An Interview with Charles Li

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An Interview

with Charles Li

HKEX-LME:

Building a Bridge Between Two Worlds

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ous example of this new strategy. The blockbuster deal, which was an-nounced in July and closed in December of last year, moved HKEx into the top ranks of the world’s leading commodity exchanges in a single jump and paved the way for greater linkages between LME and the enormous flow of commodities into China.

That is not the only example, however. HKEx is building a new clearinghouse to serve the over-the-counter derivatives markets, focus-ing on swaps denominated in renminbi. In April, HKEx announced that 12 financial institutions had agreed to buy a stake in the clear-inghouse, including international banks such as Citi, Deutsche Bank and J.P. Morgan, as well as banks from mainland China such as Bank of China and Industrial and Commercial Bank of China.

HKEx also is in the process of modernizing its technology through a HKD $3 billion investment across several initiatives. For example, the exchange is consolidating its IT operations into a new state-of-the-art data center, installing new trading platforms with more ca-pacity and faster processing, and providing low-latency connectivity for both access to its markets and the dissemination of market data.

which accounts for more than half of the exchange’s total derivatives volume. Market-making has been expanded, more contract months are being listed, trading fees have been reduced, and market data is being offered for free for a year.

Nevertheless, LME represents the key to the overall strategy. This is not only because HKEx sees the potential for greater trading of LME’s metals futures and options in the Asia time-zone. The real value, according to Li, is the potential effect on the Chinese govern-ment’s willingness to accelerate the opening of China’s financial sec-tor to the outside world.

In the following interview, Li explains his vision for how the LME acquisition will serve as a catalyst for greater outflows of capital from China and how HKEx is positioning itself to support that outflow with a greatly expanded range of products and services. This interview is the latest in a series conducted by Walt Lukken, president and chief executive officer of FIA. Previous interviewees included CME’s Phupinder Gill, DTCC’s Michael Bodson, ICE’s Jeff Sprecher and Man Group’s Tim Wong.

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LUKKEN: For many people in our

indus-try, the first thing they think of with the Hong Kong Exchanges and Clearing is the acquisition of the London Metal Exchange. Obviously you have a very strong equities franchise and a great strategic position as the gateway to China, but the LME deal re-ally takes you in a new and very different direction. Can you walk us through how the deal came to be and the strategic vision behind it?

LI: Well, to really answer that question, I should give you the overall context of how we position our exchange between China and the rest of the world. Today we are es-sentially a cash equity exchange. We are very big in terms of the market cap of the shares listed on our exchange. In fact, we’ve been number one or two in market cap for quite a long time. But we are limited to this single dimension of the markets.

So when we think about our vision for HKEx, it starts with being in this particu-lar space between China and the rest of the world. Our business model is essentially driven by how we see ourselves participat-ing in that transformative process by which China integrates into the rest of the world.

Hong Kong is a small city, with seven million people and maybe 1,100 square ki-lometers. We don’t grow anything, and we don’t manufacture anything. But we have this unique political and economic system called “One Country, Two Systems.” We are part of China, but we are a capitalist market economy, with an open society, rule of law, freedom of expression, and everything else that goes along with that. That puts us into a unique position to help with this integration.

Over the last 20 years, China has been growing in terms of manufacturing, but its

financial market is largely closed. There is a dichotomy between a globalized economy and a closed financial system. It is in that context that our exchange has become Chi-na’s capital formation center offshore, es-sentially allowing Chinese companies to sell equity, raise capital, and move that money into China.

LUKKEN: How do you see this integration

process developing over time?

LI: I think we are now coming to a turning point. We are facing a China that is going through a transformative structural change, shifting from being a capital importer to be-ing a capital exporter. I sometimes use the metaphor of the Three Gorges Dam. For the last 20 or 30 years the goal has been to fill that dam with capital from everywhere else and use that capital to support the growth of China. Today that dam is almost full. The

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water is spilling over. So the big challenge that China faces is how to open the flood-gates and move into the next phase.

