3. Settlement
Regarding settlement in Bond Connect, it`s divided into bond settlement and cash settlement. The former settlement arrangement is featured with the multi-tier custody structure while the latter mainly adopts the Cross-Border Interbank Payment System (hereinafter CIPS). Settlement is affected on the basis of delivery versus payment (DVP)[1].
3.1 Bond Settlement—Multi-Tier Custody Structure
3.1.1 Multi-Tier Custody Structure
The multi-tier structure, commonly applied in global market, is differentiated from the traditional custody with single-tier structure. The structure is as follow:
Primary Custody: SHCH & CCDC play the roles of Central Securities Depositories (CSDs), processing settlement in the primary level. CMU shall open the nominee holder account with the two CSDs for the purpose of recording the outstanding balance of all bonds it holds for investors. As the matter of fact, all trading bonds is circulated and settled within the system of SHCH/CCDC.
Secondary Custody: CMU here plays the role of the secondary custodian. CMU members shall open subaccounts in CMU system. CMU holds the assets on behalf of its members. The assets consist of both self-owned investments of CMU members and investments owned by the members’ clients. Overseas investors may either apply for CMU membership or entrust CMU members for custody and settlement to participate in Bond Connect.
Ø Relationship between CMU and Overseas Investors
Shanghai Clearing House Detailed Operation Rules for Registration, Custody, Clearing and Settlement of Bond Connect Cooperation between the Mainland and Hong Kong (Trial Implementation):
Article 7: Bonds purchased through “Northbound Trading” by overseas investors should be registered in the nominee account(s) opened by HKMA CMU with Shanghai Clearing House and the overseas investors shall enjoy the rights and interests of the securities according to applicable laws. HKMA CMU shall in its own name, exercise its rights to bond issuers through Shanghai Clearing House. Prior to excising its rights to bond issuers, HKMA CMU shall firstly consult with overseas investors and then take actions accordingly.
Article 7 shows the indirect mandate agency relationship between overseas investors and CMU. The relationship is stipulated in Article 925 of the PRC Civil Code:
The contract is directly binding upon the mandator and such third party where the mandatary enter into a contract in its own name with a third party who is aware of the mandate relationship between the mandator and mandatary.
That is, overseas investors (as the mandatary principal) and the PRC market makers (as the third party) shall be bound by obligations and rights in the transaction contracts, though it’s CMU (as the mandator agent) that exercises those rights pursuant to the mandate agency relationship.
3.1.2 Bond Settlement
Bond settlement between CMU and market makers is processed within the system of SHCH and CCDC. Offshore investors can choose from T+N settlement cycle at their own discretion. As soon as the trade is concluded, the transaction data will be automatically passed from CFETS to CCDC or SHCH for clearing and settlement. SHCH/CCDC will then send the confirmation request to CMU and market makers.
DVP settlement will be executed upon the confirmation: In the case that the seller has sufficient bonds for settlement, SHCH puts the bonds on hold, credits the funds to the seller’s account, then transfers the bonds to the buyer’s account. Meanwhile, overseas investors may inquire about their bond account balances and movements at CMU through relevant CMU members and obtain relevant reports such as settlement and delivery report and account balance report from CMU through relevant CMU members.
3.2 Cash Settlement--CIPS
3.2.1 Currency
Pursuant to Circular 1, overseas investors may invest with their own RMB or foreign currency funds. In the case of foreign currency investments, overseas investors may, through the bondholders, conduct foreign currency exchange with a Hong Kong RMB business clearing bank or an offshore RMB business participating bank in Hong Kong SAR which has permission to trade in CIFXM (hereinafter Hong Kong SAR Settlement Banks). investors shall open a RMB cash account with a Hong Kong SAR Settlement Bank for the specific purpose of currency exchange and settlement under the Northbound Trading. Funds in the RMB cash account shall remit to CIPS Co., Ltd for further settlement.
Besides, overseas investors shall exchange proceeds into foreign currencies on maturity or sale of the bonds and remit the proceeds out via the Hong Kong SAR Settlement Banks.
3.2.2 Cash Payment
Overseas investors may apply for a CMU member or entrust a global/HK custodian that carries a CMU membership to conduct cash payment. As the secondary custodian, CMU shall bookkeep its members asset (including cash and bonds) in CIBM individually. In the process of cash payment, market makers are connected with CMU via CIPS.
Since 2021, CMU and SHCH have officially connected to the CIPS system and become members of CIPS direct participant (hereinafter CIPS DP). Prior to that, cash payment could only be processed via Bank of China HK Branch (as a CIPS DP).
3.2.2.1 Cash Payment in SHCH
Pursuant to SHCH Business Guideline, two methods of cash payment may be applied:
A. Both parties entrust CIPS DP to conduct cash payment.
Under method A, SHCH doesn’t participate in the payment. It simply receives the payment result to initiate the execution of bond settlement.
