Concerns by Europe's top funds watchdog that the landmark Hong Kong-Chinese mainland trading link may not adequately protect investors are preventing thousands of funds from buying Shanghai stocks, threatening the success of the project, market participants told Reuters.

The Stock Connect scheme, [Hong Kong company registration]launched on Nov 17, allows foreign investors to trade Shanghai-listed shares via the Hong Kong stock exchange, and mainland investors to invest in Hong Kong shares via the Shanghai bourse.

But within a week of its launch, trading volumes had dwindled to less than 20 percent of the maximum allowance.

Banks, fund managers and lawyers told Reuters that was because many large EU-regulated funds are unable to participate until Europe's main funds regulator, Luxembourg's Commission de Surveillance du Secteur Financier, is satisfied that the scheme protects investors.

About 13,000 global mutual funds, or two-thirds of Europe's funds industry, are domiciled in low-tax Luxembourg and regulated by the CSSF. These include heavyweights such as Blackrock, Templeton and Fidelity, part of Luxembourg's 3 trillion euro ($3.7 trillion) asset management industry.

The CSSF, market participants say, wants to be sure that the Chinese shares EU savers buy through the link-up can be adequately recovered should the bank that guards the stocks - the custodian bank - or one of the exchanges, go bust.

The collapse of Lehman Brothers in 2008, which saw billions of dollars in fund assets sucked into the insolvent Lehmans estate, has made investors and regulators highly sensitive over custody arrangements.

Several market participants said the CSSF has questioned whether Stock Connect's arrangements meet Europe's strict rules governing the safe-keeping of assets managed by mutual funds for retail investors, popular investment products known as UCITS.

"The Luxembourg regulator is asking the custodians to clarify that the custody arrangements comply with UCITS rules," said Jeremy Lam, a partner at law firm Deacons in Hong Kong.

But some custodians feel unable to provide that reassurance, lawyers and industry participants said. [Businesses Registration] The CSSF said it had had "contacts with some custodians (over Stock Connect) and the discussions were related at this stage to general points".

It declined to give further details on these discussions, but said that it had yet to receive any formal application by a UCITS fund to participate in the Hong Kong-Chinese mainland scheme.