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From China to Japan, financial markets in Asia are opening up to overseas investors on an unprecedented scale, helped by initiatives that have been facilitated by lawyers. Among the most innovative developments is the Bond Connect scheme, launched in July last year.
The scheme links China’s onshore bond market, worth some $12tn — the third largest in the world — to Hong Kong, allowing overseas investors to access China’s bonds through a trading route set up by Hong Kong Exchanges and Clearing. Formerly, foreign institutional investors had to undertake a convoluted process to gain access to China’s debt market, which involved opening an account and applying for local currency quotas.
While Bond Connect followed Stock Connect, a similar initiative aimed at opening up China’s mainland equity market, lawyers working on the bond version faced a unique set of challenges. “Bond Connect was quite different from Stock Connect because it involved an entirely different set of regulators, participating institutions and market infrastructures for trading and settlement,” says Chin-Chong Liew, a partner at Linklaters, who assisted Hong Kong Exchanges and Clearing in devising the scheme.
“With Bond Connect, if you have a trading account with an offshore broker and custodian, you can use that account in Hong Kong, so you don’t have to create a new trading and settlement relationship onshore in China,” he adds. “You can rely on the existing infrastructure.”
One hurdle for creating the trading link was the gap between Chinese rules and practices and their international counterparts. “It was a real challenge to come up with mutually acceptable compromises without adversely impacting the local market and international investors,” Mr Liew says.
At the heart of the challenge was a standard used by international investors that unequivocally gives ownership of the bond to the investor. “If you’re buying something, you want to ensure it belongs to you,” says Mr Liew. “You don’t want someone in the process to say, if any intermediary or custodian goes bust, that the bond becomes their property.”
In the international market, this is usually known as “beneficial ownership” but China has a different legal system “with concepts which are less well understood, so this required clarifications and some procedures to be set up to put matters beyond doubt”, he adds.
At present, only around 2 per cent of Chinese bonds are held by overseas investors.
“China’s onshore bond market is one of the largest in the world and yet it has an extremely low level of foreign ownership compared to both emerging and developed market peers,” says Karan Talwar, an emerging markets debt specialist at BNP Paribas Asset Management. “We continue to expect foreign inflows into onshore Chinese bonds to gain traction over time, and recent data confirms this trend with foreign net inflows into onshore Chinese bonds reaching $36bn a year.”
Charles Li, chief executive of Hong Kong Exchanges and Clearing, said last year that Bond Connect “will give Hong Kong a bigger role in fixed income [markets]”. Data from the exchange show that by the end of the first quarter of this year, 288 overseas institutional investors had entered the China bond market through the scheme. The significance of Bond Connect, however, goes beyond Hong Kong, with the scheme potentially serving as a blueprint for other countries. Mr Liew says several markets, including the UK and Canada, are looking at joining Bond Connect to give their investors access to China’s domestic bond market.
The expansion of China’s bond market is also being driven by other initiatives supported by lawyers. Beijing-based Zhong Lun Law Firm worked on the Bank of Tokyo-Mitsubishi UFJ’s issuance of a “Panda bond” — renminbi-denominated debt issued in China by a foreign institution — representing one of the first Panda issuances by a Japanese company.
Shirley Wang, a partner at Zhong Lun, says one of the challenges she faced was language, as previous Panda bond deals had been conducted only in Chinese and English. “We had to work on two documents, and we had to form two teams — one to work on the Japanese version and another on the Chinese version,” she says.
The deal came after she had worked on Poland and Russia’s sovereign Panda bond issuances, with Poland representing the first European government to launch Panda debt with its issuance in 2016.
“It will take time for foreign investors to understand the rules and policies of the Chinese bond market, and we need to have more lawyers who speak English and other languages to provide information on how the market operates,” she says.
While China’s bond market is evolving rapidly, other countries in Asia are opening access further to international investors.
Japanese conglomerate SoftBank issued a landmark bond last year that has paved the way for similar deals. It launched a $4.5bn hybrid perpetual bond— a high-risk instrument that has characteristics of both debt and equity. This represented the first high-yield perpetual bond ever issued at the time.
Edward Cole, a Tokyo-based partner at Freshfields Bruckhaus Deringer, worked on the issuance. “It was the first time this type of Japanese bond was done in the English language and marketed internationally by an issuer who had already issued such debt domestically in Japan,” he says.
“Previously, Japanese issuers that had issued this sort of debt in the domestic market, in the Japanese language and Japanese market terms, had not then been able to access the wider international capital markets for the same type of debt.”
Hybrids are issued as bonds. However, in the event of an insolvency, investors are repaid after other creditors with the exception of shareholders, making this type of debt riskier.
“As a Japanese issuer, your challenge was how to access international capital markets and raise new debt which is marketable internationally, in a way that is consistent with the terms of Japanese debt,” says Mr Cole. “The key challenge is [that] you’re trying to make something happen that was never contemplated when earlier deals were done.”
All previous issuances of this type of bond had been written in Japanese, which made it difficult to ensure that the terms of the contract in the English version matched those of the domestic contract.
Despite such challenges, the pioneering work helped by lawyers has paved the way for these landmark deals and transformative changes. While these developments begin to open up Asia’s bond markets and, more broadly, the financial sector, to international investors, analysts say there is still some way to go.
Foreign investors laud the advent of Bond Connect and its opportunities, but warn that challenges remain. Nonetheless, they are dipping a toe into new markets that hold great promise — once further innovation comes to fruition.
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