Hong Kong’s Exchange Is Betting Its Future on Commodities and the Renminbi
With its purchase of the London Metal Exchange and a broadening array of renminbi-denominated products, HKEx aims to cement its position as the gateway between corporate China and global capitalism.
IN THE FAST-CHANGING WORLD of securities exchanges, Hong Kong Exchanges and Clearing sits in an enviable position. The Hong Kong Stock Exchange, which it operates, is the world’s fifth largest by the market capitalization of its listed companies, $2.83 trillion, and one of the most profitable. Over the past five years, it has had a greater volume of initial public offerings, $141.7 billion, than any other exchange in the world thanks to its status as the premier gateway to corporate China. At home it enjoys a statutory monopoly that protects it from upstart electronic exchanges, which have bedeviled established bourses elsewhere. Not surprisingly, investors have rewarded HKEx with a market cap of $21.5 billion, making it the most valuable exchange in the world, ahead of No. 2 Chicago-based CME Group.
Yet for all of the company’s strengths, CEO Charles Li Xiaojia knows he can’t afford to be complacent.
HKEx has a much narrower business than most of its global rivals, relying mainly on equity trading for its revenue and profits. The lucrative IPO business is vulnerable to erosion if the powers that be in China decide to promote their domestic exchanges in Shanghai and Shenzhen. Li needs to make the company bigger and broader if he wants to assure its continued success.
The former investment banker is moving quickly to do just that. Last June, HKEx outbid half a dozen rivals, including CME, IntercontinentalExchange and NYSE Euronext, to acquire the London Metal Exchange for £1.4 billion ($2.2 billion). The deal gives HKEx control of the world’s largest metals-trading venue and will, Li believes, enhance the LME’s position in China, the world’s biggest consumer of metals. He intends to use the LME’s platform to expand into other commodity sectors, such as energy.
In addition, Li and his team are creating a slew of investment products based on the renminbi, ranging from futures contracts in the Chinese currency to renminbi-denominated stocks and derivatives. This initiative is still in its early stages, but the potential for growth is enormous as China gradually liberalizes its currency and allows freer movement of capital in and out of the country.
“We are building HKEx into an integrated, multiple-asset-class exchange,” Li, 51, tells Institutional Investor. “Our mission and aim is to be the global exchange of choice for China-based clients and international clients seeking China exposure. The key thing is, we need to be in every single important place. We will leverage London Metal Exchange as a catalyst to help facilitate an accelerated opening of China’s capital account.”
Li’s ambition is bold, but he faces a number of challenges in trying to achieve those goals. Hong Kong does enjoy a natural advantage as China’s preferred offshore center — many of Beijing’s recent financial liberalization moves have specifically targeted the Hong Kong market — but HKEx remains well behind Singapore Exchange, and even further behind global players such as CME and Deutsche Börse, in developing derivatives and nonequity products. And to secure the LME, Li had to offer a full price and commit to maintaining the exchange’s physical trading floor, known as “the ring,” for the next three years. That commitment may prevent HKEx from realizing efficiency gains in the short term and eventually lead to lower returns on the deal.
In his three years at the helm, the CEO has already injected a lot of dynamism into the exchange. Those who know him well say Li, a mainland-born Chinese who studied in the U.S. and worked as a Wall Street investment banker, has the perfect blend of experience and knowledge to secure HKEx’s future in China’s wider financial sector.
“Charles is a banker who was a lawyer by training, and he has a deep understanding of China’s stock market,” says Yin Ke, vice chairman of Citic Securities Co., China’s largest investment bank, and chief executive of its Hong Kong–based subsidiary, Citic Securities International Co. “When he became CEO of HKEx, some people were worried: Can an investment banker lead an exchange? But Charles is someone with strategic vision. Since becoming CEO he’s helped move HKEx from being a passive player of China’s interests to being an active player and caterer to China’s interests.”
Born in Beijing and known for his strong ties to senior officials, Li has taken steps to transform HKEx’s relationships with mainland exchanges to be more collaborative than competitive. Last year the company formed a joint venture with the Shanghai and Shenzhen stock exchanges to develop index-linked products that can trade on all three markets; it has rolled out three indexes so far. HKEx intends to use the LME to forge similar ties with other mainland exchanges, including the China Financial Futures Exchange in Shanghai, the Shanghai Metal Exchange Market, the Shanghai Futures Exchange and commodities exchanges in Dalian and Zhengzhou, says Romnesh Lamba, co-head of HKEx’s global markets division.
