightly controlled programs, to allow some foreign participationin China’s capital markets. In November 2014 China inaugurated Shanghai-Hong Kong Stock Connect,
opening a portal to China’s largest stock exchange to foreign investors. The launch of Shenzhen-Hong Kong
Stock Connect on 5 December 2016 opens the same sort of channel to China’s second stock exchange,home to listings of mostly smaller-cap, faster growing Chinese companies.

1. What is the point of Stock Connect? Do other countries use similar schemes toenable offshore investors to invest in their stock markets? [Back to Top]
Stock Connect is indeed unusual, perhaps unique.i The typical route for investors in one country to buy
stocks in another country is via a relationship between the broker in the originating country and acorrespondent broker in the target country. Stock Connect, by contrast, is a direct link between
exchanges. The original link, launched in November 2014, enabled brokers who are members of the Stock
Exchange of Hong Kong (HKEX) to execute orders for customers through a link to the Shanghai Stock
Exchange (SSE) itself, rather than to brokers who are members of the SSE in China. The HKEX has anomnibus account at the SSE (or to be precise, with its clearing entity Chinaclear) containing all the sharesof the HKEX members who participate in the link. The link is symmetrical, allowing investors in China to
trade HKEX stocks via Chinese brokers who are members of the SSE.
The key to understanding the link is to recall that China’s capital account is still restricted. China doesn’tallow foreign investors to move money into the country and open accounts at financial institutions except
for specific, approved purposes. The Connect link enables the Chinese authorities to allow money to flow
into (and out of) Chinese shares in a way they can control because it all flows through this single conduit.
Crucially, when an investor who bought shares via Connect sells them, the RMB proceeds are delivered in
Hong Kong. Investors wishing to buy Chinese shares have to purchase RMB in Hong Kong (technically theypurchase offshore RMB, or “CNH”), not on the mainland, or have their broker arrange to purchase the
RMB for dollars or other currency for them. Thus Connect forms a “closed loop”, segregating RMB used to
buy Chinese shares from the rest of the Chinese economy.

2. Haven’t there been other ways to invest in China for some time? [Back to Top]
Yes. Foreign investors have been able to invest in Chinese securities through the Qualified Foreign
Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) programs. These
programs allow only approved, well established institutional investors that meet a high threshold of size,
experience, and other eligibility criteria set by the China Securities Regulatory Commission (CSRC) to
participate. Once approved, they may invest in Chinese assets subject to specific quotas and lock-up
periods and other restrictions on how much of the investment a QFII or RQFII institution may repatriate ina given month. The requirements for QFIIs have been steadily liberalized over the years but it’s still

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restricted to institutional investors. By contrast, any investor in the world—institutional or retail—may
access Chinese A-shares via Stock Connect so long as his broker has a correspondent relationship (orestablishes one) with an HKEX member firm approved for Stock Connect. And there are no lock-ups or
repatriation restrictions for Stock Connect.
The R/QFII programs do have advantages. The main advantage is product breadth—investors can get
access not just to stocks but to also fixed income products, warrants, ETFs, futures, and other approved
products. As of early November 2016, there were 273 QFIIs and 171 RQFIIs with total quotas of RMB
548.8 billion and RMB 371.4 billion, respectively.

3. How does Shenzhen Connect Change things? [Back to Top]
Shenzhen Connect opens the door for foreign investors to most of the stocks listed on the Shenzhen Stock
Exchange (SZSE) in exactly the same way as Shanghai Connect did for the SSE stocks. This Shenzhen leg toStock Connect is significant, though, for investors interested in equity exposure to China, because
Shenzhen makes available many new, mostly small and mid-cap “growth stocks” in fast-growing sectors
such as IT, science, healthcare and technology. At the SSE, by contrast, more large (and hence large-cap),state-owned enterprises (SOEs) predominate.

