Harsh trading lessons are legacy of HKMEx saga

May 28, 2013 7:15 pm

Harsh trading lessons are legacy of HKMEx saga

By Jeremy Grant

Derivatives exchange plans new products as trading stops

In the space of a few days this month, what had seemed like a perfectly sensible business proposition – a derivatives exchange based in Hong Kong tapping into China’s insatiable demand for commodities – has all but collapsed.

The Hong Kong Mercantile Exchange (HKMEx), created in 2008, surrendered its trading licence to the territory’s market regulator, saying it did not earn enough revenues to cover its operating expenses.Three days later, the territory’s financial markets watchdog opened a probe into “suspected irregularities” in the exchange’s finances.

Hong Kong’s commercial crime bureau is reported by various media to have arrested five people in connection with the case, while the exchange’s founder and chairman Barry Cheung, a figure well-connected with Hong Kong’s leader, has resigned from board directorships.

Remarkably, HKMEx is still operating, although one wonders what exactly its 100 staff do all day if the main business of the exchange – trading – has ceased. Presumably they are working on what the exchange says are plans for new products, including renminbi-denominated precious and base metals contracts that it says will “better meet customer needs”.

There is little point in them bothering unless the idea is to cook up something truly special. The first lesson from this saga is that it is all but impossible to launch an exchange with products that are similar to another’s – as HKMEx did.

The exchange’s gold and silver futures contracts competed with Comex, the metals trading platform of CME Group, the US futures exchange. Comex has 47 clearing members using its product, against a fraction of that number at HKMEx.

Market participants need a compelling reason to shift their trading from an existing platform to another, an exercise that involves spending money on things such as new clearing relationships and technology link-ups. That is especially the case if the rival products on offer are not substantially different from what is already out there. There is a cautionary tale here for the Singapore Mercantile Exchange, another commodities exchange also offering metals futures.

HKMEx also faced the tough reality that the commodities “supercycle” is over and that China already has four commodities exchanges of its own. Crucially, the exchange failed to deliver on promises to access to the Chinese market by offering physical delivery in China.

The last straw was the purchase by Hong Kong Exchanges & Clearing, Hong Kong’s dominant exchange, of the London Metal Exchange, creating an unmatchable rival in HKMEx’s backyard.

But the HKMEx venture was not entirely a bad idea. The bourse started out as a futures exchange for energy products. It turned to metals only after its original plan failed to leave the drawing board.

In 2008, a group of mainland Chinese investors including Titan Petrochemicals, a shipping company domiciled in Singapore, thought it would be a good idea to launch an energy exchange in Hong Kong. The idea, backed by Hong Kong, was to create the ecosystem for the establishment of a “China price” for crude oil used in the region, much like there is already a Brent contract in London based on North Sea supply, and West Texas Intermediate crude in the US.

That was seen as useful for Chinese buyers of refined crude oil products in Singapore, which is a big source of jet fuel, heating oil and bunker fuel for Chinese buyers.

Regulatory barriers in China – and missteps by HKMEx – killed off the idea. But some market participants think that an Asian benchmark for crude is inevitable.

At the moment the next best thing is Platts, the price reporting service, which produces daily prices in Singapore, Asia’s largest oil trading hub. The Dubai Mercantile Exchange has since 2007 offered a futures contract based on Oman crude oil, most of which is bought by Asian consumers. About 60 per cent of DME’s volume of trade comes from Singapore.

But longer term there is a belief in the region that there is a need for a better benchmark to more accurately reflect the dynamics of Asian energy supply and demand, particularly in China. Part of that will require the creation of a futures market, which indicates expectations for spot prices in many markets, including stock markets.

Unfortunately for Hong Kong’s ambitions to be an Asian commodities centre, Shanghai looks like beating everyone else to the punch by preparing a crude oil futures contract that could be launched this year. That is HKMEx’s real legacy.