Trading for the China Market

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China stock market, mainly the Shanghai Stock Exchange, has two types of shares. The ‘A’ shares are reserved for domestic investor whereas ‘B’ shares (quote in USD) are open to foreign investors. However, due to market liquidity, most foreign investors prefer to participate in the ‘A’ share market.

Shanghai Stock Exchange allows foreign investors that are qualified under the “Qualified Foreign Institutional Investor (QFII)” program to invest in the ‘A’ share market. Each qualified investor was given a quota for investment. All other foreign investors not in the QFII program can only buy ‘B’ shares. Smaller fund managers that could not qualify for QFII can buy P-Notes (Participatory Notes) from QFII approved market maker. Some QFII approved fund manager who are given little quota may participate in the P-Notes and A share market concurrently.

P-Note or participatory notes is an equity derivative product that allows foreign investor to participate in the restricted local stock market. Currently, India and China market is very active in P-Notes due to its restriction in foreign investment. P-Notes track the underlying share closely and allow entitlement of dividends and other corporate action to the P-Notes holders. The cost of acquiring P-Notes is higher since the market maker will transfer all other charges plus an additional premium.

Most market regulator do not like P-Notes market due to its lack of transparency. To counter the P-Notes market, China has recently increased its quota for the QFII program substantially.

The problem when buying P-Notes from these market makers is that the fund manager may buy P-Notes for a single China stock from different market makers. When it is time to sell, fund managers need to keep track of which P-Notes belong to which market makers.

One solution is to create a standard security for a China stock and create several different derivative securities with different references to differentiate between P-Notes from various market makers.  However, these securities must be able to be grouped together for fund managers to perform asset allocation.

Another method is to buy and sell shares using the same China stock quote and on a separate system, individual shares or P-notes are tracked according to the market makers.

To decide which P-Notes or ‘A’ shares to sell, most fund managers adopt the First-In-First-Out (FIFO) inventory accounting method.

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