RIDING THE CHINA WAVE: HKEX S GROWTH STRATEGIES IN THE EXCHANGES ARENA

A MEMBER OF THE UNIVERSITY OF HONG KONG GROUP 香港大學機構成員 AMY YIP ROY ZHOU RIDING THE CHINA WAVE: HKEX S GROWTH STRATEGIES IN THE EXCHANGES ARENA Our vision at HKEx is to reshape the global market landscape and connect China with the world, to build a robust and sustainable offshore RMB ecosystem, eventually developing Hong Kong into China s premier offshore wealth management centre. Charles Li, Chief Executive, HKEx 1 While the opening up of China s capital market has accelerated in recent years, Hong Kong Exchanges and Clearing Limited ( HKEx ) found itself in the unique position of being able to contribute to the development of cross-border access platform. The widely anticipated Shenzhen-Hong Kong Stock Connect ( SZ-HK Connect ) in 2016 is the next key development after HKEx introduced the first mutual access programme, the Shanghai-Hong Kong Stock Connect ( SH-HK Stock Connect ) in 2014. HKEx positioned itself as a bridge between Mainland and international markets. Could this vision drive HKEx to enhance its competitiveness in helping channel funds into and out of China, and consolidate its leading position in the global exchange arena? Strategies were formulated to diversify into commodities and to launch mutual access programmes. Would such strategies enable HKEx to fulfil its ambition of building a robust RMB ecosystem? Industry Landscape Stock Exchanges served as platforms for companies to raise funds, thus playing a vital role in financing the real economy. As of June 2015, 64 stock exchanges joined The World Federation of Exchanges ( WFE ); the world s top exchanges in terms of market capitalization were NYSE Euronext (US), Nasdaq OMX, Japan Exchange Group, London Stock Exchange Group, Shanghai Stock Exchange ( SSE ), NYSE Euronext (Europe), HKEx, and Shenzhen Stock Exchange ( SZSE ). [See Exhibit 1 for the ranking of the world s stock exchanges.] 1 HKEx (22 Jun 2015) Charles Li Direct: After 15 great years, a new beginning, https://www.hkex.com.hk/eng/newsconsul/blog/150622blog.htm (accessed 19 August 2015) To order this case, please contact Centennial College, c/o Case Research Centre, Centennial College, Wah Lam Path, Pokfulam, Hong Kong; website: http://cases.centennialcollege.hku.hk. This case was fully supported by a grant from the Research Grants Council of the Hong Kong Special Administrative Region, China (UGC/IDS12/14). 2016 by Centennial College, a member of The University of Hong Kong group. No part of this copyrighted publication may be reproduced or transmitted, in whole or part, in any form or by any means, whether electronic, mechanical, photocopying, recording, web-based or otherwise, without the prior permission of Centennial College. This case was prepared for class discussion purposes and is not intended to demonstrate how business decisions or other processes are to be handled. Ref. 16/003C Published: 5 April 2016 Page 1

