Cindy Chen – Trades settle faster when information is shared simultaneously instead of sequentially

Hong Kong Exchanges and Clearing (HKEX) is running one of the highest-profile blockchain projects in the securities industry. If its origins are specific (to resolve operational challenges for international financial institutions and investors executing a growing volume of Stock Connect trades that settle to T+0 timetable) and its focus narrow (getting post-trade processes in shape for greater accuracy, faster settlement, as well as better buy-in processes and prevention of failed trades) the consequences of success could be far-reaching. If asset managers, brokers and custodians can gain simultaneous access to transactional data in near real-time to settle buys and sells transacted via Stock Connect, they might well start asking to see the same information in a lot of other places too. But Cindy Chen, head of post-trade business development at HKEX is focused first and foremost on resolving the problems for the China markets and international custodians, brokers and investors.

“We are leveraging this technology to transform the post trade workflow,” says Cindy Chen, head of post-trade business development at Hong Kong Exchanges and Clearing Limited (HKEX). HKEX is working with a specialist blockchain technology vendor to pioneer the enhancement of an existing post-trade process by introducing a private permissioned network based on distributed ledger technology (DLT).

The HKEX DLT platform operates mainly pre-settlement

The challenge that HKEX hopes to resolve is the need to accelerate post-trade transaction processing to a speed at which it can keep up with the fact that the burgeoning mainland China stock markets settle on trade date (T+0).  “There are some big ideas such as shared ledgers, smart contracts and immutable records coming from blockchain or DLT development and innovations that can be adapted to solve key challenges resulting from the short settlement cycle,” says Chen, who joined the exchange at the turn of the year from the securities services division of Citibank. “We are creating a blockchain-powered post-trade processing network upstream of the central securities depository (CSD) to enable all the parties to a transaction to get the information they need to process on a parallel basis so that the transaction can reach the CSD for settlement finality quicker.”

What necessitates that rapid upstream sharing of information prior to settlement is the compressed settlement timetable pursued by the Mainland China stock exchanges of Shenzhen and Shanghai. “In the 20-plus years I have worked in the post-trade industry, it has always worked on a sequential basis,” explains Chen. “One intermediary completes their task before handing off to the next intermediary in the chain. It works fine in a T+2 environment, so there was no reason to change. But when you have to settle on T+0, it does not work well at all.”

As it happens, Chen knows a great deal about the difficulties of settling trades on T+0. At Citi, a key priority was to improve the settlement of China A share trades through the Stock Connect links between HKEX (which settles on T+2) and the Shanghai and Shenzhen stock exchanges (which settle securities on T+0). So she brings real-world experience to helping HKEX fulfil its stated strategic goal of making Stock Connect an even more important gateway into and out of the Mainland China stock markets for international investors and their agents.

HKEX is getting ready for a surge in transaction volumes

But the long-term attraction for Chen is the accompanying strategic priority: what she calls technology empowerment or, more plainly, the modernisation of the systems of HKEX. “We want to enhance and expand the products and services we offer to the market, and improve the client experience from trading, through clearing, to settlement,” she explains. “But we also want to improve our operational efficiency so we can cope with the increased flow of cross-border transactions as the weight of China A Shares in the MSCI indexes is increasing between May and November this year. We expect to intermediate further outflows as well, as China continues to liberalise investment abroad.”

HKEX is raising its strategic focus on post-trade services, at a time when it seeks to fulfil its ambition to capitalise on the continued growth of Stock Connect, which is the main reason for MSCI including the China A-share market in its index. HKEX has identified a lingering obstacle to the continued growth of Stock Connect: the additional costs created by the fact that the Chinese market has pre-trade checking requirements  and compulsory buy-ins.

The DLT network aims to reduce risk and cost for China A-share investors

The risk of incurring the cost of a buy-in will remain higher in Stock Connect, as long as the settlement timetables of the Shanghai and Shenzhen exchanges (which settle securities on trade date, or T+0, and cash on T+1) remain out of alignment with the international standard of T+2 for both cash and securities. The mismatch is exacerbated by the fact that many foreign investors are based many time-zones away from China.

For international asset managers, for example, the logic of settlement on T+2 is impeccable. It gives them, their broker, their global custodian and the sub-custodian to the global custodian time to complete a sequence of reconciliations in which the price of the trade and the fees and commissions are agreed sequentially and bi-laterally and the cash and securities are put in position to settle at the CSD without the risk of incurring a penalty. T+2 also matches the foreign exchange spot market settlement timetable, since most cross-border investors will also be buying or selling Renminbi.

In the Shanghai and Shenzhen exchanges, on the other hand, brokers are required to check that counterparts actually have the cash or stock in their account before permitting a trade to be executed on the exchange and proceed to settlement. “We are talking about compressing two days of work on post-trade allocations and settlement initiations into four hours between 3.00 pm and 7.00 pm Hong Kong time,” explains Chen. “Time zone differences mean it is very difficult for investors based in Europe or the Americas to perform to that timetable.”

