An advertising board (left) showing a Chinese stone lion is pictured near an entrance to the headquarters (right) of China Securities Regulatory Commission in Beijing. Hong Kong’s Securities and Futures Commission is conducting its investigation to help the CSRC.

Reuters/Hong Kong

The Hong Kong securities watchdog is investigating whether brokers and hedge funds in the financial centre violated their operating licences in creating and trading China investment products, three people with direct knowledge of the matter said.
The investigation began about two weeks ago and is focused on how international brokers and Hong Kong subsidiaries of Chinese brokers used more than $100bn in China investment quotas to create products allowing hedge funds to trade stocks and bonds in mainland markets. China controls foreign access to its markets through closely monitored programmes, such as by issuing investment quotas.
Hong Kong’s Securities and Futures Commission (SFC) has not been detailed its concerns with the financial firms it has approached for information. But two sources said it is conducting its investigation to help China’s stock market watchdog, the China Securities Regulatory Commission (CSRC).
The CSRC has been cracking down on what it has called “malicious” trading activities blamed by Chinese authorities for a 40% slump in the mainland’s stock markets since June.
The SFC declined to comment and the CSRC did not respond to a request for comment.
“They are basically clutching at straws,” one executive at a foreign institutional broker in Hong Kong said of the SFC investigation. “They have to be seen doing something and it is an extension of the crackdown on hedge funds in the mainland.”
Brokers are typically licensed to deal in securities, but some China investment product structures may have required them to hold a separate asset management licence in order to manage a portfolio of securities for clients on a discretionary basis, one person said.
A second source said the SFC was also looking at whether hedge funds had likewise transgressed their licences or the SFC’s general conduct rules.
The sources declined to be identified owing to the sensitivity of the matter.
Chinese authorities have gone to extraordinary lengths to prevent a precipitous fall in their financial markets with a frenetic series of policy changes and intervention. China’s major stock indexes have fallen nearly 40% since June.
Last month, Reuters reported the CSRC had requested information from brokers in both Singapore and Hong Kong to check if they had net short positions on Chinese stocks following the dramatic selloff on the mainland.
China is concerned that brokers operating in Hong Kong use their quotas to package products that allow hedge funds to express a negative or ‘short’ view on the China market, sources said. The CSRC has been stamping out short positions in mainland markets in recent months as part of a broader government effort to prop up stock markets.
The SFC has asked foreign brokers for information on hedge fund client trades and contracts relating to these China investment schemes, two of the sources said.
A third person with direct knowledge of the matter said the SFC was also investigating how the Hong Kong subsidiaries of mainland brokerages had used their yuan-based investment quotas to create products for hedge funds.
The SFC typically fines firms that act beyond their license provisions and has prosecuted individuals for unlicensed dealings.
But two sources said the fallout of a widespread probe by Hong Kong into these products could dent foreign investor confidence in the independence of the territory’s regulatory system.
China closely controls access to its capital markets. Until November last year it only allowed foreign investors in by allocating investment quotas under the so-called Qualified Foreign Institutional Investor (QFII) scheme and its yuan-denominated equivalent, RQFII.
The combined QFII quotas outstanding stood at $77bn while RQFII stood at 405bn yuan ($41bn) at the end of August.
The launch of the Hong Kong Shanghai Stock Connect trading link widened access in November by allowing foreigners to trade Shanghai stocks from Hong Kong. Aggregate China bound use of stock connect stood at 137bn yuan, having peaked in early July.
Brokers, asset managers and trusts in Hong Kong have for years used their QFII and RQFII quotas to structure “China access” products for international investors shut out of the mainland market, particularly hedge funds.
The practice, known as “renting” quota, has long-operated in a regulatory grey area. Beijing has never explicitly banned the practice, but has expressed concern in the past that it reduced regulators’ visibility and control over the market.
The “China access” products are traded over the counter and can take the form of participation notes or equity derivatives, or are structured as a managed portfolio investment. In some cases, hedge funds simply pay a fee to directly trade the broker’s quota.