Mainland exchanges and HKEx experienced strong growth in recent years, making them among the top eight exchanges in the world. They topped the increase in market capitalization, and have grown by 60% and 16% respectively in the first half of 2015. 2 During the same period, the total equity trading volume worldwide rose to US$ 59 trillion. This marked a 36% increase from the second half of 2014, out of which 31% was due to the Mainland s growth. Company Background HKEx was established in March 2000 following the merger of Stock Exchange of Hong Kong Limited (SEHK), Hong Kong Futures Exchange Limited (HKFE), and Hong Kong Securities Clearing Company Limited (HKSCC). It operated a securities market, a derivatives market, and their corresponding clearing houses in Hong Kong. HKEx was one of the first demutualized and listed stock exchanges in the world when its shares started trading on 27 June 2000. In the last few years, HKEx adopted a progressive growth strategy for global expansion. In September 2012, HKEx jointly founded China Exchange Services Company with SSE and SZSE, aiming to contribute further to the internationalization of the Mainland s capital markets. In December 2012, HKEx bought London Metal Exchange ( LME ), the leading global metal exchange founded in 1877. In November 2014, HKEx launched the SH-HK Stock Connect, its first mutual market access programme. These strategies injected impetus to HKEx s exponential growth. In the first half of 2015, HKEx s increased its revenue by 48% and net profit by 73%. 3 Both revenue and net profit broke the highest half-yearly record. [See Exhibit 2 for HKEx s Revenue and Net Profit 2005-2015.] During the same period, HKEx ranked second in the global IPO market. Total IPO funds raised reached HK$ 786 billion (US$ 101 billion), an increase of 58% year-on-year. 4 Through fifteen years rapid development, HKEx grew from a local exchange to one of the largest exchange groups in the world. 5 In its 15 th anniversary in 2015, HKEx reiterated its vision going forward: 6 to reshape the global market landscape and connect China with the world to build a robust and sustainable offshore RMB ecosystem to eventually develop Hong Kong into China's premier offshore wealth management centre HKEx s Growth Strategies The Mainland s continued economic expansion has helped grow the wealth of more and more businesses and individuals. These businesses and individuals would actively look beyond their national boundary to better utilise their accumulated capital by diversifying their asset allocations and investment portfolios in international markets. Meanwhile China, with its rapid economic development, has become one of the world s largest importers of many bulk commodities. HKEx was well placed to meet Mainland s evolving needs by bridging its insulated domestic markets with vibrant international markets. 2 World Federation of Exchanges (29 July 2015), Market Highlights Report, http://www.worldexchanges.org/files/statistics/pdf/2015_s1_market_highlights_1.pdf; http://www.world-exchanges.org/insight/reports/globalequity-trading-volumes-rise-36-1st-half-2015 (accessed 19 August 2015) 3 HKEX (24 August 2015) 2015 Interim Report, https://www.hkex.com.hk/eng/exchange/invest/finance/2015/documents/150824_2qr_e.pdf (accessed 19 August 2015) 4 HKEx (12 August 2015), Group Interim Results 2015, http://www.hkex.com.hk/eng/newsconsul/hkexnews/2015/documents/1508122news.pdf (accessed 19 August 2015) 5 http://www.hkex.com.hk/eng/exchange/corpinfo/history/history.htm (accessed 19 August 2015) 6 Charles Li, HKEx (22 June 2015), http://www.hkex.com.hk/eng/newsconsul/blog/150622blog.htm (accessed 19 August 2015) CENTENNIAL COLLEGE Page 2

China s Needs: From Capital Formation to Investment Diversification Hong Kong started to benefit from the opening of Mainland s capital markets in the 1990s. In July 1992, the first red chip (company with strong Mainland orientation but incorporated outside China), Hai Hong Holdings, began trading in Hong Kong. In July 1993, Tsingtao Brewery became the first Mainland-incorporated company (H-share) to list its shares in Hong Kong. This marked the beginning of Hong Kong s rise to become Mainland s primary offshore fund raising centre. Between 2001 and 2010, the Mainland economy grew strongly, enjoying an average 10.5% annual GDP growth. 7 Continued rapid growth transformed the Mainland from an importer of capital to an exporter of capital. The demand for investment diversification and risk management across all asset classes increased tremendously in China. To capture these new business opportunities, a wide range of RMB-denominated products were developed and listed on HKEx, including stocks, bonds, derivatives, warrants, Exchanged-Traded Funds (ETF), Real Estate Investment Trusts (REIT), currency futures and commodity futures. [See Exhibit 3 for RMB-denominated Products on HKEx.] Diversification into Commodities Market Following the successful acquisition of LME in December 2012, HKEx undertook a series of initiatives to expand LME s existing business and facilitate greater participation of Mainland companies in LME markets. These initiatives aimed to make cross-border access easier, to extend LME s warehouse network to the Mainland and the rest of Asia, to provide RMB clearing services, and to develop Asia time zone trading and clearing. The entry barrier was lowered to enable Asian, particularly Mainland companies, to access the deep liquid markets of LME. In 2014, the first Chinese-owned company, GF Financial Markets, began trading in the LME Ring after becoming LME s category 1 member. Since then, more Asian firms from the Mainland, Hong Kong, and Korea have become LME members. 8 HKEx also expanded LME s global network of approved warehouses for the physical delivery of commodities. On 22 September 2014, LME launched its own clearing house, the LME Clear. This allowed LME to self-clear base metals contracts and would be extended to provide Asia time zone clearing. It also launched RMB clearing services in mid-2015, and began to accept offshore RMB (CNH) as eligible cash collateral. In its Group Strategic Plan 2013-2015, HKEx further developed its commodities derivatives business by extending into other metals and commodities. The Mainland was the largest consumer of commodities, and Hong Kong s geographical proximity to the Mainland offered HKEx an unparalleled niche in broadening its assets offering. The acquisition of LME proved fruitful with LME making important contribution to HKEx s group performance. For the first six months of 2015, LME s revenue totalled HK$ 886 million (US$ 114 million), which accounted for 19% of HKEx Group s consolidated revenue. 9 7 http://databank.worldbank.org/data/reports.aspx?source=2&country=chn&series=&period=# (accessed 10 December 2015) 8 http://www.hkex.com.hk/eng/newsconsul/blog/blog.htm (accessed 22 December 2015) 9 HKEX (24 August 2015) 2015 Interim Report, https://www.hkex.com.hk/eng/exchange/invest/finance/2015/documents/150824_2qr_e.pdf (accessed 19 August 2015) CENTENNIAL COLLEGE Page 3