There are several things that China wants to achieve. One is to broaden its savings space from domestic banks and the domes-tic capital market to international diver-sification. Second, many of China’s major corporations are facing tremendous risks in currency prices, exchange rates, and interest rates. China’s own domestic futures market is incapable of meeting their need to man-age those risks.

Third, even though China is the biggest consumer or producer of many metals and other commodities, the domestic players can only do risk management in the domes-tic market, even though their exposure is much beyond the domestic market.

So the question arises—are we ready for this structural change? As I mentioned be-fore, the Hong Kong Exchange tradition-ally was a one dimensional exchange serving that equity need. We know we’re not ready for this major shift. We know that the shift requires us to be positioned where China feels comfortable experimenting with this opening in Hong Kong first, and then grad-ually opening up the mainland economy.

LUKKEN: This structural shift that you are

describing, can you give us a sense of how fast this is going to come about?

LI: This is not something that depends on how fast individual leaders or individual in-stitutions want to move. The real issue is that China, because of its unique political cir-cumstances, is constrained from moving for-ward on this sort of economic policy by her great fear of the consequences. The upside for getting the right thing done sometimes is

overwhelmed by the fear of the downside if something goes wrong. There’s a tendency to err on the side of slowing down, just in case unintended consequences are created.

So the biggest challenge and the biggest opportunity for the Hong Kong Exchange is whether we find a way to accelerate that opening by finding a way to keep the fear in check.

For example, China realizes the need for this massive change but it doesn’t want to substantially change the domestic regula-tory systems or market practices or market infrastructures. So we are trying to explore ways for us to build a mutual access model, where we could potentially have interna-tional flows into China use Hong Kong as the first stop and the last stop. That way the international flows can impact domestic

pricing, but the risk of those flows stays at the border.

The reverse is also hopefully true. Can we find ways to have the Chinese volume participate in price discovery beyond the border, but find a way for that volume to stop at the border in terms of clearing, risk management and settlement? So you could potentially accelerate the opening with a much greater scale and pace without fun-damentally altering the structures of the do-mestic market.

LUKKEN: I was in Shanghai in May 2012,

and the Shanghai Futures Exchange was talking about listing a crude oil futures con-tract that would be opened up to traders outside of China. Is that an example of the opening trend that you are talking about?

LI: That actually is a big example. Argu-ably it could become the template to make it work because it will require international

participation to gain maximum interna-tional credibility. So I think there could be a breakthrough in further opening up so that the contract can be traded by everybody.

However, there are constraints such as capital controls and cross border fund trans-fer rules. So we’re trying to find a way to see if Hong Kong can play any role in facilitat-ing international participation in mainland products and markets.

Going back to LME, essentially what we realized is that we could not stay in the cash equity side. We needed to move into fixed income and currency. We needed to move into commodities. Once we reached that realization, then we had to debate where to start. We knew that it would be extremely hard to start a commodity or currency or fixed income exchange from scratch. We

also knew that in fixed income and cur-rency, you have to have a very strong sover-eign issuer and soversover-eign backed market in order to build the benchmarks to get all the other products going.

Well, Hong Kong is not one of those types of markets. The Hong Kong Mon-etary Authority does not issue a lot of debt and a lot of the debt is done in U.S. dollars. So our fixed income and currency markets are never going to be as strong as the rest of the advanced economies, simply because we just don’t have enough of a sovereign driven sub-market.

China, on the other hand, has a huge economy and potentially a massive fixed in-come market. Once China’s capital account opens and renminbi is internationalized, that business will be huge. So we started OTC Clear. But we also know that it will take time for the currency to international-ize. We need to have enough renminbi to

Charles

Li

I remember the first call I made on this, almost three months after I

became CEO back in 2010. I spoke with some bankers who knew LME

extremely well,

but the feedback at that time was that LME would

never ever be for sale.