China is in the midst of a transformation from being a net importer of capital to build up its manufacturing industries to becoming a net exporter of capital that seeks global investments across a wide range of asset classes. Li wants to make sure HKEx becomes one of the primary conduits of this process. The potential is staggering: If China accelerates its financial liberalization, Chinese companies could issue as much as 31 trillion yuan ($5 trillion) worth of equities in the coming decade, as well as 258 trillion yuan worth of fixed income and currency products, and they could buy 95 trillion yuan of commodities, including futures contracts and other hedging tools, according to HKEx’s strategic plan for 2013–’15, which Li and Lamba presented to local analysts and media in January.
Those heady numbers may seem well out of reach today, but Li believes the LME deal could be a catalyst for faster liberalization.
“China is facing a growing need for market access,” he says. “They are shortchanged with the status quo. They are worse off with markets closed than markets open. If we are able to provide a solution in a place like Hong Kong, where they feel comfortable, and offer a value proposition to solve that problem, that will go a long way to eliminate the paranoia and concerns of opening up.”
HKEX HAS ENJOYED ROBUST GROWTH SINCE THE turn of the century. The rush by Chinese companies to raise capital offshore, including major privatizations by big banks and other state-owned enterprises, helped the exchange expand its listings to 1,533 companies between 2000 and 2009 and triple the total market cap of its companies. As exciting as that growth was, however, the HKEx board feared that the exchange was becoming a one-trick pony: It gets most of its revenue from equities and equity derivatives. By contrast, CME and Frankfurt-based Deutsche Börse get the bulk of their revenues from a wider variety of higher-margin derivatives and ancillary services such as clearing and settlement and data provision.
With average daily turnover in equities tumbling 23 percent last year, to HK$53.9 billion ($6.96 billion), HKEx’s revenue declined by 8 percent, to HK$7.2 billion, and net profit fell 20 percent, to HK$4.1 billion. Equities and equity derivatives generated 58 percent of revenue and 57 percent of profits.
“HKEx’s long-term prospects are still mainly about equity market volumes,” says Arjan van Veen, a Hong Kong–based analyst with Credit Suisse. Trading volume has recovered strongly so far in 2013, and van Veen predicts that the group’s earnings will rebound by 20 percent this year. “Long term we see the outlook for HKEx as very strong as China’s capital markets continue to develop,” he says.
The Hong Kong exchange faces much stiffer headwinds than it did a decade ago, however. China has built the Shanghai and Shenzhen stock exchanges into powerful rivals; they boasted market caps of $2.55 trillion and $1.15 trillion, respectively, at the end of 2012. Other regional bourses have developed more-diverse suites of products. In 2005, Singapore Exchange expanded into commodities through a joint venture with the Chicago Board of Trade called the Joint Asian Derivatives Exchange, or JADE. Singapore also offers one of Asia’s broadest ranges of equity index derivatives, including products based on the Chinese, Indian and Japanese markets, and it has developed one of Asia’s leading central clearinghouses.
In January 2010 the HKEx board hired Li as CEO, replacing Paul Chow, and gave him a mandate to broaden the exchange’s offering. For a company that had always been run by British expatriates or Hong Kong citizens, the decision to appoint a mainland-born chief spoke volumes about the direction in which HKEx sought to go.
Though he was born in Beijing, Li was raised in Gansu, a rural province in northwestern China where his parents were petrochemical engineers. In 1977, when Li was 16, his parents arranged for him to work on an oil rig in the Bohai Sea, off the northeast coast of China. The Cultural Revolution had just ended, but the country’s schools were not yet operating normally, and Li never attended senior high school. In 1980 he enrolled at Xiamen University, in the southeastern province of Fujian, and obtained a BA in English literature.