Mutual Market Access Programme Before 17 November 2014, foreign retail investors mostly had exposure to Mainland equities via red chips and H-shares in Hong Kong or B-shares in China. In 2002, Qualified Foreign Institutional Investor (QFII) scheme was launched to enable foreign investors to access the A- shares markets directly. In 2011, China introduced RMB Qualified Foreign Institutional Investor (RQFII) program, which allowed investors to channel RMB raised offshore to invest in A-shares. From April 2013, citizens of Hong Kong, Macau and Taiwan living in Mainland were permitted to trade in the A-shares market. For Mainland retail investors, the only option to own foreign investments was through onshore Qualified Domestic Institutional Investor (QDII) products. These barriers came down when an innovative initiative, Stock Connect, came into force on 17 November 2014. SH-HK Stock Connect was a mutual market access programme that connected stock markets in Shanghai and Hong Kong. It was carefully designed to enable investors on both sides to invest in shares listed on the other s market. Trading and settlement of these shares would be carried out through their local exchange and clearing house. [See Exhibit 4 for Stock Connect Trade Flow.] All trades under SH-HK Stock Connect were conducted in RMB. Mainland investors would invest in Hong Kong-listed stocks using RMB, while overseas and Hong Kong investors would also use RMB to invest in Shanghai stocks. All RMB conversions occurred offshore in Hong Kong, which would be isolated from the onshore RMB market and have minimal impact on the Mainland s foreign exchange reserves. Stock Connect reflected a profound structural change of a gradual but accelerating opening of Mainland s financial markets and would become the framework for mutual market connectivity in the future. 10 With the smooth rollout of Stock Connect, preparations were under way for the launch of SZ-HK Connect, expected in 2016. The success of Stock Connect drew huge interest, especially from other exchanges in the region. In April 2015, HKEx held initial talks with Taiwan Stock Exchange ( TWSE ) about a possible link-up. 11 TWSE was also exploring with stock exchanges in Singapore, Japan, and London on the possibility of similar stock connect schemes. 12 In Southeast Asia, Singapore spearheaded the discussion of forming an ASEAN Trading Link with Malaysia and Thailand. 13 Building an Offshore RMB Ecosystem China s further opening up would see its capital market integrated eventually into international markets, allowing easy flows of Chinese capital into global markets and international capital into Mainland markets. This would require a truly international currency, the RMB in this case. HKEx recognised the importance of having a diverse RMB ecosystem, onshore and offshore, for the currency to develop to its full potential. By offering a series of RMB-denominated products, it would cultivate the ground for and speed up the internationalization of RMB. 10 Reuters, (8 April 2015), http://www.reuters.com/article/2015/04/08/us-china-markets-stock-connectiduskbn0mz0yy20150408 (accessed 23 August 2015) 11 Reuters.com (29 April 2015), http://www.reuters.com/article/2015/04/29/hkex-taiwan-idusl4n0xq39q20150429 (accessed 23 August 2015) 12 http://www.legalbusinessonline.com/news/taiwan-stock-connect-link-singapore-may-be-ready-near-year-end/68413 (accessed 23 August 2015) 13 http://www.reuters.com/article/us-sgx-ceo-asean-iduskbn0l12nh20150128 (accessed 22 December 2015) CENTENNIAL COLLEGE Page 4