Source: Shanghai and Shenzhen Stock Exchanges

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Source: HKEX

Not surprisingly, the faster growing Shenzhen companies have generated impressive returns. Over the
past 10 years they returned an average of 25% a year, more than doubling in value every three years,
compared to 12% a year for Shanghai stocks.ii Of course, the familiar disclaimer that the past isn’t areliable guide to future performance is true. Blistering growth rates end eventually. The valuations ofShenzhen stocks are also high—trailing price earnings ratios (P/Es) averaged 43 for Shenzhen stocks inearly November vs. just under 16 for Shanghai. P/Es alone tell one little about a stock’s prospects; a fastgrowing company could have a very high P/E because cash flow is being ploughed into expansion for thesake of higher earnings in the future. Or it could reflect over-optimism on the part of investors.
Nevertheless, Shenzhen-listed companies are regarded as more likely to keep growing at faster than their
Shanghai counterparts, whatever the performance of their stocks.

Source: Shanghai and Shenzhen Stock Exchanges

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The Shenzhen exchange is also one of the world’s most active. Though it’s the eight largest in the world
measured by total capitalization of its listed firms, it typically ranks fourth or fifth in terms of turnovervalue.
Stock Exchanges ranked by value of turnover (USD trillions, July 2016)

Source: World Federation of Exchanges, via Wall Street Journal

The greatest benefit to investors from access to Shenzhen stocks is that portfolio managers can build
more diversified Chinese portfolios. Diversification is one of the few free lunches in investing—a morediversified portfolio generally has less risk for the same expected return. Portfolio managers for index andother large diversified funds can deploy Shanghai and Shenzhen stocks to create portfolios that morefaithfully reflect the entire Chinese economy.

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4. What Shenzhen stocks will be on Connect? [Back to Top]Not all Shenzhen stocks are part of Connect. Eligible Shenzhen stocks are those stocks in the SZSE
Component Index and SZSE Small/Mid-Cap Innovation Index with a capitalization of at least RMB 6 billion
as well as A-shares that have H-share counterparts trading in Hong Kong on the HKEX. The SZSE has three“boards”, or classes of listings: the Main Board, of which 467 stocks are eligible, the SME board, 791, andChiNext, 512, in order of decreasing average capitalization—and increasing risk.

5. Why are ChiNext stocks restricted? [Back to Top]
Because of the speculative nature of the small-cap ChiNext stocks, access to these will be restricted in theinitial phase of Stock Connect to Institutional Professional Investors (IPIs). The purpose of the restriction isto protect retail Hong Kong and other investors from plunging into these lightly traded small-cap issues
without understanding the risks that come with volatility and lower liquidity. The ChiNext restriction will
be in place during Phase 1 of Shenzhen Connect but is not expected to be permanent. Given someeducation and appropriate risk disclosures, it’s quite likely the restriction will be lifted in the not-toodistant future.

6. What about the quotas? How are they changing and why? [Back to Top]
When Hong Kong-Shanghai Stock Connect was launched, an aggregate quota of RMB 300 billion for
Northbound and RMB 250 billion for Southbound trades put an upper limit on total investment allowed
through Connect in either direction. (This “aggregate” is calculated as the value of net aggregate turnover,or value of total buys minus total sells.) The reason is that, like so many Chinese initiatives over the years,
the program was intended to be a “pilot”. That is, its size was limited initially so that the authorities andmarket participants could evaluate it. After two years of problem-free operation, the aggregate quotas inboth directions were abolished in August 2016, when the Shenzhen Connect Link was announced.
For similar reasons there has also been a daily quota of RMB 13 billion for Shanghai Connect trading
Northbound into Shanghai listed stocks and RMB 10.5 billion for Southbound Chinese investors. Thesequotas remain in effect. The Shenzhen leg will get its own RMB 13 billion quota, however, so that the total
daily quota for the Stock Connect program will be RMB 26 billion upon launch of Shenzhen Connect. The
Northbound daily quota has been fully utilized once, on its launch date November 17, 2014; theSouthbound twice, both times in April 2015.

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7. What are the implications of the daily quotas and the end of the aggregate
quota? [Back to Top]
Quotas are problematic especially for institutional investors because a quota could unexpectedly preventthe execution of a buy order—and throw the portfolio out of alignment relative to its investment
mandate. Straying from an investment mandate whatever the reasons creates “tracking error”, thedeviation of portfolio performance from its benchmark and a key measure of a fund’s performance. In
short, quotas are an implicit cost, and elimination of the aggregate quota gets rid of part of it. Though theNorthbound daily quota was hit only once, on the day it was launched, if and when A-shares get approved
for index inclusion for MSCI Emerging Markets, Northbound investment could increase substantially,
along with the risk of hitting the limit. Hence they remain a concern to institutional investors.

