The market for US dollar (USD)-denominated funds in Greater China has undergone rapid transformation. Professional services providers have been grappling with the impact of a flurry of new laws and regulations, while fund managers have suddenly found themselves overwhelmed by choice. This has led some to question whether market convergence has finally led to the creation of a level playing field for all jurisdictions, or whether in fact this is the beginning of widespread divergence in the fund market industry.

This article explains how and why the market has blossomed in recent years, and considers how it may develop in future.

USD fund market outside mainland China

The USD fund market outside mainland China has flourished due to the emergence of free markets such as Hong Kong, in tandem with the tight capital controls maintained by China. These controls have laid the foundation for China's economic evolution in the past 40 years, which have seen the confluence of international asset allocation, pensions and endowments on the one hand, and the emergence of ultra-high-net-worth individuals, domestic insurance funds and a burgeoning asset management industry on the other.

This dichotomy of two markets — domestic and international — created a real need for offshore vehicles so that USD capital could be pooled and invested, and investment returns distributed in a tax-efficient way. This in turn smoothed the way for the widespread recognition of the Cayman Islands and its investment-holding and fund products, such as exempted limited partnerships for private equity funds, exempted companies as mutual funds and certain non-fund arrangement vehicles.

International standards and rule books

The coordination of international standards and rule books for the fund management market was led by the Organisation for Economic Cooperation and Development (OECD), the Financial Action Task Force (FATF) and, to a certain extent, the UK government. The financial services industry has been beset by "regulatory fatigue" since 2015, as it has got to grips with heightened scrutiny of anti-money laundering and counter-terrorist financing and proliferation measures, and with new requirements governing the exchange of tax information (automatic, spontaneous or on request). At the same time, it has had to deal with new requirements governing economic substance, data collection and transparency in beneficial ownership, as well as measures to safeguard fund assets and heightened oversight of virtual asset issuers and service providers.

The sheer volume of regulatory changes in recent years has certainly felt overwhelming, but it is also necessary to consider how the market has responded to the resurgence of neo-liberalism, and the free flow of capital and free movement of people across borders. The answer may be moot, but governments and regulators have made substantial progress toward establishing a mutual framework for information-gathering and exchange, as well as behavioral standards to which fund managers must adhere.

While this convergence has been taking place, many individual jurisdictions have quietly been re-designing their tax regimes to make them clearer, friendlier and more flexible. As just a few examples:

• Hong Kong has established the Unified Fund Exemption Regime and introduced a much-anticipated tax concession for carried interest.
• Singapore's new variable capital companies and Hong Kong's partnership funds have garnered considerable interest.

Investors have begun to revisit and "rediscover" alternative structures, notably those offered by the British Virgin Islands, which are more versatile for small to medium-sized funds and for those renminbi fund managers just dipping their toes in the water of the USD fund market for the first time.

Amid all the hype, fund managers have tended to focus on how comparable, or otherwise, these new products are to conventional offshore products, rather than exploring the nuances in terms of what they are designed to do, and establishing why — while a certain product may be the perfect fit for one fund manager — it will be totally unsuitable for another. Once the dust has settled, however, it will become clear that the market has evolved from being able to offer a single mature product to the point where it can now deliver a dynamic and solution-oriented range of products. There are a number of reasons for this transformation:

• Tax optimisation and product strength have gradually replaced privacy absolutism, against a backdrop of greater transparency regarding the exchange of tax information, controlled foreign corporation rules and enhanced client know-your-client procedures. Removal of ring-fencing and measures to prevent unfair tax treatment have blurred the boundary between onshore and offshore structures.
• A holistic approach — there has been increasing consensus about traditional offshore solutions in the context of onshore/mid-shore operation and investments and their returns.
• Democratisation of the market — new fund managers are quickly acquiring in-depth knowledge and flexing their muscles, while well-established fund houses have continued to maintain strong momentum in terms of fundraising and deployment.
• Unprecedented sophistication — teams of professional and specialised service providers are now able to help their clients navigate the fast-changing marketplace and identify the investment options which most closely meet their interests.

What does all this mean?

Will the democratisation of the market lead to even greater demand for more tailored and versatile (and perhaps previously overlooked) products, or will the homogenisation of tax implications allow managers to be more creative and receptive to non-conventional onshore/ offshore structures or to a Cayman/British Virgin Islands hybrid? Will there be further consolidation of service providers, who will then be able to incorporate more comprehensive service offerings into their networks, or will boutique and nimble players thrive?

Much remains to be seen, but the authors would not be surprised if all of these things were to happen.

The foregoing is for general information only and not intended to be relied upon for legal advice in any specific or individual situation.

This article was originally published by © Thomson Reuters on 4 December 2020.