No commodity futures extension to Hong Kong Stock Connect

China will instead look to build futures trading onshore via the Shanghai Free Trade Zone

Plans by the Hong Kong Exchange (HKEx) to expand its Stock Connect programme to include commodity futures are set to be stymied by Chinese moves to only allow global firms access to its onshore futures markets via the newly minted Shanghai free trade zone (FTZ).

Since the launch of Stock Connect on November 17, HKEx chief executive Charles Li has been vigorously promoting the expansion of the current cash-only link to include derivatives and other asset classes. Speaking at a recent industry conference in Hong Kong, Li said the bourse is "looking to build another bridge [into China] that is more relevant to you in the derivative universe".

Previously, Li had referred to a multi-stage process that would see ETF options, commodities, derivative warrants, options, currency futures and interest rate products added to the bridge once Stock Connect had been successfully extended to the Shenzhen bourse, a move which is expected to happen in the second half of 2015.

However, one person familiar with Chinese government thinking said that while there was a strong case for allowing local investors a broader range of cash equity investments via Stock Connect there was no compelling case to do so for commodity futures.

Instead the source pointed to the move by Zhengzhou Commodity Exchange at the end of December to stop US-based Ice launching cotton and sugar futures on its Singapore exchange which were similar to ones it already trades – and which the source says is part of a broader move to keep China futures trading onshore.

This view was backed by Eric Ren, Shanghai-based general director of Haitong Futures business development group, who says Stock Connect should not be interpreted as the model for allowing global investors to access all Chinese financial markets.

"The Stock Connect programme is a symbol that shows China's willingness to open up, but it does not mean other asset classes, for example, commodities, will follow the same opening path. From the Chinese regulators' perspective, the core question is whether it is beneficial to our country and our investors."

Ren says that while there is a strong two-way interest in cash equities between global and local investors, the case for commodity futures is far less compelling. While China's commodity futures markets are booming – there was a 38.9% increase in volumes in 2013, according to the Futures Industry Association – Hong Kong's are anaemic at best.

For example, on December 1 HKEx launched three renminbi-denominated mini commodity futures contracts – zinc, copper and aluminium – to little market impact, with the latter currently trading just 43 contracts a day in February according to pricing agency Platts. Ren says his firm hasn't seen any interest in HKEx's mini commodities contracts so far and that clients who want to trade with the LME or CME directly are already able to do so.

"Stock Connect works well because it mutually benefits mainland and global investors. A lot of mainland investors are interested in buying Hong Kong-listed Chinese stocks, but Hong Kong is traditionally not an active market for trading commodities, so doing a commodity link might be of little value to Chinese investors," says Ren.

Gold trading was launched in the FTZ last September, with renminbi-denominated oil futures due imminently at the newly created International Energy Trade Centre, and a number of base metal futures contracts expected to follow afterwards. As a result Ren says he expects the FTZ, not Hong Kong, to benefit from China looking to internationalise its futures markets.

"The FTZ can be the fastest path to internationalise commodities trading because it will give foreign investors so far the greatest flexibility in managing their capital, compared with QFII or Stock Connect, both of which have quota limits."

Ren's view was backed by a senior official from the Shanghai International Energy Exchange, who says that both Stock Connect and the FTZ represent different stages of China's economic development.

"The Stock Connect programme is a temporary measure under the backdrop of semi-closed capital market of China, while free trade zone represents the essential moves of opening up," says the official, who declined to be named.

Several global banks including BNP Paribas, Citi, Standard Chartered as well as regional players such as DBS are already active in the Shanghai FTZ, while a number of Chinese institutions including the Shanghai Gold Exchange, the China Financial Futures Exchange and the Shanghai Equity Exchange have announced they will set up units in the zone.

As such, according to one Singapore-based commodity trader, "it's only natural that the confluence of the offshore and onshore China commodity markets will occur in Shanghai and not Hong Kong."

If so, it wouldn't be the first time HKEx's China ambitions have been thwarted: a previous attempt to set up LME-licensed (LME is owned by the Hong Kong bourse) warehouses was ended by a ban on foreign exchanges owning such facilities onshore. The Chinese authorities have instead approached individual LME members to set up stand-alone warehouses within the FTZ.

An HKEx spokesman says the exchange is still committed to expanding the range of asset classes beyond the current cash equity arrangement.

"HKEx's focus now is on completing a Connect model with Shenzhen and it hopes a link will commence later this year. HKEx has said from the beginning that the Connect concept can be extended to other asset classes, including commodities.

"HKEx's aim is to assist international investors to invest in mainland products by either providing them with access to domestic markets, or bringing mainland China's domestic products through listing or licensing to Hong Kong when direct access is not yet possible; and vice versa for mainland investors."