It is precisely because this timetable is so tight that HKEX has worked over the last 18 months and successfully developed a Proof of Concept to deploy distributed ledger technology (DLT) in the Stock Connect settlement process. “The sequential process does not work well in a T+0 environment,” says Chen. “We need a technology to enable everybody along the chain – the asset manager, the global custodian, the broker, the clearing participant and the sub-custodian – to get access to the necessary information and status of the trade in near real-time simultaneously, so they can complete their share of the process in time to settle.”

Asset managers, brokers and custodians gain simultaneous near real-time access to post-trade data

“The prototype demonstrated near real-time synchronisation of post-trade status between asset managers, brokers, custodians and the Hong Kong Securities Clearing Company Limited, the HKEX clearing house,” explains Chen. “This enables these financial institutions to complete their compliance checking and internal processes such as confirmation, affirmation, sanction, credit and position checks, and FX and cash settlement,  simultaneously, instead of the chain having to wait for one link to complete its part of the settlement process before passing the information along to the next link.”

This does not mean every member of the network sees everything (it is after all, a private network). Instead, the DLT technology allows HKEX to show each member only what they need to see. “Each member sees only what is relevant to what they need to do,” explains Chen. “For example, the global custodian sees the settlement details, but it does not see the commission paid to the broker. The technology gives us the flexibility to share information on a need-to-know basis, and not simply show the complete record of the whole transaction to everybody.”

The HKEX Stock Connect DLT solution is taking advantage of the key features of blockchain technology, such as shared ledgers, smart contracts and immutable records, to provide near real-time information to the relevant parties and eliminate the time-consuming and expensive bi-lateral, sequential post trade processes and layers of reconciliation. But in order to benefit from this solution, they have of course to invest in a connection to the DLT network.

Connection to the DLT network is flexible

The cost and complexity is not trivial, but Chen argues the investment pays off quickly, because members of the network get quicker access to far more data about trades than can ever be encapsulated even in a series of bi-lateral and sequential SWIFT messages. “We are not making this mandatory because we are confident that the value it adds will make it attractive,” says Chen.

Making it optional also gives users the flexibility to opt in any clients willing to pioneer the new technology and opt out the clients that prefer to wait and see – though having to support both the old technology and the new does impose some additional costs on intermediaries. For ease of adoption and to minimize the incremental costs for members, HKEX for now plans to host the entire DLT network itself: members do not yet have to run their “nodes” themselves.

HKEX has also incorporated the functionality (“backward compatibility” as Chen dubs it) to receive and send SWIFT messages, and an API to give users access to the data on the DLT network. “Supporting existing forms of connectivity creates less of a barrier for the industry to adopt and deploy this technology,” says Chen. “You have to continue to support the standard forms of connectivity global firms have invested heavily in. It is also difficult to make changes quickly at large global institutions, so we have to be patient, and provide support during the transitional period. Once they see the benefits of this technology, in terms of richer, more accurate and more up-to-date data, as well as the ability to leverage and create value added services, then they will likely want to take charge of their own `nodes.’”

That willingness to accommodate and to wait has not prevented HKEX from soliciting the support of institutional investors, brokers and custodian banks for its DLT strategy. “We have had a lot of market engagement with this project from investors, custodians and brokers globally,” explains Chen. “In fact, we have received very positive feedback, because the goal of the solution is to resolve their key pain points.” She adds that many banks and brokers agree it is relatively straightforward for them to adopt the technology so long as HKEX is running the entire network, and that they are excited by the possibility of developing value-added services of their own once they take charge of their own “nodes.”

The HKEX DLT platform will be of interest to other CSDs

For its own part, HKEX has experience working with blockchain vendors and is continuously looking at other processes where DLT might help. However, the Stock Connect DLT solution is likely the first DLT initiative to go live. There is no agreed timetable, but the HKEX Post Trade Business Development team is now refining the user requirements and technology solution based on a revised set of specifications and feedback from investors, who are the key market participants. Chen says the exchange aims to deploy the DLT solution “as soon as possible.”

But DLT is only one of several technologies the exchange is exploring. Last year, HKEX established an Innovation Lab to explore and filter technologies that can help its various businesses improve and enhance existing services and invent new ones. It is looking, for example, to leverage advanced data analytics, artificial intelligence (AI) and machine learning (ML) to improve the efficiency and accuracy of data. “These technology advances are important tools to help transform data into a new asset class for financial markets,” says Chen.

The experience of the Innovation Lab with AI is now being applied to another post-trade inefficiency: improving the accuracy of corporate actions data. “The corporate actions team is training the AI to pick up the key fields in unstructured corporate actions notifications,” explains Chen. “Over time, it can replace the manual process of compiling corporate actions messages.”

Chen agrees that the DLT technology being developed by HKEX will be of interest to other markets, especially those affected by compulsory buy-in regimes, such as the European markets regulated under the Central Securities Depositories Regulation (CSDR). “I think there is definitely a lot of value in what we are doing for other markets but let us first make it a success in Hong Kong,” concludes Chen. “Once it is working, we would be happy to see if we can generate the same benefits for other markets.”

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