RMB settlement of LME commodities futures could impede market progress

Currency risk and restrictions on offshore RMB will act as a drag, but extension of cash equity 'through train' proposals to include commodities could be game changer

Hong Kong Exchanges and Clearing's (HKEx) plans to launch renminbi-denominated metals and coal futures contracts on its trading platform later this year will create a potential foreign exchange risk for investors and may deter participants until the "through train" trial is extended beyond equities, say market experts.

HKEx announced on April 22 that it would list aluminium, zinc, copper and thermal coal futures on the exchange later this year. The first three contracts will be traded and settled in RMB while the thermal coal contract will be dollar denominated. The products are based on the London Metal Exchange (LME) existing suite of futures but at a much smaller size – five tonnes per contract as opposed to 25 tonnes. Additionally the HKEx products will be cash settled, instead of physically delivered on the LME.

HKEx chief executive Charles Li hailed the move as helping the internationalisation of the RMB; however, market players questioned whether using the yuan as a settlement currency could inhibit the contracts' success. "By designating RMB as settlement currency, HKEx wants to facilitate the internationalisation of Chinese currency, but it actually creates unnecessary problems for investors," says a Hong Kong-based dealer.

As well as the currency risk that the RMB's current weakness versus the dollar causes for investors, restrictions on moving renminbi offshore mean the contracts will attract a limited number of investors from China, says the dealer. This could dampen HKEx's plans to target mainland physical trading firms looking to arbitrage the difference between onshore and offshore base metals prices, and retail investors on the mainland and Hong Kong.

"Market participants who are bullish about Chinese currency may have a good response to the products, but at least right now yuan is depreciated against dollar and will stay at a two-way float in the long term, so the currency risk cannot be ignored," the dealer says.

HKEx points to its RMB currency futures or other products which can be used to hedge out this risk, but the dealer says listing the products in a range of currencies would be a preferable approach.

"A better solution is to introduce two types of contracts simultaneously, one in RMB and the other in dollar. Let the market tell which one is more accepted by investors." The dealer questions whether the trading volumes of the contracts will see a significant growth in the short term.

This view was backed by Simon Tint, chief analyst at GF Futures (Hong Kong), who says that investors may take a wait-and-see approach for the first six months of the product launch to gauge open interest and trading volumes.

The launch of LME contracts marks HKEx's first step to move into the commodity business. HKEx hopes eventually to develop a commodity version of the Shanghai-Hong Kong Stock Connect pilot programme and develop itself as an important bridge connecting China's derivatives market to the world.

So far this pilot programme – referred to as the "through train" – is restricted to a section of the cash equity market. However, speaking at LME Week Asia in Hong Kong at the end of April, HKEx's Li said he was hopeful the policy could be extended to commodities. Crucially, the current through train proposals see trades settled at the border, meaning no currency risk, potentially giving investors from China access to HKEx.

According to Daniel Weinberg, Sydney-based partner at Optiver, a market-maker on HKEx, if the existing proposals for trading of equities are expanded to include commodity derivatives it will provide a major boost to the Hong Kong market given that China currently accounts for three of the five largest commodities futures exchanges globally, according to the World Federation of Exchanges.

"What they have proposed with the through train is really clever: if you are a mainland investor, everything stops at the borders, so if you buy something in Hong Kong, everything will be cleared and held in China in RMB, so there are no currency issues. Mainland Chinese investors will be able to buy the securities without opening up accounts with Hong Kong brokers – it's all going to be as smooth as possible."

HKEx has been in talks with Shanghai Futures Exchange (SHFE), Zhengzhou Commodity Exchange (ZCE) and Dalian Commodity Exchange (DCE) to study the potential cross-listing of products but no firm plans have yet been made.

A spokesman for DCE in Dalian says: "We have been discussing co-operation with HKEx since 2012, to authorise HKEx to use our settlement price, but the essential progress hinges on the regulatory development in China."

Speaking at LME Week Asia on April 24, SHFE president Yang Maijun said the exchange was keen to collaborate with international exchanges and has been paving the way for this for a long time. He predicted that the opening up of the futures market will start with the commodity types that enjoy stable trading volumes such as gold, silver and nonferrous metals.