8. Southbound buying has been on an uptrend since November of 2015. Is there areason for that? [Back to Top]Two reasons probably explain it. In November of 2015 the RMB was devalued 3% relative to the U.S.
Dollar and it has since continued on a gradually weakening path. This created an appetite for Hong Kong
Dollar assets, which are tightly linked to the appreciating U.S. currency.
Another likely motivation for Chinese investors is the “A-H anomaly”. Some Chinese companies with Ashares trading on a mainland exchange also have “H” shares trading on HKEX. H-shares are equivalent interms of ownership rights and rights to dividends as A-shares, but many of these H-shares are
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considerably cheaper than their A-share counterparts. Some value-minded Chinese investors havedoubtless been taking advantage of this price disparity and buying H-shares at significant “discounts”.

Source: Hang Seng Indices

9. Are there any other differences in trading from other global markets? [Back to
Top]
There are a few other quirks. China prohibits day-trading, so that applies to Stock Connect. Short selling ispermitted in theory, but because of the way the rules are written, it’s been impracticable. A short seller
has to borrow a stock in order to sell short. The rules allow only Hong Kong Exchange Participants (EPs) tolend stocks, but EPs typically don’t have inventories of stocks to lend—it’s the asset managers andcustodians who do. As a result, there have been no short sales so far by Northbound Stock Connect
investors since its launch two years ago. This is unfortunate not just because short selling facilitatesvarious investment strategies but because short selling is an important element in supporting market
liquidity, particularly when markets are stressed. ASIFMA and industry are hoping the Chinese authorities
will amend the rules to allow affiliates of EPs such as asset managers and custodians to engage in stock
borrowing and lending, and make short selling feasible.

10. What does the Shenzhen launch mean for A-share inclusion in benchmark
indices such as MSCI and FTSE? [Back to Top]
Accessibility is a major criterion for the index managers and Shenzhen Connect makes a lot of new
Chinese shares more accessible. The lock-ups and repatriation restrictions of QFIIs and RQFIIs are absent
from Stock Connect. In short, the addition of Shenzhen Connect to the program adds weight on thepositive side of the scale but is not decisive. The index managers have said that their key criteria areaccessibility, implementation of the more liberalized capital mobility rules, reduction in stock suspensions,and resolution of the pre-approval requirements by Chinese exchanges on launching financial products
based on indexes that include A-shares. An additional consideration is steadiness in the application of newPage 9 of 12and existing rules, with less of the sort of ad hoc changes that kept investors guessing during the turmoil
in Chinese equity markets during the summer and fall of 2015.

11. What are the legal, regulatory, and operational implications of Connect? [Backto Top]The basic principle is that home country rules apply. Hong Kong brokers and investors offering A-shareproducts are subject to the Securities and Futures Ordinance and SFC regulations. In practice it’s morenuanced and regulators on both sides of the border need to cooperate. Early on, foreign investors wereconcerned that their legal claims to Chinese A-shares were ambiguous because in China the shares areheld in an HKEX omnibus account, lacking specific customer information. However, CSRC has issued FAQs
that have largely addressed this concern. Hence, in its June 2016 conclusion of its review of possible Ashare inclusion in the MSCI EM index, index manager MSCI noted the improvement in “issues regarding
beneficial ownership”.
Operational issues are a bit complex. The key challenge is that in China, stock is settled on the trade date,
T+0, but the payment settles the following day, T+1. This contrasts to the method used in most developed
markets, “delivery versus payment” (DVP) where stock and cash settle on the same day, usually on T+2.
Brokers and custodians and the HKEX have devised ways that largely overcome the disconnection of
settlements, though some operational and counterparty risk remains.
The European regulators who oversee the UCITS regime initially had concerns about the above issues but
have been largely reassured. Regulators in Luxembourg and Ireland, where most European funds are
domiciled, essentially require funds and their custodians to ensure that any investments in Chinese Ashares are consistent with their investment mandates and other regulatory obligation. Since the launch of
Stock Connect over 100 UCITS funds have embraced A-shares in their investment mandates.

