COLUMN-Goodbye Shanghai, hello Qianhai: HKEx's quest for a metals connector: Andy Home

(Repeats with no changes. The opinions expressed here are those of the author, a columnist for Reuters)

By Andy Home

LONDON, Oct (HKSE: 3366-OL.HK - news) 27 (Reuters) - When Hong Kong Exchanges and Clearing (HKEx (HKSE: 0388-OL.HK - news) ) bought the venerable London Metal Exchange (LME) in 2012, the narrative was all about China.

HKEx was, it claimed, uniquely positioned to bridge the gap between the world's oldest marketplace for trading base metals and the world's largest market for those metals.

The exchange was already far advanced in constructing a stocks bridge between Chinese and international markets, subsequently realised in the form of the Shanghai-Hong Kong Connect pipeline.

That, it was hoped, would be a template for something similar in the metals and wider commodities trading space.

Yet four years on and there is no similar metallic product.

That is largely because the obvious Chinese partner, the Shanghai Futures Exchange (ShFE), which dominates industrial metals trading on the mainland, has shown a conspicuous lack of interest.

So time for Plan B. HKEx is going to launch its own mainland Chinese metals exchange with which to connect.

But will it work and, equally importantly, what will it mean in terms of the uneasy stand-off with the Shanghai market?

GOOD-BYE SHANGHAI!

While the purchase of the LME was all about China, it wasn't a Chinese company that was actually doing the buying.

Hong Kong has its own unique history and place within China, a relationship famously dubbed "one country, two systems" by former Chinese premier Deng Xioaping.

Indeed, HKEx chief executive Charles Li, speaking to Hong Kong investors in the original unveiling of the LME deal, stressed that the purchase "really consolidates our strategic relevance to China," helping to dispel nagging fears about "marginalisation".

And at the LME Week Asia meet in June 2013 he reached out to potentially wary mainland exchanges.

Switching from English to Mandarin, he assured mainlanders HKEx would not "develop products that threaten to capture their existing business". Rather, "it is our long-term goal to seek co-operation with them to develop new products together and share the profit."

At least one member of his audience was apparently unconvinced.

The battle-ground for Chinese metals market share had already been defined by the issue of listing LME warehouses on the mainland.

The LME's previous attempt to open warehouses had run into a brick wall in the form of a ruling from China's regulator, the China Securities Regulatory Commission (CSRC), explicitly prohibiting any overseas exchange from doing so.

It was seen at the time, and is still seen, as a barricade erected to protect ShFE from overseas competition.

HKEx and Li were initially optimistic they had sufficient political leverage in Beijing to break the impasse.

But two years later Li, speaking at the LME's annual London event, conceded "that battle has huge machine guns and bunkers that are very hard for you to take."

No deal then?

HKEx then decided to offer a mini bridge to the mainland in the form of "mini" yuan-denominated contracts mirroring in scaled-down size the core base metals products traded on the LME.

But initial enthusiasm for these products has flagged. Total (LSE: 524773.L - news) volumes of 26,265 lots in the first nine months of this year were down by 33 percent on last year. Open interest has fallen 28 percent to 229 lots over the same period with two contracts, tin and lead, closing out September with zero open interest.

Quite evidently, if HKEx is going to make good on its promise to open up the Chinese metals markets, it needs to find a new connection point.

HELLO QIANHAI!

And this time it's looking closer to home. The Qianhai free trade zone is part of the city of Shenzhen, just north of Hong Kong.

A memorandum of understanding was signed in September with the Authority of Qianhai Shenzhen-Hong Kong Modern Service Industry Cooperation Zone, to give it its full title.

At the heart of the tie-up is a proposed "well-regulated, transparent and reliable spot commodities trading venue on the Mainland backed by physical delivery and a warehouse system to support the Mainland's real economy," according to HKEx' Li.

Last month came news that the new platform will be headed up by Guo Xiaoli, who has held senior positions at both the Dalian and Zhengzhou exchanges in the past. First (Other OTC: FSTC - news) trading is scheduled for some time in the first half of 2017.

It's a neat way of side-stepping the protective wall thrown around the Shanghai market.

As a spot trading platform Qianhai poses no direct threat to Shanghai and falls below the radar of the CSRC, which has jurisdiction only over futures trading on the Chinese mainland.

Moreover, physical delivery will be effected not by LME warehouses but by what Li has described as a "unique LME warehouse kind of system".

Something presumably along the lines of LME Shield, the build-out of the existing LME Sword electronic warranting system to the non-warrant, off-exchange part of the market.

YOUR MOVE!

This is obviously a fall-back plan in response to the Shanghai Future Exchange's rejection of any thought of connecting with Hong Kong. It's also a move into an already congested space.

Even Li concedes there are more than 1,000 commodity trading platforms on the Chinese mainland.

However, many of these are little more than localised trading hubs and some little more than dressed-up "get rich quick" investor scams. Think of the Fanya Metals Exchange in the city of Kunming, described by local authorities as a multi-million dollar Ponzi scheme.

There is a palpable need for some sort of authoritative cash pricing benchmark in China.

The 2014 Qingdao scandal, involving the multi-pledging of metals stored in some of the port's warehouses, has also revealed the need for a more trustworthy storage mechanism.

On paper at least, HKEx can leverage the credibility of the LME's existing benchmark pricing, already used by many of China's heavyweight industrial players, and its Shield depository receipt system to offer both.

And if it can make a success of the Qianhai platform, it will have created something with which to connect.

Emphasis on the word "if" in that sentence.

But how will the Shanghai Futures Exchange react? Having used the CSRC to block previous attempts to import LME pricing onto the mainland, what will it make of this latest move?

Because it's clear that in this particular game of chess, or maybe this being China, mahjong, it's being challenged to make the next move.

(Editing by David Evans)