China-Hong Kong Swap Connect: What Does it Mean for Foreign Investors?

Swap Connect is another milestone in China’s financial opening up that further facilitates offshore investors interested in participating in the mainland financial derivatives market. The Swap Connect clearly intends to expand Hong Kong’s role as a connector between China and the world.

On July 4, 2022, authorities in mainland China and Hong Kong announced that they will jointly launch a “Swap Connect” program in six months to facilitate offshore investors’ access to the mainland interest rate swap (IRS) market.

This announcement came on the same day as the official launch of the ETF Connect, which saw recorded RMB 150 million (HK$175.96 million or US$22.3 million) in northbound transactions and trading and HK$84.13 million (RMB 72.07 million or US$10.72 million) in southbound transactions on its first day of trading on July 4, 2022.

Both programs are designed to further open China’s financial market to overseas investors. Meanwhile, as the opening came just a few days after the 25^th anniversary of Hong Kong’s return to China on July 1, the two new cross-border trading schemes reflect Beijing’s commitment to maintaining and expanding Hong Kong’s role as a connector between China and the world.

What is Swap Connect and how will it work?

Swap Connect is a new financial opening-up program that aims to enhance the interconnection and cooperation between Hong Kong and the mainland financial derivatives market.

Hong Kong Exchanges and Clearing Limited (HKEX), through its clearing subsidiary OTC Clear, is working in partnership with China Foreign Exchange Trade System (CFETS) and Shanghai Clearing House (SHCH) to build the Swap Connect. Its official launch date, likely in six months, will be confirmed after regulatory approval and the completion of operational arrangements.

Under Swap Connect, investors on both sides can mutually access the IRS market of Hong Kong and mainland China and conveniently complete transactions and clearings without changing their trading habits. Global investors will be able to trade in the onshore IRS market by using existing international practices, including legal documentation, clearing, settlement, and risk management procedures.

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In the initial stage, Swap Connect will first allow investors wider access to the IRS markets. An IRS refers to a practice in which two parties exchange interest payments through a derivative contract. Such a swap can hedge risks, reducing investors’ exposure to uncertainties in the financial market.

More specifically, the program is enabled through a connection between the clearing houses in both mainland China and Hong Kong. It will first commence northbound trade to allow offshore investors to participate in the mainland’s IRS market. It will then enable the southbound trade based on market conditions to allow mainland investors to access the Hong Kong derivatives market.

In this process, CFETS will provide trading services for international investors through overseas third-party platforms recognized by the People’s Bank of China (PBOC). It will transmit real-time transaction information to OTC Clear and SHCH to support the efficient clearing of these transactions. OTC Clear and SHCH will then build a clearing link to provide central clearing services, where OTC Clear serves Hong Kong and international investors and SHCH focuses on mainland investors. The two clearing houses will also tackle the daily operation, including margin management, settlement payments, and default risk control through the establishment of a central counterparty margin fund.

A look at the multiple “Connects” between Mainland China and Hong Kong

Over the past few years, China has strived to further open up its financial market via Hong Kong. Its very first endeavor with the “Stock Connect” has yielded valuable experience and knowledge to configure other programs facilitating mutual market access.

• Stock Connect was launched between the Shanghai and Hong Kong stock exchanges in 2014 and extended to the Shenzhen stock exchange in 2016. The program enables investors from the mainland to buy shares from companies listed in Hong Kong and provides streamlined access for Hong Kong and international investors to invest in Chinese A-shares listed on the mainland.
• Bond Connect was launched in 2017 and provides northbound access to offshore investors to the China Interbank Bond Market through Hong Kong. In September 2021, the launch of the southbound part completed this two-way channel.
• Wealth Management Connect was launched in October 2021 and is the first two-way investment mechanism for individual investors in the GBA. Under the scheme, mainland residents of the nine Guangdong cities in the GBA are allowed to invest in certain products sold by banks in Hong Kong and Macao via the “southbound link”. Meanwhile, Hong Kong and Macao residents are also able to invest in eligible products distributed by mainland banks in the GBA via the “northbound link”. 
• ETF Connect was recently launched in July 2022 and allows global investors to tap into 83 exchange-traded funds (ETFs) in China – 53 in Shanghai and 30 in Shenzhen – through accounts held in Hong Kong. The ETF Connect is expected to attract up to RMB 200 billion (US$29.74 billion) in investments within a year or two.

What would be the impact of Swap Connect?

Swap Connect marks a new move for China to bolster efforts to further open its financial market to overseas investors. As offshore investors become more active in trading Chinese bonds, their demand for derivatives to manage risks of fluctuating interest rates will continue to grow. Foreign investors will find the Swap Connect program useful, as it helps them hedge their interest rate risk exposure.

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China’s bond market has seen rapid growth in recent years, particularly since the establishment of Bond Connect in 2017. At the end of 2021, overseas investors held RMB 4 trillion (US$627 billion) worth of RMB-denominated bonds, accounting for 3.5 percent of the total outstanding bonds under custody, according to data from the PBOC.

Nonetheless, progress has not been without setbacks. Due to the resurgence of the domestic pandemic, foreign investors cut their holdings of onshore RMB bonds for multiple months in a row earlier this year.

The launch of the Swap Connect program thus serves as one of China’s efforts to address these challenges and increase the attractiveness of its bond market. In the longer run, this mechanism will help stabilize the bond market development in China, as it encourages continuous investing and improves the efficiency of cross-border IRS trading and clearing.

To summarize, the extension of market access to over-the-counter derivatives through Swap Connect will mark another milestone in China’s financial opening, enabling global investors to participate more broadly in the vast mainland bond market. This new mutual access mechanism will also augment Hong Kong’s role as an international financial hub.

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