The DVP reform kicked off in December 2022 in China’s capital market, making China the first market in the world to adopt T+1 DVP. Six months after the reform, the market responded with positive feedback and stable operation. This article will briefly introduce the DVP reform of China's Capital Markets.
Overview of China's Capital Market Development
China's capital market stands as one of the pivotal practices since the country's reform and opening-up. Since establishing the Shanghai Stock Exchange in 1990, the market has seen rapid growth. As of June 30, 2023, the market capitalization of China's capital market is close to 90 trillion yuan, ranking second globally. The number of listed companies has surpassed 5,200, with an annual trading volume exceeding 18 trillion shares. Through 33 years of persistent efforts, China has now established a multi-tiered capital market. This includes national securities trading venues like the Shanghai, Shenzhen, and Beijing Stock Exchanges, as well as the National Equities Exchange and Quotations (NEEQ), covering main boards, ChiNext for growing businesses, the STAR Market for high-tech innovative enterprises, and the NEEQ, among others. These cater specifically to companies at different stages of development, sizes, and types, both listed and unlisted. Entry channels for international investors keen on participating in China's capital market include the Shanghai/Shenzhen-Hong Kong Stock Connect and the Qualified Foreign Institutional Investor (QFII/RQFII) programs. Over the past five years, foreign capital inflows into China's capital market have totaled nearly 1.3 trillion yuan. The scale of China's bond and futures markets also ranks among the top two worldwide.
China's Capital Market Settlement Business
Just as in mature overseas markets, the foundational settlement principles of China's capital market encompass tiered settlement, legal entity settlement, multilateral netting, and central counterparty. As of June 30, 2023, the monthly average settlement gross amount for the year in the market stood at approximately 194 trillion yuan, marking an 8.38% increase from 2022. The market is home to 220 million investors. Of these, institutional investors number 532,700, while individual investors account for a staggering 219 million, making up more than 99.76% of the total.
Given this market structure, China’s capital market implemented ex-ante risk management measures to ensure a secure environment for securities delivery and money settlement. These measures include a trade front-end monitoring system to protect against naked short selling, a third-party fund custody system to prevent securities companies from misusing their clients' settlement funds, and a full margin system in brokerage trading to safeguard against overbuying risks. Those arrangements in brokerage trading effectively achieve the same outcome as the DVP model in principal risk prevention, contributing to the steady operation of China's capital market for years.
2.1 The Push for DVP Reform
While the measures above secured steady operation of the Chinese market for years, China's capital market continually aims for enhancement. China's capital market responds to the need for opening up by refining the settlement system in the Chinese market. It expedited the DVP reform, aligning with the 2016-2017 Financial Sector Assessment Program (FSAP) recommendation that “CSDC should adopt full delivery versus payment.”
Several foundational legal measures were solidified within China's capital market to ensure a seamless rollout of the DVP system:
A. From a legislative standpoint, the National People's Congress's Legislative Affairs Committee has clarified that key DVP reform components will be stipulated by capital market regulators in alignment with the Securities Law, including using tagged securities and the procedures for handling defaults. Specific operations can be defined based on higher-level authorizing legal statutes. In support, the Supreme Court has also endorsed this DVP reform initiative.
B. Adhering to the Securities Law and integrating the demands of the DVP reform, CSRC has finalized its amendments to the Securities Registration and Settlement Management Measures. These updates solidify provisions such as protecting tagged securities still in settlement from enforcement and clarify principles for addressing defaults in fund settlement.
C. CSDC has introduced the Settlement Rules, incorporating revisions to specific operational procedures and guidance. This clarifies the processes, including the linkage of securities delivery and funds transfer, via tagging and addressing defaults on cash.
These legal and procedural refinements provide a robust legal foundation for the DVP system, ensuring the reform's successful implementation.
