Navigating the QDII maze
April 2008 - The Qualified Domestic Institutional Investor (QDII) program has presented Chinese retail and institutional investors with access to global securities markets. As many of us have read in recent months, the success of the program has shaken the foundations of the fund management industry around the world, by highlighting the current and future potential of this immense fund market.
Looking past the celebrations in Shanghai, Beijing and Shenzhen following each QDII fund launch, the mutterings of COO’s the world over can be heard - expecting the emerging market infrastructure of China to collide with the straight-through processes of Western partners and suppliers, as each renminbi makes its way to the stock markets of the world.
What sets the QDII program apart from other well-known programs originating in China, in particular the Qualified Foreign Institutional Investor (QFII) program, is its surprising commitment to global settlement and communication standards. An erstwhile reviewer of standard QDII workflows between the investment manager, custodians, brokers and markets would likely think he is reviewing the process map of a US fund investing in the UK, not a fund originating from Shenzhen. Remnants of a centralized system appear only in foreign exchange transactions that can represent a challenge, but China is not the only market that can lay claim to FX-related bottlenecks.
When the Chinese regulators introduced the QDII program, their objective was the education of Chinese institutions and the development of world-class investment and operational standards. Foreign institutional sub-advisory of funds was almost a prerequisite, and room was made for the inclusion of a global custodian in tandem with a local Chinese custodian. Emulation of global workflow standards was not an accidental by-product, but an intentional plan to ensure that Chinese institutions would adhere to, and learn within, an environment of global standards.
Successful QDII relationships must encompass a dedication to operational excellence, through the application of professional and regular education of both partner institutions. This includes both sub-advisors to the fund as well as the global custodians entrusted with the efficient settlement and reporting of fund holdings.
The Bank of New York Mellon supports bi-monthly seminars on every aspect of operational excellence to both clients and prospects in all major Chinese cities, with the understanding that a common understanding of products, services, systems and procedures has a significant impact on the efficiency and success of the overall relationship. Topics covered include Accounting, Operations, Compliance, Global Custody and Settlement, delivered in Chinese by professional trainers under the employ of the bank.
Global partner institutions must recognize that prior to the QDII program, which has been in existence for less than a year, all Chinese institutions have been operating in a trade-date environment - knowledge of T+3 settlement processes should not be assumed. Extrapolate these local Chinese standards through the full spectrum of trade flows across international markets, and the need for education across both domestic and global platforms becomes clear.
To begin a detailed analysis of educational requirements within the QDII space, we should begin with an understanding of the legal framework of funds originating in China. Chinese regulators have done an outstanding job of introducing best global practice into their financial system. They continue to visit and learn from the world’s top regulators and think-tanks, in an effort to ensure that China maintains a regulatory framework that is wide enough to sustain growth, whilst minimizing illegal or dubious practices. The regulators’ commitment to dynamic markets in China is best demonstrated by looking at the first QDII fund launches, which received a lukewarm response due to their investment restrictions. Responding to the call for increased breadth of investment instruments and markets, Chinese regulators released a second round of QDII funds which provided access to a wider range of asset classes, and the results made headlines around the world.
Regulators in China, being receptive to new ideas and proving uniquely dynamic in their responsiveness to market conditions and requirements, remain at the top of the pyramid in terms of process and product education. Today, regulators are grappling with the challenges that their current model of custody and trustee presents to global custodians - in most major markets the role of custodian and trustee remain separate functions to ensure segregation of duties. In China, the custodian is expected to act as the trustee, therefore introducing complexity into the traditional global custodial role. Education at the regulatory level should remain a priority for all institutions involved with the QDII program. There has been consideration of a lobbying group to ensure that these issues obtain the regulatory consideration they deserve.
The regulatory requirements in China will obviously impact the expectations that domestic custodians and fund managers place upon their international sub-advisors and global custodians. This will permeate all educational efforts within the market. It should not, however, delay educational initiatives with Chinese partners, as the importance of bridging the gap between domestic Chinese regulations and global practice remains paramount.
Let us examine specific areas of educational focus. Operational workflow and process is the most likely point of entry for any educational program targeted at QDII participants. As explained earlier, a great majority of Chinese custodians and fund managers have worked within the closed market conditions of trade date settlement. The transition to global markets, with multi-day settlement periods and enhanced cash management practices can, and does, create confusion amongst the uninitiated. By comparison, Chinese markets have never experienced a failed trade condition due to mandatory buy-ins at the end of the trading day. Operational personnel of global custodians should not be surprised to receive distressed calls from the local Chinese fund manager and custodian, concerned about the potential of a failed trade situation. Thus, global custodians should focus on global workflows and procedures to ensure that their domestic Chinese partners understand the potential for a wide variety of possible outcomes during the lifecycle of a trade.
Extended operational workflow education must also include a formal understanding of foreign exchange processes given the highly regulated nature of such transactions within the Chinese market. Subscription and redemption processes must be clearly outlined and explained, and ‘dry-run’ scenario planning is a critical element of the training process. It is also suggested that global custodians receive an overview of their local Chinese partners foreign exchange processes, including account structure reviews, to understand the methodologies in place to handle foreign currency transactions. A global custodian should never rely on their own opinions of how a domestic custodian will operate - ensure that you receive a full overview of their internal account process flows before entering a live environment.
Fund administration should also be considered as an area of review for Chinese institutions. One of the peculiarities of the Chinese market is the overwhelming reliance by the fund administration industry on a single accounting system that is sold in an ‘open format’ leading all domestic institutions to develop specialized extensions to the software in an ad-hoc manner. Once again, educational events should be held wherein an overview of global fund account processes are reviewed, followed by a review of sample reconciliations completed between the global custodians systems and the domestic Chinese partner system. Lacking a cohesive or managed approach to the development of the original software package, the output from individual fund accounting systems at Chinese institutions will vary significantly and can result in significant reconciliation issues. Knowing how the underlying systems generate their final output is an important step in avoiding costly delays in a live environment.
Compliance training should be on the agenda of all global custodians who have this responsibility to an underlying fund. Operating within a quantifiable framework, compliance requires data that can be analyzed by mathematical algorithms in order to report investment breaches. Often, Chinese custodians will not understand that subjective reviews of data are not possible within an automated environment, and in some cases the broad nature of their compliance requests, such as individual market tax or regulatory breaches across a large number of markets, may not be possible. In this scenario educational efforts should be directed to the quantitative nature of compliance and the inherent limitations of compliance monitoring against subjective analysis.
Finally, we come to performance and risk training. In most situations it is unlikely that domestic Chinese institutions will require sophisticated performance analysis, however the provision of such services are becoming more commonplace and thus considerations to the training program surrounding performance and risk services should be considered. It is highly likely that regular training will not remove the need for professional performance and risk personnel to make regular visits to the client site. It will still be necessary to decipher the reports generated by these sophisticated systems, and budgets should be adjusted accordingly to cover these recurring costs.
The education of the Chinese fund and custody market should be a priority for any and all organizations attempting to do business there today. Education is a major part of any value proposition placed in front of a Chinese organization and to ignore this reality is to artificially limit the opportunities available within this dynamic and important market. As an industry, we should also recognize that the education of buyers leads to increased knowledge of the underlying products and services we provide, and thus value differentiation and pricing leverage can be achieved. Failure to realise the benefits of an integrated educational platform within the sales process in China will relegate sellers to a commoditised product model and margin squeeze - not the ideal way to take advantage of the Chinese economic miracle!