Analysis: HSBC's China gold futures foray harbinger of change

SHANGHAI Wed Aug 3, 2011 5:04am EDT

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SHANGHAI (Reuters) - China giving HSBC Holdings Plc (HSBA.L) (0005.HK) entry to its gold futures market, a first for a foreign bank, is likely a harbinger of a further opening to local and overseas institutions to trade the precious metal.

For the Shanghai Futures Exchange, which has received tepid interest in its gold futures, having HSBC as a trading member is arguably one of the best endorsements to show that it will play a larger role in China's booming gold market.

That process in turn will enhance the lagging role of futures in Shanghai's gold market -- an essential component to its hopes of becoming a major gold trading center on a par with London and New York.

But that opening up is likely to be confined to gold for now, analysts say, as China wants to keep a tight grip on the futures markets for other commodities from copper to soybeans, seen as a bedrock of the stability of China's economy.

"It is a structural shift and has a deep symbolic importance," Chen Baizhu, a professor of finance at the USC Marshall School of Business, said of the HSBC move.

"It sends the signal that Chinese regulators are ready to take the next step to develop its gold market and are ready to start linking up with international players."

China's moves to free up its gold market will not only create more trading opportunities for foreign banks, but it will also allow them to tap growing local demand for gold investment products.

In the longer term, being a major gold trading center would boost the country's clout in setting global prices.

"CELEBRITY" ENDORSEMENT

China, the world's top gold producer, second-largest consumer and sixth-largest holder of reserves, already boasts a flourishing trade on the Shanghai Gold Exchange (SGE), set up in 2002 after half a century of government monopoly.

There, banks, producers and refiners trade spot gold and the SGE's spot deferred contract, using it as a hedging tool since its launch in 2004.

But the road to building a successful international gold trading market -- part of China's broader aim of turning Shanghai into a world-class financial center within the decade -- will require a series of overhauls to its financial system, not least the creating of a thriving futures market.

The Shanghai Futures Exchange (SHFE) launched a gold futures market in 2008, but that contract has failed to garner much interest due to limited bank membership and short trading hours.

On average, monthly trading volume of the SHFE's gold futures ranges from 50 to 60 percent that on the main gold exchange, even though turnover of gold futures tends to exceed spot volume by many times on other exchanges.

By letting in HSBC, one of the world's leading gold trading houses, the SHFE will pave the way for more foreign and local banks to join the market -- a big step toward the liberalization of the tightly controlled gold sector and one that could help deepen the derivatives market.

Until now, only four domestic commercial banks, in addition to local futures brokerages, have been allowed to trade the contract.

Mechanisms set up by the Shanghai Futures Exchange to limit members' open interest would allay concerns of excessive dominance by a handful of traders.

Overseas banks that are next in line to enter the gold futures market will likely be those that already have a trading membership on the Shanghai Gold Exchange, analysts said, including the Chinese units of Standard Chartered Bank (STAN.L) (2888.HK), ANZ Bank (ANZ.AX), Bank of Nova Scotia, Credit Suisse CSGSN.UL and United Overseas Bank (UOBH.SI).

Bringing HSBC, one of five members of the London Bullion Market Association with the right to fix prices, onto its register also means the SHFE will be able to tap the bank's deep knowledge and expertise to improve its own trading system.

"This shows the wheels are now in motion for the further liberalization of China's gold market and in time, foreign players could also be allowed to supply gold to the exchange," said He Wei, a gold analyst at Nanhua Futures Brokerage.

"It won't happen overnight or the next one or two years, but when it does, it would greatly boost China's gold imports."

DOUBTS LINGER

Bringing in foreign players will not be enough, though.

The short trading session of the SHFE's gold contract -- currently four hours a day -- limit its relevance and give a leg up to the main gold exchange.

The exchange is already eyeing an extension into the night to be more closely connected to foreign markets, although industry experts are skeptical that the plan will materialize soon since it will have to work out a slew of operational problems first.

"Having night trading is key for Shanghai Futures to claim back its relevance. Otherwise, the trading risks for members are too high," said He.

Beijing has also been gradually loosening up other regulatory restrictions on the gold market, with an eye to expanding its global stature.

The People's Bank of China, the central bank, last year unveiled plans to let more banks import and export gold, and open trading further to foreign companies.

However, a web of other restrictions in the financial sector, including China's capital controls, will likely hinder the futures market's development.

To transform into a gold trading hub, both exchanges will also have to roll out more financial gold products, including forwards, swaps, gold loans and gold-focused exchange-traded funds.

Beijing will also need to win back the trust of investors, who clearly remember its move to embolden state-owned firms in 2009 to renege on money-losing derivative contracts that ran into billions of dollars.

"China needs a big image overhaul before it can compete with New York or London to be a major gold center," said a senior executive at a foreign bank doing gold trading in China who declined to be identified by name.

(Additional reporting by Polly Yam in Hong Kong; Editing by Jason Subler and Michael Urquhart)

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