After graduating in 1984, Li became a reporter, then editor, at China Daily, the government’s English-language newspaper, where he frequently interviewed foreign dignitaries. A few years later he went to the U.S. to earn a master’s in journalism at the University of Alabama, then attended Columbia Law School in New York, where he acquired a JD degree in 1991. Li worked as an associate at Brown & Wood and later at Davis Polk & Wardwell, where he helped American clients establish legal frameworks for their Chinese operations. While making preparations for a $1 billion global bond sale by the People’s Republic of China, Li worked alongside bankers from lead underwriter Merrill Lynch & Co. Wall Street banks were ramping up their international networks at the time, and Li’s Chinese background and language skills made him a hot commodity. In 1994 he accepted a job offer from Merrill — and at a stroke tripled his salary, he recalled in a 2011 talk to Columbia Law students.
Friends say Li used his position at Merrill Lynch and later J.P. Morgan, which he joined in 2003, to befriend top officials at the China Securities Regulatory Commission, offering free regulatory reform advice and establishing relationships that would pay off when Beijing began privatizing its big state-owned enterprises. He helped Merrill win underwriting mandates for several landmark deals, including China Mobile’s 80 billion-yuan IPO in 2000 and the $1.4 billion New York and Hong Kong share offering by China National Offshore Oil Corp. (Cnooc) in 2001. Li also advised half a dozen Chinese companies on overseas acquisition attempts, most notably working with Cnooc on its $19 billion agreement to buy Unocal Corp. Cnooc ultimately abandoned that deal in the face of heated political opposition in the U.S. Congress.
When Li took over as CEO of HKEx in January 2010, he was determined to shore up the exchange’s competitive standing. HKEx was performing well, but there were potential threats on the horizon. Technology, the explosive growth of derivatives and globalization have upset the established order in the exchange industry, making even some of the largest players vulnerable. The latest evidence: ICE’s $8.2 billion takeover offer for NYSE Euronext, which was accepted in December and is awaiting regulatory approval.
If HKEx wants to avoid a fate like NYSE Euronext’s, it needs to diversify and strengthen its links with China, says Li. “Yes, we are lucky we have leadership in Hong Kong and we don’t have competition yet. We have access to the China market. But this leadership can be easily taken away. You saw that when NYSE Euronext was taken over by a small futures exchange. This is why we are moving into metals and futures. We must have multiple products in order to survive.”
The purchase of the LME, which HKEx closed on in December, represents the biggest move to expand product range in the exchange’s history. Li and Lamba, whom the CEO had brought with him from J.P. Morgan, laid the groundwork for the deal at an off-site management meeting at the luxurious Sands Macao hotel on January 9, 2012. At the meeting the duo persuaded the HKEx board to endorse a more aggressive growth strategy, including a major push into commodities by supporting their bid to acquire the LME. Li and Lamba boarded a plane for London the next day and began an intensive six-month lobbying effort to win over the 70 shareholders that controlled the 135-year-old LME. They included big banks such as Deutsche Bank, Goldman Sachs Group and JPMorgan Chase & Co.
“There were widely divergent interests among LME’s shareholders, and the CEO and the chairman [Chow Chung Kong] both expended a lot of shoe leather going to meet each and every one of them, taking notes on what each of them wanted and selling them the vision of what HKEx wanted to do,” recalls James Fok, Li’s chief of staff and a former Citigroup banker.
The LME’s unique franchise and the attractions of its commodities-based business lured a number of deep-pocketed suitors. HKEx prevailed when the LME board endorsed its bid on June 15. CEO Martin Abbott, who continues to run the metal exchange, says the reason was simple: “HKEx offers strategic advantages in positioning LME for growth with Chinese markets and the rest of Asia.”
Victory came at a cost, though. The final tab was nearly double the £700 million estimate that analysts initially put on the London exchange. In addition, Li agreed to maintain open-outcry ring trading — an integral part of the LME’s history but an increasingly anachronistic feature in today’s electronic era — at least through January 1, 2015. Li also promised to maintain the exchange’s physical metals warehouses and expand that network into China.
Although some analysts are dubious about the future of ring trading, Li insists that the commitment was a sensible one; HKEx had no existing metals business and didn’t need to disrupt the LME’s operations.
