Why China's takeover of the Chicago Stock Exchange would have been a very bad thing

Late Thursday, the Securities and Exchange Commission issued a notice announcing it did not approve the proposed acquisition of the 136-year-old Chicago Stock Exchange by a Chinese-led consortium.

The Chicago exchange, better known as CHX, is not happy, saying in a statement the SEC “unfairly” disadvantaged “our company and shareholders.”

The stakes for the rest of America are high. As Rep. Robert Pittenger, R-N.C., pointed out before the SEC turned down the deal, a successful takeover would be “the first time a Chinese-owned, possibly state-influenced, firm maintained direct access into the $22 trillion U.S. equity marketplace.”

At the moment at least, Chinese plans are on hold. And that, for many reasons, is a good development.

In December 2016, CHX filed a proposed rule change, pursuant to the Securities Exchange Act of 1934, that would allow a group, led by Chongqing Casin Enterprise Group, to acquire the exchange.

Chinese ownership could permit Beijing to “breach personal and business data.”

The SEC on Thursday blocked the $25 million takeover due to concerns about the ability of the Chicago exchange “to ensure ongoing compliance” with ownership and voting limitations. Moreover, the Commission questioned whether “the proposed ownership structure” would allow it “to exercise sufficient oversight” of the exchange.

It’s not hard to see why the SEC reached that conclusion. As the Commission’s staff sought more and more information about the deal, the clearer it became that the ties among the acquirers were murky. “The information made available to the Commission was insufficient to verify the ultimate source of the funds certain of the proposed upstream owners were using to fund their part of the transaction,” Thursday’s SEC notice states.

The Commission also noted that there were “potential undisclosed connections between purportedly unrelated members of the investor consortium.”

These connections are important because, as the Commission pointed out, “upstream owners” might be able to “exercise undue influence over the Exchange.”

To facilitate approval, three members of the acquisition group dropped out, according to an announcement last November. After the change, the remaining Chinese participant, a Casin-owned shell company, held a 29 percent interest in the consortium. Said John Kerin, CHX’s CEO, “We are confident this will address any concerns the Commission may have had about the ownership composition.”

Yet the reduction in Chinese ownership did not help. The fact that the acquirers did not answer previous questions from the Commission’s staff left the SEC unable to resolve matters relevant to the structure of the proposed acquisition after the trio exited the deal.

Theoretically, the Casin investment group could go back to restructure the deal to get the SEC to give its nod, yet the group’s deceptive responses to the Commission mean that, as a practical matter, it is unlikely to ever win approval.

It’s bad enough that the acquirers apparently tried to mislead the SEC. What is even more disturbing, as Fraser Howie, a prominent Asia-based investment analyst, told Fox News, is that Casin’s bid was “odd” to begin with.

For one thing, CHX was not a particularly attractive investment. Casin argued it could bring Chinese companies to market in Chicago, yet it’s hard to see how it could do so. The identity of owners of an exchange is almost never a factor for companies going public. As Andrew Collier of Orient Capital Research in Hong Kong told Fox News, exchange ownership would be relevant only “if the listing company thinks that doing a favor to the owners would pay off.”

As Collier points out, companies selling shares care most about liquidity and valuation. The tiny CHX, which handles about 0.5 percent of daily stock trading volume in the U.S, lacks liquidity and would continue to do so.

In the meantime, what happens when another Chinese group comes along to buy CHX? The SEC, basing its decision on technical grounds, did not have to consider the broader arguments about Chinese involvement in the U.S. financial system.

Such involvement is not in America’s interests. “Why can Chinese companies come and buy U.S. exchanges yet U.S. companies can neither start nor buy Chinese exchanges?” Howie, the co-author of “Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise,” asks. “Reciprocity should be our new mantra.”

There are also concerns about China undermining the U.S. economy. “Because any Chinese entity permitted by Beijing to play in foreign markets is effectively controlled by the Chinese government, all such deals, no matter how small or marginal the takeover target seems, enable that government, and the state-dominated Chinese system, to grow its footprint in the U.S. economy,” Alan Tonelson, a Washington, D.C.-based trade expert who blogs at RealityChek, told me. That, he persuasively argues, weakens our economy’s “basic free-market structure.”

No Chinese company could demonstrate independence these days due to Beijing’s tightening control, so allowing access to the America’s financial backbone looks exceedingly dangerous. Michael Wessel, a long-time commissioner of the U.S.-China Economic and Security Review Commission, tells Fox News that running an American exchange would give China inside information on its markets.

There are three principal dangers that flow from China having that information.

First, Beijing could gain technical information about infrastructure weaknesses should it cyberattack the markets.

Second, the Chinese could conceivably use their preferential position, inside the backbone, to profitably trade the markets.

Third, Chinese ownership could permit Beijing to “breach personal and business data,” as Rep. Pittenger, who has led the charge in Washington against the Casin bid, told Fox.

“Why on earth would we think that allowing them to control a U.S. exchange is in our interest?” Wessel asks.

Casin’s bid to buy CHX is unlikely to be the last Chinese attempt to control an American exchange. The next offer from that country will require Washington to answer, head on, Wessel’s critical question.

Gordon G. Chang is the author of The Coming Collapse of China. Follow him on Twitter @GordonGChang.