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Hong Kong Mercantile Exchange Collapse Raises More Questions than Answers

Failure mars Hong Kong’s financial reputation, stirs political scene and prompts an investigation into potential misdeeds.

The Hong Kong Mercantile Exchange seemed like a surefire winner when it opened two years ago. The commodities exchange debuted in the middle of a roaring bull market for precious metals, energy and other commodities, thanks to seemingly insatiable demand from China. HKMEx, as it is known, also enjoyed strong backing both locally and on the mainland. Its founder and chairman, Barry Cheung, was a longtime aide to Leung Chun-ying, the chief executive of the Hong Kong Special Administrative Region. Industrial & Commercial Bank of China, the mainland’s largest lender, was a major shareholder, as was Russian metals magnate Oleg Deripaska. How could HKMEx miss?

But miss it did, in spectacular and mysterious fashion. For reasons that are still poorly explained, HKMEx collapsed last month, the biggest failure of a local bourse since the Hong Kong Futures Exchange went bust in the wake of the global stock market collapse in October 1987. The failure threatens to tar Hong Kong’s reputation as an efficient and well-run financial center and raise doubts about Leung’s leadership.

The exchange, which had been operating unprofitably since opening in May 2011, surrendered its trading license on May 18 after a check from a mainland trader, reportedly in the amount of $460 million, bounced. Since then, the authorities have arrested six Chinese traders on charges of possessing false documents or using a “false instrument,” and regulators and police have launched an investigation into the collapse.

At the very least, the collapse and resulting investigation is an embarrassment for the government, which supported the exchange’s founding in 2008 through public endorsements by the financial secretary, John Tsang. Chairman Cheung, 56, managed Leung’s successful election campaign for the chief executive post last year. Since the exchange’s collapse, Cheung has relinquished his seat on the city’s ruling 31-member Executive Council as well as the chairmanship of the city’s powerful Urban Renewal Council.

James Tien, a Hong Kong legislator with close political and economic ties to the mainland, called for Hong Kong’s Legislative Council to open an investigation of Cheung, but the council rejected that motion on June 8. Executive Council member Laura Cha, chairman of Hong Kong’s Financial Services Development Council and a former vice chairman of the China Regulatory Commission in Beijing, said at a news conference that the exchange’s collapse “would affect Hong Kong’s reputation as a global financial center.”

“The collapse of HKMEx has wide implications” because the close ties between founder Cheung and Hong Kong Chief Executive Leung, says Anshuman Jaswal, a New York–based senior research analyst at Celent, a financial services research and consulting firm. “So there would be political repercussions, and while Hong Kong’s global reputation might not be dented too severely just by this one instance, there might be question marks over the administration of capital markets in the special administrative region.”

Authorities have provided few details on the arrests or why the police are conducting a commercial crime investigation. It was widely reported that the bounced check was backed by a letter of guarantee from Standard Chartered Bank. Spokespersons for the bank in Hong Kong and Singapore refused to respond to questions about the matter.

Jonathan Li, a spokesman for the Securities & Futures Commission of Hong Kong, which is working with police to investigate the case, said regulators withdrew the exchange’s “automated trading services” license upon discovering that HKMEx lacked sufficient operating funds. “We cannot say more,” Li says.

Exchange spokeswoman Aubrey Ho also refused to comment, referring only to a statement the exchange released on May 18 about the surrender of its license.

“The voluntary surrender decision was made to enable the exchange to realign its strategy with the new industry environment since its trading revenues have not been sufficient to support operating expenses and, as a result, its inability to meet the required regulatory financial conditions,” the statement said. Sources say exchange chairman Cheung is trying to raise $100 million in fresh capital from existing shareholders and new investors to revive the exchange.

Cheung officially opened HKMEx in 2011 with shareholders including ICBC (Asia); COSCO Treasury Co., a subsidiary of China’s largest shipping company; China Ocean Shipping (Group) Co.; and En+ Group, the Deripaska holding company that controls Russian aluminum producer Rusal; each had a 10 percent stake. Spokespersons at ICBC, COCSO and En+ Group declined to comment.

Total investment in the exchange amounted to about HK$1 billion ($129 million), of which Cheung contributed 56 percent through his New Effort Holdings company. The exchange also attracted 37 members, many of them from China, including Bank of Communications’ Hong Kong securities trading subsidiary and Bank of China International Securities.

The exchange offered just two products: U.S. dollar denominated 32-troy ounce gold futures and 1,000 troy ounce silver futures. Executives had planned to introduce gold, silver and copper future contracts denominated in renminbi later this year, and they talked of eventually adding base metals, energy, agricultural products and currencies.

HKMEx never lived up to its founders’ ambitions. Trading volume from the exchange’s launch in May 2011 to this January exceeded 2.2 million contracts worth a total of $114.5 billion, but activity fell off dramatically in recent months, which coincided with a sharp decline in precious metals prices. Gold futures volume averaged just 866 contracts a day in May, down from 5,415 in May 2012, while silver volume tumbled to an average of 182 contracts a day from 5,415.

A trader, who asked not to be identified by name and whose firm paid $50,000 for an annual membership on HKMEx a year ago, said his firm didn’t even trade on the exchange as volume was “simply too low.”

The exchange’s collapse appeared to be anything but a surprise to many traders. Most of them closed their positions the day before the exchange shut down; open interest totaled only 200 contracts when HKMEx suspended trading.

There is no question that HKMEx faced stiff competition. Hong Kong has a total of 22 other licensed electronic exchanges, including Australian exchange operator ASX, a local affiliate of Bloomberg Tradebook, the Chicago Mercantile Exchange Inc. and the London Metal Exchange. The latter firm was acquired by Hong Kong Exchanges & Clearing, operator of the local stock exchange, for £1.4 billion ($2.2 billion) last year. China has four commodity exchanges of its own, and those exchanges have been lobbying regulators in Beijing to restrict Chinese investors’ access to offshore futures trading venues.

“LME and CME are well-established exchanges and HKMEx would have found it tough to compete with them on an ongoing basis,” says Celent’s Jasmal. “The Chinese commodity exchanges are quite strong as well, so it is not really an untapped market as such.”

Regulators began their investigation into the exchange on May 15 after finding that its finances were deteriorating. They passed the case to police after discovering “suspected irregularities,” Li says, citing a statement the regulatory agency gave to Hong Kong legislators who questioned authorities on the matter. Li and other authorities refuse to comment further, but do confirm they have questioned HKMEx’s Cheung as part of their investigation.

Paul Schulte, a former Asia equity strategist at Nomura Securities and now the editor of Paul Schulte’s Bull’s Eye Report, says he believes Hong Kong officials realize their city’s reputation as a global financial center is at stake and will do everything to protect it.

“This seems to be part of a broader attempt to reinforce the reputation of Hong Kong as a separate legal entity from China, which is ruled by laws and not by people,” says Schulte. “And if institutions fail, or people go to jail, or people get banned from the financial industry for life, so be it. This reinforces confidence in Hong Kong.”

David Webb, a local corporate governance activist, blamed a faulty business model for the exchange’s collapse.

“HKMEx was based on a fundamental misconception that China needed its own offshore exchange to influence prices,” Webb says. “Supply and demand influence prices, not the location of the futures market. HKMEx was always going to struggle to gain traction against well established trading venues elsewhere in the world.”

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