“LME was a transformational deal,” says Lamba. “In one step we entered a new asset class and changed our significance to China. We are saying to the Chinese, ‘We are facilitating something you desperately need, which is offshore risk management of your critical commodity needs.’ ”
Some Chinese firms appear receptive to that pitch. Citic’s Yin says his securities firm is interested in seeking regulatory approval to trade directly on the LME; it currently relies on international banks to execute its trades on the metals exchange. “We do hope Citic Securities and Citic Futures can trade on LME, whether through our HKEx membership or directly,” he says. Currently, regulators allow only 28 state-owned metals and commodities firms to trade offshore, chief among them China Minmetals Non-ferrous Metals Co. and Aluminum Corp. of China, also known as Chinalco. Chinese futures companies are limited to trading on domestic venues like the Shanghai Metals Exchange.
Li has a two-pronged strategy to grow his new subsidiary. He plans to expand the LME’s product range to include new commodities such as iron ore, coking coal and energy. He also intends to give the exchange a strong presence in Asia, especially China. That will include extending the LME’s warehouse network in Asia, an important factor for a commodities exchange that relies on users being able to take physical delivery. Over time he also wants to develop clearing arrangements and price benchmarks in Asian time zones, eventually using the renminbi. “We will support the LME’s effort to establish its own clearinghouse for base metals and help to equip it for Asian time zone clearing, RMB clearing and clearing of other products relevant to Asia,” the CEO says.
Many analysts regard the purchase as a strategic coup. “The LME acquisition by HKEx should strengthen its brand on a number of levels,” says Anshuman Jaswal, a New York–based senior analyst with Celent, a financial services research firm. “It will enable HKEx to provide LME’s capabilities to the fast-growing Chinese and Asia-Pacific markets by leveraging its local market expertise.” He adds that the deal also gives Li a beachhead in London. “HKEx can use this to roll out its services in not just commodities but also other asset classes to a more global audience and also direct more business toward HKEx in Hong Kong,” says Jaswal.
BESIDES EXPANDING INTO COMMODITIES, Li is looking to position HKEx as the leading gateway for investment flows into and out of China. The exchange’s H-share business was a natural way to play the mainland economy in the days when Beijing kept a tight lid on its capital account and barred foreigners from investing directly in Chinese stocks. Chinese authorities have been liberalizing slowly but surely in recent years, however, allowing foreigners to buy mainland stocks through the qualified foreign institutional investor program and encouraging the use of the renminbi for settling international trade. The volume of renminbi on deposit in Hong Kong swelled to 625 billion yuan in January. Li wants to provide investors with more ways of putting that money to work.
HKEx pioneered the first offshore renminbi-denominated IPO in 2011, when Hui Xian Real Estate Investment Trust, a REIT controlled by Hong Kong property tycoon Li Ka-shing, raised 10.5 billion yuan with a share offering. Although no companies have followed Hui Xian so far, exchange executives are confident that more companies will seek to tap the growing pool of renminbi in Hong Kong by offering shares there.
The Hong Kong exchange is also making a big play for renminbi futures. In September, HKEx launched the world’s first deliverable offshore renminbi futures contract. The $100,000 face-value CNH contracts are offered with one-, three- and 12-month delivery dates. Volume has been modest, but it is growing, rising from 217 contracts a day in September to a high of 550 a day in January before settling back to 352 in February.
Competition in this space is heating up. In February, CME’s Chicago Mercantile Exchange unveiled its own CNH futures contract, which is deliverable in Hong Kong for periods of up to three years. The contract is part of a suite of futures on currencies of the BRIC countries — Brazil, Russia, India and China — says KC Lam, the exchange’s Singapore-based Asia head of foreign exchange products. Like all CME products, BRIC currency futures are available for trading 24 hours a day, he adds. “We have a global CNH product, not just local,” Lam says. “Our clients are global.”
HKEx says it isn’t worried by CME’s offering. “We welcome the challenge,” says Fok. “We will look forward to hopefully proving them wrong and showing we are better. Competition is a fact of life. The RMB products are a big space. No doubt other people will want to get into it, but it is important we build on the first-mover advantage that our unique position in Hong Kong gives us.”