It was just a broker club. Well, obviously that

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call I made on this, almost three months af-ter I became CEO back in 2010. I spoke with some bankers who knew LME ex-tremely well, but the feedback at that time was that LME would never ever be for sale. It was just a broker club. Well, obviously that changed, and the timing worked out very well for us.

LUKKEN: Given that interest in the

com-modities sector broadly speaking, why did you decide to focus on LME and the metals market in particular?

LI: Why LME? Because out of all the major commodities, base metals is really the one area where China is massively relevant. The urbanization of China has created a mas-sive need for base metals. China has been 40% of global consumption of base metals for the last 10 years. But because of China’s own self-imposed restrictions, China’s par-ticipation in the base metals futures markets is a lot less than the number seems to be suggesting.

We think Chinese participation in LME markets is somewhere around 20%. We don’t really have reliable statistics on this be-cause you never really know from the bro-ker numbers who is behind the trading. But every year, during the Chinese New Year holidays, LME volume drops 15% to 20%, and then as soon as the holidays are over, it goes back up 20%. I see that as the closest proxy for Chinese participation. So there is a huge way to go relative to the 40% of the physical production that China consumes.

Also, if you go to China and talk to Chi-nese players, the only international com-modity exchange that they really know, that everybody considers to be sort of the holy grail of commodity trading, is LME.

LUKKEN: Do you feel that the price you

paid to acquire LME was the right price?

LI: Well, we think history will show that we bought a massively great asset at a very good

uct suite of LME work a lot better in terms of getting more volume. Number one, by reducing the current restrictions on trad-ing an LME product. Number two, hope-fully, building LME warehouse access into China. Number three, introducing Asian time-zone clearing and Asian time-zone price discovery, which hopefully will stimu-late greater Asian time-zone demand. And number four, renminbi clearing for the contracts with Chinese participation. Those things alone will make a very healthy return on our investment in LME.

The second bucket is using LME to get into other commodities linked to China, such as ferrous metals, coal, iron ore, freight, maybe rubber or jet fuel or any other thing that we could potentially develop. We’re thinking that these may be more suited to a traditional futures contract, a cash-settled monthly contract, rather than the LME day structure, which is heavily premised on physical delivery. Probably this will not be directly from the LME platform. This is probably going to be Hong Kong-based product or Hong Kong-based trading vol-ume. Some of these second bucket contracts we’re going to put onto the Hong Kong platform, but supported by domestic China flows, if we’re able to get that bridge built. The value there is massive.

The third bucket on LME is that over time it will have to commercialize. We’re now funding the build-out of the clearing house. With clearing there will be signifi-cant new revenue possibilities and also the capability to develop other products that, without clearing, would be awfully hard. We also know, in the future, fees will have to be commercialized. Right now, our fees are only a fraction of our competitors.

So all three of those buckets over time will make this price extremely reasonable. But all of that is based on LME or derived from LME. The other dimension of our vi-sion for LME is that it helps us accelerate

again is all about access with China. Both of those initiatives will create significant need for renminbi to go in and come out of China. When that happens, our fixed income and currency business will become extremely important and bring new busi-nesses, such as OTC Clear. We started OTC Clear because we see a huge potential as renminbi becomes internationalized and China’s capital account opens, but we don’t have the aspiration to become a competitor for LCH.Clearnet and go after the dollar and Euro business. All of this is premised on the successful breakthrough on equity and commodities with renminbi flow, with renminbi being used to invest in equities or commodities, which will trigger significant risk management needs, and that will be when our currency product and the OTC world become more thriving.

LUKKEN: I think people are interested

in the historic nature of LME and how the trading has worked with the ring system. Are there plans to bring that into the more modern era, or to have different types of trading access to those LME markets? Are you thinking about potential cross listing in Hong Kong and what’s going on in Lon-don? What are the plans there?

