Shanghai-Hong Kong Stock Connect: New short selling rules.

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1 March 2015 Shanghai-Hong Kong Stock Connect: New short selling rules. With the launch of the Shanghai-Hong Kong Stock Connect ( Stock Connect ) in November of last year, foreign investors now have direct trading access to many shares listed on the Shanghai Stock Exchange ( SSE ). One feature that was not introduced at the time of launch is the ability for Stock Connect investors to engage in short selling. Hong Kong Exchanges and Clearing Limited ( HKEx ) have recently announced 1 that short selling will commence on 2 March 2015 pursuant to amendments to the rules of the Stock Exchange of Hong Kong Limited ( SEHK ) that have been approved by the Securities and Futures Commission. Contents Covering of Short Selling Orders... 2 Uptick Rule... 3 Flagging and periodic reporting... 3 Short Selling Ratio... 4 Next Steps... 4 Several aspects of the new Stock Connect short selling rules are similar to requirements in other international markets, namely: > naked short selling is categorically prohibited; > only certain shares will be eligible for short selling. The list of Stock Connect shares eligible for short selling will generally correspond to those shares that the SSE permits to be short sold domestically (except for shares that are subject to trading restrictions in Stock Connect, known as Special China Connect Securities ); > short selling is subject to an uptick rule, based on the last execution price. There are, however, certain aspects of the new rules that are different from other markets, namely: > the way in which short selling orders are covered; > the applicability of the uptick rule to certain long sales; > the periodic reporting requirements; and > the variable limits that apply to the volume of short selling permitted via Stock Connect. These requirements are largely intended to harmonize Stock Connect trading with Mainland China requirements and practices. Stock Connect participants 1 Shanghai-Hong Kong Stock Connect: New short selling rules 1

2 and investors will need to be mindful of these differences once the finalized new rules come into force. Covering of Short Selling Orders The Securities and Futures Ordinance ( SFO ) requires brokers executing a short selling order in respect of Hong Kong listed shares to have obtained a documentary assurance from clients (for example, a confirmation that shares are available for lending to settle the sale if executed) to ensure that such orders are covered. Although this requirement will not apply to Stock Connect trading, China Connect Exchange Participants ( CCEPs ) will need to ensure that their clients have borrowed sufficient shares to cover a short sale in SSE shares via Stock Connect under the new SEHK rules. The persons from whom the clients can borrow are limited to their brokers who are CCEPs approved by the SEHK for stock lending. The CCEPs may either lend from their own principal holdings or via stock that they have in turn borrowed from other SEHK participants or certain other Qualified Institutions. At present, the categories of Qualified Institutions includes funds managed by Type 9 licensed asset managers and CCASS participants (which includes custodian participants). This represents a wider list of eligible stock lenders than in Mainland China, where investors may only borrow shares from its securities broker. CCEPs are also subject to a monthly reporting requirement in respect of any stock borrowing and lending activity they engage in (either as lender or borrower) 2. Where the executing CCEP is also the lender of the shares, the executing CCEP should know whether there are sufficient borrowed shares in the relevant account to cover the relevant short sale as a matter of course. However, it is also possible for clients to borrow shares from one CCEP with which it has an account and use those shares to cover short sales executed through another CCEP. In this situation, the executing CCEP will need to have appropriate arrangements with the client to confirm the quantity of the borrowed shares and ensure they are delivered to its CCASS account in time for the relevant pre-trade check in order to execute the short sale. Because the pre-trade checking requirements will apply to short selling through Stock Connect, 3 the borrowed shares will need to be in the account of the client or its custodian in time for the daily pre-trade check, which may require the borrow to be in place on the day before the short selling order is executed. This reflects the practice for short selling by domestic investors on the SSE, and therefore PRC and international investors are subject to equivalent requirements. 2 3 Note, however, that the provisions of the Sixth Schedule of the SEHK Rules, which set out various collateralisation and other requirements on stock lending conducted by SEHK participants, does not apply to Stock Connect stock borrowing and lending. Please see our earlier Bulletin for further information on pre-trade checking under Stock Connect. An enhanced pre-trading checking model for Stock Connect has also been recently announced. See related circular and participant briefing. Shanghai-Hong Kong Stock Connect: New short selling rules 2

