LME's hopes of breaking into China market fading fast

Beijing has made it clear that it intends to exercise control over futures trading in a five-point policy pronouncement for the Shanghai FTZ

PUBLISHED : Saturday, 05 October, 2013, 12:00am
UPDATED : Saturday, 05 October, 2013, 3:11am

It's time to wake up from the dream that the Hong Kong stock exchange and its new pet, the London Metal Exchange (LME), might secure a big slice of the mainland's futures trading pie.

The mainland wants to keep that pie to itself, as its top securities watchdog made clear in a five-point policy pronouncement for the Shanghai Free Trade Zone last week.

From here onwards, China will gradually open up its futures market

Hopes that the LME might break into the mainland market have been running high ever since it was acquired by the Hong Kong stock exchange late last year, thanks to the myth that the expensive deal would not have been done without Beijing's blessing.

The dream looked very real in the past few months, when some media reported that foreign commodities exchanges would be allowed to operate warehouses in the Shanghai zone, something the China Securities Regulatory Commission (CSRC) has banned since 2008.

It did not happen. The State Council announcement on the zone last Friday made no reference to the warehouse plan.

It was removed from the announcement because of strong ministerial opposition, in particular from the CSRC, according to sources.

On the face of it, it makes perfect sense for the LME to have storage facilities on the mainland, a net consumer of metals.

Doing so would facilitate stock delivery for LME clients, including some mainland firms.

However, the warehouse of a futures exchange is more than just storage. With it, investors can conduct physical settlement and deliveries of futures contracts. The attractiveness and liquidity of the LME would increase as a result.

The physical settlement would also make arbitrage possible between the domestic and London markets, bringing down the premium the domestic one now commands. It is true that Beijing could limit the impact by controlling who could play in the LME. But underground agents have always been present to serve clients keen to bet in London.

The chain effect triggered by a warehouse would not be just about greater competition for domestic bourses and intermediaries, but, more importantly, who has control of the mainland market.

The Hong Kong ownership may have made the LME less foreign, but not enough to make mainland regulators comfortable. Nor could the promise by some HKEx officials that they would "keep a watchful eye" on developments for Beijing.

The concerns and interests involved were so overwhelming that even the political clout wielded by the Shanghai zone - which has support from the very top - could not defy them.

Instead, the CSRC has come up with a plan that will make good use of the zone to develop the mainland's futures market, with liquidity and control staying in house.

As the zone was inaugurated, the CSRC issued a statement saying the Shanghai Futures Exchange would set up a Shanghai International Energy Trading Centre, which would establish an international energy trading platform in the zone.

"The platform will be the basis of a full introduction of foreign investors into domestic commodities trading," the CSRC said. "From here onwards, China will gradually open up its futures market."

In short, they are setting up a special baccarat room, away from the main gambling floor, for their boys to play real games with the big boys.

Their boys get to learn the tricks and the big boys get to profit from a big gambling pool. Everything will be done under their watchful eyes. Whatever happens, the main gambling floor won't hear or feel a thing.

The control is much tighter than the control the CSRC exercises over the equities market, where foreigners at least get to play in the main gambling area, even though the CSRC tightly controls the entry tickets and the amount of money they can bring in or out.

Now you see how conservative and cautious Beijing is when it comes to the opening up of its futures market.

To be fair, the CSRC also said companies registered in the zone and individuals working there would be allowed to invest in the Shanghai equity and futures markets as well as international markets.

However, as always, it said there would be specific conditions governing who could invest and how they could do it. The announcement offered no clue about those conditions.

It is hard to be optimistic about this promise of new investors from the mainland given the lack of physical settlement there for LME contracts and Beijing's ultracautious control of players in foreign futures exchanges.

Beijing allows only 31 state-owned enterprises to make international futures bets, with the size and product having to be approved beforehand.

In 2011, three brokers were chosen for a pilot scheme to return to overseas futures markets. That pilot scheme is still in the preparatory stage.

With all that stacked against it, what are the chances the LME dream could come true?