Other centers are gearing up for renminbi business. British officials are actively promoting London as a center for renminbi financing. The Bank of England recently struck a swap arrangement with the People’s Bank of China to support the business, and HSBC Holdings made the first renminbi bond offering in London. Singapore is also angling for a slice of the growing market. Li dismisses talk of competition, though, insisting that the efforts of other centers will expand the global market for products denominated in the Chinese currency rather than hurting Hong Kong. “We are more than delighted to see London become an international RMB center,” he says. “We have no interest in keeping this to Hong Kong. When there is increasing global need for RMB products, that ultimately will benefit Hong Kong and HKEx.”
Meanwhile, Li is looking to collaborate with mainland partners. Last year HKEx formed a joint venture with the Shanghai and Shenzhen exchanges, called China Exchanges Services Co., to develop index-linked products. In December the three exchanges formally launched the CES 120, the first cross-border index that covers HKEx-listed Chinese companies as well as companies listed on the mainland exchanges. In March it unveiled two breakouts from the CES 120: the CES China A80 Index, which contains the 80 mainland-listed A shares in the broader index, and the CES China HK Mainland Index, which contains the 40 Hong Kong–listed H shares in the CES 120.
To match the global reach of some of HKEx’s rivals, Li announced in February that the exchange had received regulatory approval to start after-hours futures trading and would begin the service on April 8. The move will allow Hang Seng Index and H-shares Index futures to be available for trading from 5:00 p.m. to 11:00 p.m. Hong Kong time; HKEx hopes this will attract European and U.S. investors.
Other efforts at diversification have been less successful. Last year Li signed an agreement to form the Brics Exchanges Alliance with the major exchanges of Brazil, Russia, India, China and South Africa. The alliance members agreed to cross-list stock index futures, which began trading in the Hong Kong and Brics markets last year. Trading has been abysmal, however. Hong Kong has seen only seven contracts traded in Brazil’s Ibovespa index since the product was launched in March 2012.
In another project, HKEx is leading the Hong Kong government’s efforts to build a transparent trading venue with the establishment of a clearinghouse subsidiary for derivatives, named OTC Clearing Hong Kong. The unit will initially focus on interest rate and currency swap contracts, according to executives.
HKEx enjoys statutory protection as Hong Kong’s sole equity exchange operator. The government is the largest single shareholder, with 5.8 percent, and appoints six of the board’s 13 directors. The expansion into futures and commodities does put it into competition with the Hong Kong Mercantile Exchange, one that is getting heated. William Barkshire, the mercantile exchange’s chief operating officer, has asserted that HKEx should lose its monopoly on equities now that it is competing in commodities through the LME.
The mercantile exchange was founded with government backing in 2008. It sold a 10 percent stake to Industrial & Commercial Bank of China in 2009 and began trading U.S. dollar–denominated gold and silver futures in 2011. The exchange, known as HKMEx, has attracted 35 members, many of them from China; precious-metals-trading volume has reached a total of 2.2 million contracts, worth $114.5 billion. Pending regulatory approval, HKMEx is set to launch more products later this year, including gold, silver and copper future contracts in renminbi. Executives are also planning to introduce futures and options on base metals, energy, agricultural products and currencies, including the renminbi.
HKEx is backing up its expansion into metals and futures with a HK$3 billion investment in technology. It is developing a new high-speed trading platform called HKEx Orion that will more than triple capacity, to a peak of 100,000 orders per second, and slash latency more than tenfold, to 100 microseconds. The system is housed in a state-of-the-art data center in Hong Kong’s Tseung Kwan O neighborhood, an hour’s drive from the Central business district, which is home to HKEx’s main offices at International Finance Center and its trading hall at Exchange Square. The new platform, which involves technology developed in-house and bought from third-party vendors, will help strengthen links between HKEx and the LME, potentially leading to the LME’s consolidation with Orion. “The key objective is to ensure HKEx is always competitive with other leading exchanges in the world in terms of our technology platform capabilities,” says Richard Leung, co-head of HKEx’s information technology division.
New technology, new markets, new products — it all amounts to a full agenda for Li, who is determined to be ready for the day when China fully opens its capital account to the world.
“Some people are saying, ‘You are doing a lot, perhaps too much,’ and that that is the biggest risk to our strategy,” says Li. “But I say the biggest risk is when all the great things will happen to Hong Kong and we are not ready. We need to make sure we are prepared. We have no guarantees of success, of course, but we can say if we don’t plan, we definitely can’t succeed.”