3 Uptick Rule As noted, short selling of Stock Connect shares will be subject to an uptick rule, where orders may only be placed at or above the most recent execution price (or the previous day s closing price if there have not yet been any executions on a particular trading day). Consistent with the requirements of the SSE, the Stock Connect uptick rule applies whenever a person has any outstanding stock borrows for the purpose of short selling, up to the amount of the outstanding borrow. In other words, even if a sale is to be settled out of an investor s long inventory (for example, where an investor runs a separate trading book), it may be subject to the uptick rule if the investor has an open short position. CCEPs must require their client to comply with this requirement. Flagging and periodic reporting The executing CCEP will be required to flag a short selling order when it enters the order into Stock Connect. To ensure compliance with this requirement, the executing CCEP may seek to put in place appropriate language in its client terms to require the client to notify it when a sell order is a short selling order. Executing CCEPs will also be subject to two new reporting obligations in respect of short selling, which will require brokers to track their and their clients open short positions: > Weekly report of short selling activities CCEPs that execute short selling orders will be required to submit a report before the start of trading on the first day of the week if they or their clients were engaged in any short selling activities in the previous week, had any open short positions or closed out any open positions. > Large open short report CCEPs and SEHK participants that trade Stock Connect shares through CCEPs will be required to file a report if the combined value of their and their clients open short positions exceeds RMB25 million or 0.2% of the issued share capital for a particular stock. The report must be filed after market close on the last trading day of a calendar week in which one of the thresholds has been met. Note that this timing is different from the Securities and Futures (Short Position Reporting) Rules for short positions in SEHK-listed shares, which requires reporting by the end of the second trading day in the following week. Where a client borrows shares from another CCEP to cover a short sale, the executing CCEP will need to have an arrangement with its client for the client to notify it when the borrowed shares have been returned to the other CCEP, so that the executing CCEP may be able to comply with its obligation to report the closing out of open short positions. Note that the requirements to make the above short selling reports will apply in addition to the requirement to provide a monthly report of stock borrowing and lending activities. Shanghai-Hong Kong Stock Connect: New short selling rules 3

4 Short Selling Ratio While there is not a fixed quota on the volume of short selling possible via Stock Connect, there are certain variable limits calculated by reference to the volume of shares in a particular Stock Connect stock held in aggregate by Northbound investors on a given day and over a period of time. > Firstly, on any given day, executed short selling orders for a particular stock may not comprise more than 1% of the total number of that stock held by Northbound investors as of the beginning of the trading day this is referred to as the Short Selling Ratio. So, for example, if Northbound investors held 100 million shares of Stock X at the beginning of a trading day, only 1 million shares of Stock X may be sold short on that day. > Secondly, the cumulative Short Selling Ratios of a stock over any period of 10 consecutive trading days may not exceed 5% (which again reflects only the holdings of Northbound investors). Therefore, if over the previous 9 trading days the cumulative Short Selling Ratios added up to 4.5%, the remaining Short Selling Ratio would only be 0.5% on the tenth trading day. One implication of the Short Selling Ratio is that if a stock is thinly traded via Stock Connect, Northbound investors may only be able to short sell it in limited quantities, even if there is active domestic trading on the SSE in that stock. The SEHK will monitor the amount of short selling available under both the daily and cumulative limits on a real-time basis and will provide updated information via its website on the amount of quota available every 15 minutes throughout the trading day. Next Steps While the new Stock Connect short selling rules and related stock borrowing requirements are more restrictive than what market participants are used to in Hong Kong and other markets, this can be understood given the practices and policy concerns in Mainland China, where the market is more closely regulated. The regime is in no doubt a step forward in making stock borrowing and short selling of A shares more widely available to offshore investors and improving liquidity in the Stock Connect A share market. Market participants that are considering offering short selling services to their clients may wish to consider what adjustments they will need to make in order to comply with the new requirements. This may include: > considering changes to client terms to include short-selling related provisions, such as imposing requirements to flag Stock Connect short sales, comply with the uptick rule price requirement, inform the CCEP of the return of borrowed shares and disclose any other salient matters in relation to Stock Connect short selling; Shanghai-Hong Kong Stock Connect: New short selling rules 4

5 > supplementing existing stock borrowing and lending documentation to cater for requirements relating to stock lending of Stock Connect shares by a CCEP to its clients or other CCEPs and/or stock borrowing of Stock Connect shares by a CCEP from other CCEPs, non-registered exchange participants or qualified institutions; > reviewing trade and position reporting systems to ensure that the firm will be able to comply with the new reporting obligations; and > ensuring that trading systems will be able to comply with pre-trade checking requirements for short-selling orders. Author: Karen Lam, Kevin Marr This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. Linklaters. All Rights reserved 2015 Linklaters Hong Kong is a law firm affiliated with Linklaters LLP, a limited liability partnership registered in England and Wales with registered number OC It is a law firm authorised and regulated by the Solicitors Regulation Authority. The term partner in relation to Linklaters LLP is used to refer to a member of the LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP and of the non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ, England or on Please refer to for important information on our regulatory position. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by ing us at marketing.database@linklaters.com. Contacts For further information please contact: Chin Chong Liew (+852) chin-chong.liew@linklaters.com Stephen Fletcher (+852) stephen.fletcher@linklaters.com Teresa Ma (+852) teresa.ma@linklaters.com Kevin Marr (+852) kevin.marr@linklaters.com Karen Lam (+852) karen.lam@linklaters.com I-Ping Soong (+852) i-ping.soong@linklaters.com Simon Zhang Managing Associate (+852) simon.zhang@linklaters.com Derek Chua Managing Associate (+852) derek.chua@linklaters.com 10th Floor, Alexandra House Chater Road Hong Kong Telephone Facsimile / Linklaters.com Shanghai-Hong Kong Stock Connect: New short selling rules 5 A /0.6/02 Mar 2015