Launching the SH-HK Stock Connect was a major breakthrough of the liberalisation of the Mainland s capital account. The capital market connectivity and cross-border RMB flows facilitated a healthy and vibrant offshore RMB investment ecosystem. On 30 November 2015, the International Monetary Fund (IMF) announced the inclusion of RMB in its Special Drawing Rights (SDR) basket. This marked a significant milestone of RMB s journey towards becoming a truly international currency. 14 Hong Kong was the largest offshore RMB market and the testing ground for the Mainland s RMB liberalization initiatives. However, it also faced competition from other financial centres in the world such as London and Singapore that were also keen to get a share of the offshore RMB business. Epilogue Thanks to its unique geographical location and position under One Country, Two Systems, HKEx has excelled on riding the giant wave of the Mainland s economic growth. It had diversified into the international commodities markets, launched an innovative mutual markets model, and started building an offshore RMB ecosystem. How can HKEx work to its advantage the Mainland s constraints of limited financial products and channels for overseas investments? With the rise of other offshore RMB markets such as Singapore and London, what are HKEx s niches in building a sustainable RMB ecosystem that attracts both international liquidity and Chinese liquidity? What is HKEx s relevance to the roadmap of China s internationalization? In the last 15 years, HKEx has made a remarkable achievement in serving Mainland companies for their financing needs and the investment community with an interest in China market. To move forward, who are the strategic clienteles of HKEx in building Hong Kong as an international and China s premier wealth management centre? 14 http://www.bloomberg.com/news/articles/2015-11-30/imf-backs-yuan-in-reserve-currency-club-after-rejection-in-2010 (accessed 22 December 2015) CENTENNIAL COLLEGE Page 5

Learning Objective: This case describes how HKEx has capitalized on the opportunities that have arisen from the gradual but accelerating opening up of China s capital market. Students will be required to evaluate HKEx s moves of diversifying into commodities market and launching the mutual access programme. Students will also discuss HKEx s strategy in building an offshore RMB ecosystem with a suite of RMB-denominated products. Suggested Questions: 1. Evaluate HKEx s diversification strategy into the commodities market. 2. How does the SH-HK Stock Connect work? What benefits does it bring to retail investors and the two markets? 3. How is the launch of RMB products relevant to HKEx s vision of becoming China s premier wealth management centre? CENTENNIAL COLLEGE Page 6

EXHIBIT 1 World s Leading Stock Exchanges by Market Capitalisation (As of June 2015) Worldwide Ranking Stock Exchange Market Capitalisation (US$ billion) 1 NYSE Euronext (US) 18,336.69 2 Nasdaq OMX (US) 6,745.63 3 Japan Exchange Group (Japan) 4,405.20 4 London Stock Exchange Group (UK) 3,962.37 5 Shanghai Stock Exchange (China) 3,951.57 6 NYSE Euronext (Europe) 3,184.31 7 Hong Kong Stock Exchange (Hong 2,992.28 Kong) 8 Shenzhen Stock Exchange (China) 2,651.23 9 Toronto Stock Exchange (Canada) 1,653.37 10 Deutsche Borse (Germany) 1,584.97 Source: Adapted from World Federation of Exchanges and Bloomberg http://www.sfc.hk/web/en/files/som/marketstatistics/a01.pdf EXHIBIT 2 HKEx Revenue and Net Profit (2005-2015) Year Revenue (HK$ million) Net Profit (HK$ million) 2005 2,694 1,340 2006 4,147 2,518 2007 8,390 6,169 2008 7,549 5,129 2009 7,035 4,704 2010 7,566 5,037 2011 7,855 5,093 2012 7,211 4,084 2013 8,723 4,546 2014 9,849 5,138 2015 (Jan - Jun) 6,853 4,083 Source: HKEx 2014 Annual Report www.hkex.com.hk/eng/exchange/invest/finance/2014/documents/f112_14.pdf HKEx 2015 Half-yearly Result https://www.hkex.com.hk/eng/exchange/invest/results/documents/150812_accounts_e.pdf CENTENNIAL COLLEGE Page 7

EXHIBIT 3 RMB-Denominated Products Listed on HKEx Source: HKEx Group 2015 Interim Results Presentation (12 August 2015) http://www.hkex.com.hk/eng/newsconsul/hkexnews/2015/documents/1508122news.pdf (P33) CENTENNIAL COLLEGE Page 8

EXHIBIT 4 Stock Connect Trade Flow Source: Shanghai-Hong Kong Stock Connect Information Book for Investors, HKEx (updated 30 July 2015) https://www.hkex.com.hk/eng/market/sec_tradinfra/chinaconnect/documents/investor_book_en.pdf (P4) CENTENNIAL COLLEGE Page 9