By Michelle Price and Saikat Chatterjee
HONG KONG (Reuters) - Concerns by Europe's top funds watchdog that a landmark Hong Kong-China trading link may not adequately protect investors are preventing thousands of funds from buying Shanghai stocks, threatening the success of the project, market participants told Reuters.
The so-called Stock Connect scheme, launched on Nov. 17, allows foreign investors to trade Shanghai-listed shares via the Hong Kong stock exchange, and mainland investors to invest in Hong Kong shares via the Shanghai bourse.
But within a week of its launch, trading volumes had dwindled to less than 20 percent of the maximum allowance.
Banks, fund managers and lawyers told Reuters that was because many large EU-regulated funds are unable to participate until Europe's main funds regulator, Luxembourg's Commission de Surveillance du Secteur Financier (CSSF), is satisfied that the scheme protects investors.
About 13,000 global mutual funds, or two-thirds of Europe's funds industry, are domiciled in low-tax Luxembourg and regulated by the CSSF. These include heavyweights such as Blackrock, Templeton and Fidelity, part of Luxembourg's 3 trillion euro ($3.7 trillion) asset management industry.
The CSSF, market participants say, wants to be sure that the Chinese shares EU savers buy through the link-up can be adequately recovered should the bank that guards the stocks - the custodian bank - or one of the exchanges, go bust.
The collapse of Lehman Brothers in 2008, which saw billions of funds' asset sucked into the insolvent Lehmans estate, has made investors and regulators highly sensitive over custody arrangements.
Several market participants said the CSSF has questioned whether Stock Connect's arrangements meet Europe's strict rules governing the safe-keeping of assets managed by mutual funds for retail investors, popular investment products known as UCITS.
"The Luxembourg regulator is asking the custodians to clarify that the custody arrangements comply with UCITS rules," said Jeremy Lam, a partner at law firm Deacons in Hong Kong.
But some custodians feel unable to provide that reassurance, lawyers and industry participants said.
Contacted by Reuters, the CSSF said in a statement it had "contacts with some custodians (over Stock Connect) and the discussions were related at this stage to general points".
It declined to give further details on these discussions, but added that it had yet to receive any formal application by a UCITS fund to participate in the Hong Kong-China scheme.
SAFE-KEEPING
Sally Wong, chief executive of the Hong Kong Investment Funds Association, said funds have been working around the clock with European regulators to resolve the issue.
Some market participants said it could take six months to find a solution to satisfy the CSSF, or longer if China is required to make changes to its securities law.
Shares and bonds bought by mutual funds are typically held by custodians on behalf of the investor, a concept known as beneficial ownership.
Under EU rules for mutual funds, the custodian must be able to identify and monitor the client funds at all time.
But the China trading scheme makes it tough for custodians to fulfil these obligations, because Shanghai shares are physically held in China through an unusually complex three-tiered structure involving the custodian, the Hong Kong clearing house, and the Shanghai clearing house.
To make matters worse, some lawyers say Chinese law does not explicitly recognise the concept of beneficial ownership, meaning foreign investors may not be able to prove they own the shares if something goes wrong.
"Ultimately, fund managers have fiduciary responsibilities to the clients," said Wong.
In reply to a request by Reuters, the Hong Kong stock exchange said in a written response that the scheme's custody arrangements are clearly stated on its website. The exchange has said it will provide custodians with certificates as proof of ownership.
But it is unclear if this will satisfy the CSSF's requirements, custodians said.
The Shanghai Stock Exchange told Reuters low trading volumes were caused by a variety of factors, without giving details.
Mutual funds experienced a similar problem when attempting to invest in China through a quota-based cross-border scheme known as RQFII first launched in 2011. In this instance, the UCITS funds had to wait nine months for a green light from CSSF.
A similarly long delay in addressing the custody issue could throw the rollout of the stock connect scheme to other asset classes into jeopardy, and may even prompt global index providers such as MSCI to delay inclusion of mainland China shares in its emerging market indexes.
The Central Bank of Ireland, which oversees Europe's second biggest UCITS hub, told Reuters it could not comment on specific cases, but "applications must comply with all legislative and regulatory requirements applicable to UCITS".
(Editing by Lisa Jucca and Will Waterman)