LI: All those things are probably slightly a distance into the future, simply because we have so much low hanging fruit to pick in Asia on the back of the LME acquisition. We have no immediate plans or even tangi-ble preferences to keep the market structure the way it is or make changes to it, because ultimately those things are not going to move the needle for us. So we will continue to rely on the existing business model and see what happens. At some point, if all the members feel that there’s a need to change, we can consider that. Many of the things that we’re doing here in Asia will bring sig-nificant tangible benefits to our member-ship. Hopefully they will find a lot of value

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in participating in those Asian-based initia-tives, and maybe, one day, that will be an impetus or catalyst for us to consider chang-ing the market structure. But at this point, as I said, it doesn’t move the needle. We bought it not because we think we have bet-ter ideas as to how to make it betbet-ter. There are many bigger things and bigger fish for us to fry. We’re going to leave it alone.

LUKKEN: Are there any other strategic

as-sets that you need to implement or buy in the future?

LI: Well, the other initiative that I should mention is our data center. For a long time we have not invested in our equity market. Our return on equity was very high, it was 70% at one point, and that reflected the money we were making but also the

under-investment in our fixed assets. So building the new data center is something we had to do to put us on the map in terms of the modern technology of trading, and most importantly, consolidating all of our tech-nology assets in one place.

LUKKEN: Do you allow for co-location?

LI: Yes, though we call it hosting services. This is about creating an ecosystem where the clearing participants, the trading par-ticipants, the technology vendors, everyone is all together. The other thing is connec-tivity. We have a big pipe into the equity exchanges of China. We have pipes to ev-eryone else, so we potentially could become a central transfer point for connectivity be-tween global and China.

One other point is related to our vision of mutual access. China has a very different market structure, where retail investors all have individual accounts with exchanges. There are 120 million accounts between Shenzhen and Shanghai. We only have two

million accounts. So over time, if we want to be more closely integrated with them, our market infrastructure needs to have the capacity to accommodate that market structure. In that context, our data center allows us to really enhance our capability to make those accommodations when they become necessary.

LUKKEN: We’ve talked a lot on the theme

of Hong Kong being a bridge between China and the world. I look at your per-sonal background, having gone to school at Alabama, having worked at JP Morgan. How has that background helped you in your current position, as the CEO of this organization, and to help connect these two worlds?

LI: I think I’m very fortunate that I am

in this position at the right time, with the right circumstances. Because being in Hong Kong, particularly with the acquisition of LME, we need to be credible with every-body.

In China it’s not necessarily about who you know, it’s more about your fundamen-tal understanding of their needs and mak-ing the other side feel that you are deliver-ing value to them and they have no problem with you making money out of that. On the other hand, they need to be willing to trust you. They need to understand that in order for you to deliver that value, you need to be trusted by everyone else.

To make that work, to maintain our credibility with the rest of the world, we need to continue to maintain a high qual-ity market based on the rule of law and free market capitalist systems, rather than arbitrary interference by government. Having worked in Wall Street in different dimensions and different roles, I under-stand that, both in terms of our insistence

on integrity, and also the apprehension that somehow Hong Kong could slide into the other direction.

I can tell you that this was a big chal-lenge in the context of LME. On the one hand, the owners wanted to sell to some-body who could bring strategic value rather than just the price. Clearly they bought the story that Hong Kong brings much greater potential collateral benefits to them than just the check. So they like to hear that you’re very close with China and that you’re able to deliver all the things that they have not been able to do. But on the other hand, that connection to China makes the regulators, the press, and the community afraid that we are a puppet or a proxy for China. So, in a sense, we had to make two arguments that conflict with

each other at the same time, in order to make sure the people who wanted to sell to us trust that we are China enough, and the people who are worried about it, thinking we are not China at all.

So it’s really a question of getting all sides to feel comfortable with our role and appreciate the value that we are deliver-ing. In that sense, the opening through Hong Kong becomes, to use the adage you mentioned earlier, a way of touching the stones and crossing the river. Because they already have crossed a couple of times, they know the stones are there, they are solid and they are not going to slip. That confidence and familiarity hopefully will allow us to build on the LME acquisition and leverage it into mutual access across a whole range of dimensions.