12. Does this complete the rollout of the Stock Connect Program, or will there be
further developments down the road? [Back to Top]Yes indeed, the HKEX has made clear there’s more coming. Next on the runway are ETFs. ETFs traded in
Hong Kong could be of particular interest to Southbound investors, who could use global or regional ETFs
to globalize their portfolios in one step. In addition to the ETFs already trading in Hong Kong, there may be
scope to create new ETFs likely to appeal to Chinese investors. For some Northbound investors Chinese
ETFs might be attractive given the limited acceptance of A-shares by index managers outside China todate.
Further down the road Stock Connect could embrace exchange-traded derivatives (ETD), such as the CSI
300 contract traded at the China Financial Futures Exchange, and the Hang Seng Stock Index futures inHong Kong. The availability of CSI futures will open numerous possibilities for improved portfolio and risk

Page 10 of 12management for offshore China investors into China. HKEX also trades currency futures and has theworld’s most active market in warrants and structured products such as callable bull/bear contracts(CBBCs), all of which could become part of the Connect program eventually. In short, there’s still plenty ofroom for growth in the Stock Connect program, even without looking beyond Hong Kong.

13. What about new Connects with financial centers other than Hong Kong? [Backto Top]
The Chinese authorities have held discussions with counterparts in London to explore the possibility of a
London Connect. At first blush a London Connect might seem to add relatively little value to theNorthbound value proposition since Shanghai and Shenzhen Connect already take offshore investors to
China’s equity markets. It’s too soon to say, but if creatively structured a second channel to China’s equity
markets such as London Connect could offer added value to investors, such as lower cost or greater
convenience and efficiency. For Chinese investors, on the other hand, a London Connect would likely bequite attractive because it would potentially open a rich menu of European and global equity products notavailable in Hong Kong.

14. How does Stock Connect affect capital outflows? [Back to Top]As described in the first question, Stock Connect is a closed loop in both directions. Southbound Chinese
investors who sell their Hong Kong holdings get their proceeds returned to them in China. For thesereasons, Stock Connect limits capital outflows since investments can go only into Hong Kong stocks andnothing else. In addition, China restricts Southbound participation to investors who have no less than
RMB 500,000 in their stock and cash accounts, limiting the participant universe.
In theory, there is no upper limit on Southbound flows now that the aggregate quotas are gone. In
practice, Stock Connect is likely seen by authorities as an acceptably constrained outbound channel withina controlled capital account because it targets just a single asset class at a single exchange (and a Chinese
exchange at that). Should market conditions nevertheless at some point in the future prompt concerns
among Chinese authorities that outflows are excessive, the single-channel structure of Connect makes it
easier to reimpose limits.

15. What’s the future of Connect when China’s capital account becomes open?
[Back to Top]As explained in the first question, Stock Connect is designed to keep foreign stock investments walled offfrom the rest of China. Northbound investors’ proceeds come back to Hong Kong (or elsewheredepending on the location of the client) when a stock is sold. Chinese authorities have announced
intentions to eliminate capital controls as early as 2020. When that happens, investors will be able to buy

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RMB and invest in any Chinese assets more or less without restriction (or subject to the same restrictions
as a domestic investor). Would there still be a role for Stock Connect then?
In theory, no. Given how cross-border investing works in the rest of the world, one might expect Connect
to be replaced by the global model. But by then Stock Connect will be familiar to China-bound investors
and it may be efficient and low cost as well. If HKEX continues to meet the demands of the market, Stock
Connect could survive, uniquely quirky but working. But if the conventional model turns out to be cheaperand more efficient, Stock Connect would eventually retire into history.

i There are some similarities to the MILA (Mercado Integrado Latinoamerica) program integrating the stock

exchanges of Chile, Columbia, Mexico, and Peru.
ii “China's two stock connects are a study in contrast”, Kelvin Soh, UBS Market News, 22 August 2016.

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