QFII clients face op risk challenges as China sticks to manual processes

Offshore investment managers making cross-border investments into Chinese securities through the country’s qualified foreign institutional investors (QFII) scheme are facing operational risks from not being able to process trades quickly for settlement, due to the lack of incentives by their Chinese brokerages to invest in automation.  

Many Chinese brokerages still manually key in trade details for confirmations, despite most of their offshore counterparts having already automated the process. These differences in handling post-trade processes may be restricting the speed at which the QFII scheme can be expanded to provide foreign investors with access to more complicated securities and derivatives, such as exchange-traded funds (ETFs). ETFs are already widely-traded by many local fund managers, industry participants say.  

Eric Chua, head of the Shanghai office for Swift, a body that promotes interbank telecommunications, says the low volume of transactions placed by QFII foreign investment managers has acted as a disincentive for many Chinese brokers to invest in an electronic trade confirmation system. Instead, many Chinese brokers prefer to have staff manually key in trade details, such as names of the securities, settlement dates and terms of the trade for their offshore QFII clients to confirm.  

As China strictly controls its currency, the renminbi, the authorities in Beijing introduced the QFII scheme in 2002 as a partial way to open up the country’s capital market to foreign institutional investors. QFII investors can use the approved quota issued by the State Administration of Foreign Exchange (Safe) to invest in the country’s equity and fixed income securities via local brokers. Since the inception of the scheme, Safe has approved an aggregate $15.72 billion QFII quota to 78 foreign institutions. 

“The problem now is that when the Chinese brokers execute on the orders placed by their overseas QFII clients, they do not have a good way to communicate with them because they are still relying on faxes and excel spreadsheets attached to emails to confirm the trade details. The process is still largely manual,” says Chua. 

This has created a host of operational risks for both parties – especially for the QFII clients, which have typically invested in automated systems to help them process payment, give settlement instructions and account for net asset values (in the case of mutual funds). The preference of their Chinese brokers to manually key in non-standardised trade information for confirmation has also created problems related to data conversion – in many cases, trades are formatted in Chinese characters. 

In China, settlement for domestic trading of some securities, such as A-shares is very efficient. A-share securities, which are denominated in renminbi, can be settled at the  China Securities Depository and Clearing Corp on a T+1 basis. In the US and Hong Kong, settlement of domestically-traded securities is typically done on a T+3 and T+2 basis. Hence the quicker the confirmation process is completed, the faster a trade can be settled domestically.

But there are increasing signs that Chinese brokerages are warming to the idea of automation, with Chua saying he sees more Chinese brokerages subscribing to connectivity services that enable brokers to provide standardised trade confirmation messages to their QFII foreign clients. This enables the trade details to feed directly through to their clients’ automated trading systems offshore. “While it’s not a full-automation service, for the Chinese brokers the trend of using a standardised message is a step-up from their emailing and faxing of trade confirmations,” says Chua. 

Meanwhile, Singapore-based James Drumm, executive director for sales and relationship management, Asia Pacific, at post-trade service group Omgeo, says the increasing use of electronic confirmation processes should help local Chinese fund managers that are offering foreign securities to their Chinese investors in the form of qualified domestic institutional investors (QDII).   

“Regulators and investors alike generally look at three areas of risk – investment, operational and credit risk,” says Drumm. “Before the collapse of Lehman Brothers last year, most of them had focused on the performance of funds and, to a lesser degree, investment risk. But in the post-Lehman era, the spotlight is on operational risk.”

Multiple and disparate mid- and back- office systems that are not interconnected provide a “feeding ground” for trade inefficiency and failure, thereby increasing operational risk, he says. 

QDII works in the opposite direction to QFII, in that domestic institutional investors qualified by Safe and the securities regulator, the China Securities and Regulatory Commission (CSRC), can offer offshore securities under China’s still restrictive capital account.  

It requires a total of three licences issued by Safe and CSRC before a fund house can launch a QDII product. Today, 31 fund houses have QDII licences, 12 of which have all three licences required to enable them to launch products, with the remaining 19 still awaiting a full set of licences.