Hong Kong and Shanghai, future metals allies or rivals?

By Andy Home/LondonYesterday the Shanghai Futures Exchange (SHFE) expanded its metals trading suite to include both nickel and tin. What is the preeminent trading venue for industrial commodities in China now boasts a base metals portfolio that fully matches that of the London Metal Exchange (LME), which dominates trading everywhere outside of China. In theory this should benefit both exchanges by stimulating arbitrage flows. And in theory it should also benefit Hong Kong Exchanges and Clearing (HKEx), which bought the LME in 2012 and which aims to leverage the LME franchise to replicate in the commodities space its Stock Connect mainland equities trading model. But there remains an ambivalence at the heart of this metals trading triangle. Are Hong Kong and Shanghai future collaborators or potential competitors in the world of metals pricing? The SHFE’s launch of nickel and tin futures fills an obvious gap in its base metals offering. But there remains a wide gulf between the Shanghai and London metals markets. The former is still in essence a Chinese market with just about all of its liquidity deriving from mainland players. SHFE metal prices are inclusive of the value-added-tax levied on imports and denominated in renminbi with all the accompanying constraints arising from China’s capital controls. The Shanghai market also has a significant retail investment user base, in stark contrast with the LME and its industrial and financial wholesaler clientele. That difference in user profile helps explain why some SHFE contracts fare better than others in terms of volumes. Copper, which is an investment favourite the world over, is the highest-volume base metal traded on the SHFE. Zinc comes in second, largely because its relatively low price appeals to Chinese retail punters. Aluminium and lead, by contrast, have low retail investment appeal, whether in China or anywhere else, and SHFE volumes are dwarfed by the equivalent LME contracts, where only the biggest investment players dare to venture. Even attempting the sort of volume comparison shown in the graphic above is tricky given the differing formats and methodologies used by the two markets. The figures, for example, exclude LME options turnover because there is no options trading on the SHFE. The SHFE volume figures are a double-count because of the SHFE’s practice of counting both buy and sell as separate volume contributors. The LME volume figures, meanwhile, are as arcane as the London market’s trading system with its multiple prompt dates and tiered membership structure. Broadly speaking, the two markets are best viewed as two complementary trading systems with arbitrageurs offering a degree of connectivity, albeit one constrained by the obvious technical hindrances. It is precisely this gap between the international and Chinese metals markets that HKEx is looking to fill, building on its existing role as a renminbi gateway between China and the rest of the world. The template is already there in the Stock Connect link-up with the Shanghai stock exchange. Launched in November last year, it has just passed another milestone with record “southbound” (mainland to Hong Kong) trading turnover of HK$5,593mn yesterday. The glittering prize for HKEx would be to achieve something similar in terms of connecting China, the largest consumer and in many cases the largest producer of base metals, with the international metals market-place. For China it would mark another step towards eventual renminbi convertibility and a transition from resented price-taker to coveted price-setter status.  For the trading community outside of China it would represent the opening up of what is the world’s biggest player in all things metallically tradable. Hong Kong’s unique status, enshrined in Deng Xiaoping’s “one country, two systems” description, makes it the obvious connector, according to HKEx Chief Executive Charles Li. “’One country, two systems’ is our core competitive advantage,” he wrote in a June 2013 blog. “Without the ‘one country’, Hong Kong would not have the opportunity to support the Mainland. Without the ‘two systems’, Hong Kong would be no different from other Mainland cities.” (Charles Li Direct, June 28, 2013) It would, he argued, be a win-win situation for mainland markets such as SHFE. “We do not intend to take away business from our Mainland peers. Rather, we are interested in cooperation and creating new markets and new opportunities together.” The intriguing question, though, is whether SHFE agrees, or whether metals will be just another battle-ground in a centuries-old trading rivalry between Shanghai and Hong Kong. Shanghai is itself pursuing its own internationalisation agenda, most obviously in the form of the Shanghai Free Trade Zone (FTZ), established in 2013 as a testing ground for financial reform.  Another connector path to the international market-place has been opened up by the Shanghai Gold Exchange, located in the FTZ and the first Chinese exchange to explicitly target foreign participation. When it comes to base metals, Shanghai’s ambivalence about its relationship with the London market, and by association, with its Hong Kong peer, is encapsulated in the thorny issue of warehousing. The LME lobbied long and hard to extend its warehousing network into mainland China as a way of smoothing and encouraging arbitrage between it and the SHFE. The latter evidently did not see this as a “win-win situation” and the China Securities Regulatory Commission decreed a ban on the listing of overseas exchange warehouses. A ban which remains in place to this day. wAnd while the ban is still there, there remains a high degree of uncertainty as to SHFE’s place in the grand scheme of metals trading envisaged by HKEx’s Li.  The launch of nickel and tin futures to match the base metals portfolio traded on the London Metal Exchange maintains rather than resolves that uncertainty.  *Andy Home is a columnist for Reuters. The opinions expressed here are those of the author.