Once the settlement confirmation done, the buyer shall remit the full amount of settlement cash through CIPS message to the CIPS account designated by the seller before 13:00. Upon receiving the cash in full, the seller shall check the authenticity and accuracy of settlement information provided in postscript and inform the CIPS DP to send CIPS messages to SHCH before 15:30. SHCH shall process bond settlement accordingly and feedback the results.
B. CMU entrusts SHCH to conduct cash payment.
Under method B, SHCH plays the role of an intermediary of both bond and cash settlement.
Ø CMU as the buyer
CMU shall open a dedicated cash account with SHCH and shall entrust overseas CIPS DP to remit the settlement cash to the cash account of SHCH via CIPS before 13:00 on the settlement date. Once both parties confirm the settlement, SHCH shall verify whether the remittance is received in full and the seller has sufficient positions, debit the buyer’s dedicated cash account, remit the settlement cash to the CIPS account the seller dedicated, and deliver the bonds to the buyer simultaneously. Provided that the seller has insufficient positions in its account, cash payment and bonds delivery shall not be processed.
Ø CMU as the seller
Upon settlement confirmation done, the buyer (or its agent bank) shall remit the settlement cash to SHCH CIPS cash account before 13:00 on the settlement date. After verification of the sufficiency of positions and the accuracy and authenticity of the payment information, SHCH credits the special cash account of the seller and delivers the bonds to the buyer. Providing that the seller has insufficient positions in its account by the end of settlement date, cash remittance and bonds delivery shall not be processed and SHCH will refund cash to the buyer.
3.2.2.2 Cash Payment in CCDC
Step 1 Upon receiving the trading date from the electronic trading platforms that are approved by PBC, CCDC will generate settlement instructions for the trading parties to confirm before forming the settlement contracts.
Step 2 On the specified date of settlement, CCDC will check the bond balance of the seller. If it is sufficient for settlement, CCDC will lock the bonds.
Step 3 Upon completion of the payment by the payer, the two parties of trading shall send to CCDC their confirmation documents with electronic authentication code or seal specimen before 15:30 on the date of delivery. After the receipt and verification of the documents, CCDC will proceed with the transfer of bonds.
3.2.3 Failure of Settlement
Basically, settlement fails due to the insufficiency of bond or cash. SHCH and CCDC will unlock the relevant bonds. The trading parties are liable to the default, instead of SHCH/CCDC and CMU.
The failure shall be filed. Under the situation where a transaction is invalid or settlement failure occurs, both parties shall submit Filing Form of Settlement Failure of Bond Transactions, affixed with both parties' business seals to SHCH. CMU shall affix its own business seal as a nominee holder on behalf of overseas investors.
4. Taxation
The tax policies of foreign investors investing in the traditional interbank bond market shall be applied to Northbound.
4.1 Taxation on Bond Interest Income
According to the Announcement of the Ministry of Finance and the State Taxation Administration on Continuing the Enterprise Income Tax and Value-Added Tax Policies for Overseas Institutions' Investment in the Domestic Bond Market (No.34 [2021] of the Ministry of Finance and the State Administration of Taxation, hereinafter as Circular 34), the bond interest income of overseas institutions derived from investments in the PRC bond market is temporarily exempt from corporate income tax and value-added tax. Therefore, the bond interest income obtained by foreign institutional investors from CIBM Direct is not subject to corporate income tax and value-added tax.
4.2 Taxation on Transferring Bonds
Currently, there are no special regulations on the foreign institutional investor taxation of transferring bonds. Thus, Enterprise Income Tax Law of the People's Republic of China (2018 Amendment) are applied.
A foreign institutional investor is a non-resident enterprise that have no branch or establishment in China but have income sourced from China. Its income derived from transferring bond, deemed as one kind of income from asset transferring, shall be taxed 20%.
5. Conclusion
Bond Connect has been the main access for overseas investors enter into CIBM. By February 2023, 786 registered investors[2] had been attracted to participate in Northbound Trading, accounting for approximately 60% of the total overseas institutional investors entering CIBM. Bond Connect maintained relatively high liquidity while the global financial market was brought down by the Dollar Shortage during the pandemic.
In recent years, new measures have been carried out intensively to enhance the Scheme of Northbound Trading, including: the launch of Defaulted Bond Transfer service, ePrime and Defaulted Bond Transfer service, enablement of special settlement cycles beyond T+3 & recycling settlement and the introduction of dealer pay method. For further opening-up of the PRC financial market, Bond Connect may enrich the types of trading and complete the rules of debenture bond. Chance Bridge will follow up with the innovative practice of Bond Connect and keep updating our insights.
Contacts: Wenhui Luo wenhui.luo@chancebridge,com
Wen Liu [email protected]
[1] The list check at https://www.chinabondconnect.com/en/Northbound/Onboarding/Approved-Investors.html
[2] Delivery versus payment (DVP) is a securities industry settlement method that guarantees the transfer of securities only happens after payment has been made. DVP stipulates that the buyer's cash payment for securities must be made prior to or at the same time as the delivery of the security. see https://www.investopedia.com/terms/d/dvp.asp