Key Measures of the DVP Reform Plan
DVP stands as a cornerstone settlement system, and its reform touches upon every participant in the capital market, marking yet another significant step for furthering all-round reform in China. Under the leadership of the CSRC, CSDC has always upheld a systemic view and placed the protection of all investors' interests, especially those of small and medium-sized investors, at the heart of the reform's objectives and ultimate goals. Staunchly advancing in the direction of a modern capital market with distinct Chinese characteristics, the DVP reform plan's formulation process solicited opinions from nearly 300 domestic and international market entities, including securities companies, custodian banks, fund managers, QFIIs, and insurance asset management companies. Input was also sought from domestic and international experts and scholars, including those from the International Monetary Fund, the Hong Kong Stock Exchange, and universities. The DVP reform plan was meticulously crafted and finalized, taking into full account the advice from domestic and international experts and investors.
From the outset of the reform, following multiple interactions with both domestic and international institutions, the market established three underlying principles for this DVP reform: First, stick to the core value of DVP by linking the securities leg and cash leg to guard against principal risk. Second, draw on global practices. Third, formulate the reform plan considering China's capital market's unique characteristics and history. Following these principles, the various participants in the market underwent ten rounds of discussions and joint research, eventually reaching a consensus and shaping this DVP reform plan. The specific points are as follows:
* Firstly, a linkage between securities delivery and funds transfer is established by tagging securities. At the end of T+0, for buyers with sufficient funds in their accounts, CSDC freezes the corresponding amount in the buyer's fund settlement account, earmarking it for the next day's settlement, and transfers the due securities to the buyer's securities account. For buyers with insufficient funds, CSDC freezes all funds in their fund settlement account and transfers the corresponding securities to the buyer's securities account. At the same time, a "sellable settlement block" is applied to the securities of the deficient amount, indicating that the tagged securities are still in the settlement process and cannot be accessed by anyone. For sellers, when their securities are debited, CSDC will credit their available cash balance simultaneously. Sellers can withdraw the funds from 8:30 am on T+1. Moreover, the funds are deposited in a special cash account and segregated from CSDC’s assets. According to relevant laws and regulations, judicial authorities cannot freeze or deduct the funds, effectively ensuring the funds’ safety.
* Secondly, once the full funds are credited on T+1, the "sellable settlement block" is removed, completing both securities and funds settlements, with the final settlement time being 16:00 on T+1.
* Thirdly, the management mechanism of default on cash is optimized. Participants who fail to provide enough cash by 16:00 on T+1 will be defaulted. CSDC is entitled to earmark their securities under “sellable settlement block” with “to-be-disposed settlement block” and to dispose of them to guard against principal risk.
By tagging “sellable settlement block” to establish the linkage between the securities leg and funds leg, introducing multiple-batch settlement, and putting in place default procedures, the principal risk is well controlled, and DVP is fully adopted in China’s capital market.
Results of DVP ReformThe reform is of milestone significance in China’s capital market and has also achieved significant results.
First, China became the first country to adopt T+1DVP system in its capital market, a further boost to its supremacy in efficiency and safety of securities settlement.
Second, CSDC’s capability to guard against the principal risk of the settlement system is remarkably enhanced. Via the reform, a linkage between the securities leg and cash leg is established, and interim and ex-post risk control measures are set up to play a part with existing ex-ante measures, effectively controlling principal risk. Therefore, DVP is fully adopted in China’s A-share market.
Third, liquidity risk in China’s settlement system is effectively controlled. Before the reform, settlements could only occur at the end of T+1 at 16:00. After the reform, market participants can provide funds earlier during the day on T+1 to complete the settlement, thereby reducing liquidity risk in the settlement system. Future Outlook of Reform
In recent years, many important reforms and opening-up projects have been rolled out in China’s capital market, including the Shanghai/Shenzhen-Hong Kong Stock Connect, the connectivity mechanism of depository receipts (DR), the DVP reform, and the registration-based IPO system reform. In the future, China’s capital market will continue to promote reform and opening-up to contribute to building a standardized, transparent, open, dynamic and resilient capital market.
The views, thoughts and opinions contained in this Focus article belong solely to the author and do not necessarily reflect the WFE’s policy position on the issue, or the WFE’s views or opinions.