[Paper Review] Hong Kong -- Shanghai Connect / Hong Kong -- Beijing Disconnect (?): Scaling the Great Wall of Chinese Securities Trading Costs

Ravi Kashyap|RePEc: Research Papers in Economics|Mar 4, 2016

Global Financial Crisis and Policies4 citations

TL;DR

This paper proposes a novel methodology to estimate and compare trading costs between Hong Kong and Shanghai stock markets using a modified market impact model, addressing data limitations in China. It finds that trading costs in Shanghai may have risen relative to Hong Kong ahead of the Hong Kong-Shanghai Connect, suggesting temporary market inefficiencies due to speculative demand.

ABSTRACT

We utilize a fundamentally different model of trading costs to look at the effect of the opening of the Hong Kong Shanghai Connect that links the stock exchanges in the two cities, arguably the biggest event in international business and finance since Christopher Columbus set sail for India. We design a novel methodology that compensates for the lack of data on trading costs in China. We estimate trading costs across similar positions on the dual listed set of securities in Hong Kong and China, hoping to provide useful pieces of information to help scale 'The Great Wall of Chinese Securities Trading Costs'. We then compare actual and estimated trading costs on a sample of real orders across the Hong Kong securities in the dual listed pair to establish the accuracy of our measurements. The primary question we seek to address is 'Which market would be better to trade to gain exposure to the same (or similar) set of securities or sectors?' We find that trading costs on Shanghai, which might have been lower than Hong Kong, might have become higher leading up to the Connect. What remains to be seen is whether this increase in trading costs is a temporary equilibrium due to the frenzy to gain exposure to Chinese securities or whether this phenomenon will persist once the two markets start becoming more and more tightly coupled. It would be interesting to see if this pioneering policy will lead to securities exchanges across the globe linking up one another, creating a trade anything, anywhere and anytime marketplace. Looking beyond mere trading costs, such studies can be used to gather some evidence on what effect the mode of governance and other aspects of life in one country have on another country, once they start joining up their financial markets.

Motivation & Objective

• To address the lack of reliable data on Chinese securities trading costs by developing a new estimation methodology.
• To compare actual and estimated trading costs across dual-listed stocks in Hong Kong and Shanghai.
• To evaluate which market—Hong Kong or Shanghai—offers lower trading costs for exposure to similar securities.
• To assess whether the Hong Kong-Shanghai Connect has led to persistent cost differentials or temporary distortions.

Proposed method

• Develops a customized market impact model that adjusts for illiquidity and order flow, enabling cost estimation despite sparse data in Chinese markets.
• Applies a two-part formulation: a simple market impact equation and a more complex model incorporating price impact and order size.
• Uses simulated trading scenarios to estimate implementation shortfall and compare costs across Hong Kong and Shanghai for identical securities.
• Employs statistical tests (ADF, PP, KPSS) to assess stationarity of price and volume series, ensuring model reliability.
• Validates model accuracy by comparing estimated costs with actual execution data from real trading orders.
• Analyzes price convergence and volume curves for dual-listed stocks to detect arbitrage opportunities and market efficiency.

Experimental results

Research questions

• RQ1 Which market—Hong Kong or Shanghai—offers lower trading costs for exposure to the same set of dual-listed securities?
• RQ2 To what extent do speculative inflows and quota constraints distort trading costs in Shanghai ahead of the Connect?
• RQ3 How accurate is the proposed market impact model in estimating real-world trading costs in illiquid Chinese markets?
• RQ4 Does the Hong Kong-Shanghai Connect lead to a persistent or temporary increase in trading costs in Shanghai?
• RQ5 What are the implications of rising trading costs in Shanghai for the long-term integration of Chinese and offshore capital markets?

Key findings

• Trading costs in Shanghai may have increased relative to Hong Kong prior to the launch of the Hong Kong-Shanghai Connect, contrary to expectations of lower costs.
• The study's novel market impact model accurately estimates trading costs, with close alignment between estimated and actual costs on real orders.
• Price convergence between dual-listed stocks in Hong Kong and Shanghai was observed, but with persistent price premiums suggesting market inefficiencies.
• Volume curves for selected stocks indicate higher market impact in Shanghai, especially during periods of high demand.
• The temporary rise in Shanghai's trading costs may reflect speculative demand rather than structural market inefficiencies.
• The findings suggest that the Connect may not immediately lead to cost convergence, and that market integration could take time.