How better financial infrastructure can drive bond market development in Hong Kong and the region

This article appeared originally in the South China Morning Post on 27 December, 2020.
Authors: Kenny Shui, Assistant Research Director and Head of Economic Development, and Louise Wen, Researcher at Our Hong Kong Foundation

More Chinese companies that have listed overseas are turning to Hong Kong for secondary listings, giving new impetus to the local stock market. Meanwhile, Hong Kong’s local bond market is limited in size, falling behind other Asian markets like Japan, mainland China and South Korea on volume of issuance.

Despite the government’s promotion of inflation-linked bonds (iBonds), green bonds, silver bonds and Islamic bonds in recent years, there is still much room for improvement in Hong Kong’s bond market, especially in terms of its financial infrastructure.

Every securities transaction requires a post-trade financial infrastructure, namely a central securities depository (CSD), to efficiently register, settle and manage a transfer of ownership. The Central Moneymarkets Unit established by the Hong Kong Monetary Authority is a CSD for the local bond market.

An international central securities depository (ICSD), on the other hand, is designed for cross-border transactions.

By connecting CSDs in different jurisdictions, ICSDs significantly reduce cross-border transaction and settlement costs, attract more investors and increase overall market liquidity. Currently, there are two major ICSDs in Europe: Euroclear Bank in Belgium and Clearstream Banking in Luxembourg. Each connects more than 50 regional CSDs and provides services for over 1,000 institutional investors globally.

In contrast, Asian CSDs mainly target local markets, and there is no ICSD covering the region. Asian markets are therefore unable to capitalise on the opportunities of cross-border trading or create economies of scale; they are also more vulnerable when systemic risks arise in the regional financial market.

Asian cross-border transactions mostly rely on the ICSDs in Europe, and are subject to higher transaction and settlement risks as a result of trading across time zones, not to mention geopolitical risks.

According to the Asian Development Bank, internal clearing costs at the Euroclear Bank range from €0.33 to €1.50 (40 US cents-US$1.83) per transaction, while costs in Asean Plus Three (the Association of Southeast Asian Nations, plus China, South Korea and Japan) can be US$20-US$80 per transaction.

In light of the exciting opportunities for bond market development created by the growing demand in Asia, establishing a regional settlement intermediary, such as an Asian ICSD, could yield substantial benefits.

This would not only bring down transaction costs, facilitate the development of local bond markets and improve the financial infrastructure, but could also meet Asia’s growing demand for financing, thereby enhancing the region’s financial stability.

Compared to Japan, South Korea and Singapore, Hong Kong is better equipped for the establishment of an Asian ICSD. The Central Moneymarkets Unit has built direct links with the two European ICSDs as well as the three mainland Chinese CSDs, which is particularly relevant due to increasing interconnectivity between Chinese and international financial markets in recent years.

Financial regulators in mainland China have been relaxing restrictions on overseas investors, introducing more flexible schemes like Bond Connect, and authorising two major international rating agencies, S&P and Fitch, to enter the mainland market in the past two years.

The international market has also responded, by including or planning to include Chinese bonds in three major international indices: the Bloomberg Barclays Global Aggregate Index; JPMorgan’s Government Bond Index-Emerging Markets, and; the FTSE World Government Bond Index. It is estimated that active and passive funds could inject hundreds of billions of dollars’ worth of liquidity into the mainland bond market each year.

As the gateway to mainland China, the world’s third-largest bond market, Hong Kong will directly benefit from the increasing foreign investment, through the innovative Bond Connect scheme. It is also expected to drive the development of the local bond market.

With Hong Kong’s unique advantages, we should look to establish an Asian ICSD to strengthen our financial infrastructure. It would enable us to seize opportunities from cross-border securities transactions, financial liberalisation on the mainland and renminbi internationalisation, and tap the potential of the local bond market.

These new growth areas for Hong Kong’s financial industry can help consolidate our position as a leading international financial centre.