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COLUMN-Lacking alternatives, HKEx has to keep the faith with London Metal Exchange: Andy Home

Exchange: Andy Home@ (The opinions expressed here are those of the author, a columnist for Reuters.)

LONDON, Sept 11 (Reuters) - The London Metal Exchange (LME) last week laid out its plans for stemming a near three-year slide in trading volumes.

The first step will be a dramatic cut in some of the exchange's trading fees as it looks to grab back business that has been seeping into the over-the-counter (OTC) shadows.

The LME has the backing of Hong Kong Exchanges and Clearing (HKEx), which bought the 140-year old grande dame of metals trading in 2012.

Charles Li, chief executive of HKEx, told Reuters he accepted that mistakes had been made with some of the previous hikes in fees.

He's confident that any short-term hit on revenue will eventually be offset by the proposed introduction of a new fee on some OTC trades.

In truth he has little choice in the matter.

In terms of HKEx's commodities business, the LME is pretty much all he's got right now because the broader strategy into which the London exchange was supposed to fit has unravelled.

NO CONNECT

"We'd love to have a commodities connect," Li told a Reuters Newsmaker event last week, adding it "would be a natural extension of the connect programme."

HKEx has a "stocks connect" and, since July, a new "bond connect", linking international and Chinese domestic markets.

Commodities has always supposed to have been on the list.

Indeed, leveraging Hong Kong's unique position to tap China's huge metals industry was the key reason HKEx forked out $1.388 billion pounds for the LME in the first place.

While everyone was interested in the potential revenues from commercialising the LME, at that stage a limited profit entity, only HKEx brought an extra strategic vision to the negotiating table.

One in which HKEx would use the LME's global pricing franchise to "open up" China's metal markets to the rest of the world. And vice versa.

But that has not happened.

For the simple reason there is no one to connect with in mainland China.

It's not that there aren't any candidates.

The Shanghai Futures Exchange (ShFE) is an obvious one, trading a similar spectrum of metals contracts as the LME. The Dalian Exchange dominates in Chinese iron ore, while Zhengzhou Exchange trades more esoteric alloys such as ferrosilicon and silico-manganese.

It's just that no one is interested in connecting.

The domestic exchanges, according to Li, "need to feel they can get something out of it".

After the acquisition of the LME, "we have more and more to offer but they need to feel that what we have to offer is what they need".

Finding that "common ground" remains work in progress but Li's initial optimism seems to be fading. There's a "distinct likelihood" domestic exchanges such as ShFE decide they have no need for a connector.

SLOW BOAT TO QIANHAI

HKEx's plan B is to build its own Chinese exchange with which to connect.

The Qianhai Mercantile Exchange will not be a futures market since that would require official Chinese regulatory approval.

Rather, it will be a spot market with warehousing infrastructure similar to that on the LME. The idea, according to Li, is to create "a commodity bank, so to speak".

One that would facilitate the financing of physical metals without the attendant ownership and supervisory risks that were exposed by the Qingdao port scandal in 2014.

All of which sounds eminently sensible and feasible but don't hold your breath in terms of timing.

Li declined to put any specific time-frame on development of the Qianhai metals project.

The initiative is at "an early stage" and it's going to "be a long work in progress". But "we are prepared to go the long haul".

You get the idea.

Plan A is on hold and Plan B is going to take a bit of time. Quite a lot of time, by the sound of it.

PIPE DREAM?

HKEx' original vision of using the LME to connect with the Chinese mainland appears to have run aground.

Was it all a pipe-dream?

Certainly the premise that international and Chinese metal markets were two separate universes just waiting for someone like HKEx to connect them may have been questionable.

Many of China's biggest state owned metals players had been directly involved in LME trading for many, many years.

Even the country's secretive State Reserves Bureau was a major user of the LME copper contract until it got undone by a trading scandal in the middle of the last decade.

Such parts of the Chinese metals industry didn't need a new connnector to link them with an exchange they were already trading.

And although Li is certainly right when he talks in terms of physical commodities as a facilitator of financial flows within China, the market may have beaten him to it.

After all, a good part of the copper sitting in bonded warehouses in Shanghai is locked down in some sort of financing structure, while LME nickel has emerged as a favoured collateral play for Asian players, including the Chinese.

True, as Qingdao demonstrated, there is space for a more stuctured and regulated mechanism for collateral financing in mainland China.

But that's a different pitch from the original vision of using the LME to tap massive latent demand in China.

Moreover, there was always a chance that domestic exchanges were going to view HKEx as a potential aggressor rather than partner.

The Shanghai Futures Exchange had already shown its hostility to the LME prior to the HKEx purchase by getting the Chinese regulators to ban any overseas exchange opening up delivery warehouses on the mainland.

HKEx's exuberant purchase of the LME was based on a belief that a Hong Kong company was better placed to pull the right political levers in Beijing.

Five years on and there are no LME warehouses in mainland China. Nor are any likely any time soon.

Lacking a connector option, HKEx's Chinese metals strategy boils down to maintaining a dialogue with domestic exchanges while travelling down the long road to creating its own mainland market.

That leaves its global strategy dependent on its turbulent LME franchise. It can only hope the LME has worked out a way of stopping that volume slide. (Editing by Greg Mahlich)