KUNMING, China (Reuters) - The plain four-storey Fanya exchange building in this southern Chinese city is teeming with investigators trying to understand how an obscure metal trading business turned into one of China’s most audacious investment schemes.

Workers direct a crane lifting newly-made steel bars at a factory of Dongbei Special Steel Group Co., Ltd., in Dalian, Liaoning province, China, October 13, 2015. REUTERS/China Daily

Tucked behind an upmarket shopping mall, the Fanya Exchange was founded in 2011 with the aim of giving China greater global control over the supply and price of 14 strategic and rare metals. It also offered an investment product promising annual returns as high as 13.68 percent and the flexibility to deposit and withdraw money at will.

It almost seemed too good to be true. And it was.

In July, hundreds of citizens gathered outside the exchange building in Kunming, demanding to know what had happened to more than 40 billion yuan ($6.6 billion) they had invested in a Fanya-backed product known as “Rijinbao” or “Daily Golden Jewel”. Five months later, they are still waiting for answers.

Government investigators and independent auditors are trying to get to grips with yet another wealth management product (WMP) gone awry in China, one that the government itself had promoted.

Fears are rising about the underlying risks to China’s financial system from the $2.6 trillion WMP industry and the challenges it pose to Chinese regulators. Many of these products are being sold on a plethora of privately run exchanges, which have come under increasing scrutiny from the state securities regulator, who is worried illegal behavior was putting billions of yuan at risk.

The scandal also highlights the political and social risks for the ruling Communist Party as China’s growing class of retail investors, with limited investment opportunities, become outraged over the disappearance of their life-savings into schemes they thought the government had endorsed as safe.

“We do see that Chinese regulators tend to be a bit more behind the curve,” said Zhou Hao, senior emerging markets economist at Commerzbank in Singapore. “We’ve seen it with stocks, in forex, and in the futures markets. It’s kind of a policeman and thief problem.”

“It’s not that they don’t want to do well, but the market develops very quickly and part of the problem is that there are many different regulators and a lot of gaps between them.”

As the Fanya scandal unfolded, a group of investors tracked down the chairman of the exchange, Shan Jiuliang, and hustled him off to a police station. Other groups of investors have descended on government bodies in Beijing and Shanghai to stage protests.

Security guards blocked Reuters from entering the Fanya exchange building. But in an interview outside, a Fanya manager who identified himself only by his surname Liao said the current investigations were expected to conclude within two months.

“We urge investors to show patience,” he said.

In a sign that Beijing has finally taken notice, the Kunming city government has said it is investigating illegal behavior at the exchange and that it had set up a “clean and rectify” team. It has promised to take action if illegal activity is uncovered.

A new Communist Party head has been appointed in Kunming and the vice-mayor was dismissed in October on corruption charges. Still, after waiting so many months for action, investors are skeptical they will recover their money.

“If the government had taken just 10 percent of the energy it used to stop us and spent it on trying to deal with Shan Jiuliang, then the Fanya situation would have been resolved immediately,” said a Shanghai-based investor who gave his name as Wang.

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The exchange and the Kunming government declined to comment.

Investors said the “Rijinbao” scheme was advertised on state television and the Fanya exchange described itself as government-backed and regulated. However, analysts say Chinese investors often assume banks and the government will cover any losses, so they fail to read the small print. Fanya guaranteed the product, which was based on rising metal prices and interest earned on financial deals.

RARE EARTHS

The Fanya Metals Exchange was launched shortly after China, the world’s dominant producer of rare earths, imposed quotas on production and exports in a bid to support prices and attract downstream consumers to China.

Fanya was keen to provide a supporting role, saying it wanted to raise the value of the whole minor metals industrial chain. It stockpiled and traded 14 metals, rapidly becoming the biggest minor metals market in the world. These metals are minor because they are a byproduct of extracting other major metals, such as zinc or copper.

“Fanya prices already lead global prices, and have made China’s voice on the minor metals’ stage growing increasingly strong,” it boasted on its website in 2014.

Prices for the metals traded on the exchange rose sharply and became increasingly out of sync with world prices.

Its most traded metal - indium – more than doubled between 2012 and 2015 to $1,200 per kg. Prices kept rising from the end of 2014 even as global prices headed into a rapid decline.

The price difference kept traders outside of China wary of using the exchange. Now they are worried about what will happen to the accumulated stock of metals on the exchange.

“It’s not clear how all this winds down, or what the local government or Beijing will do,” said David Abraham, director of the Technology, Rare and Electronic Materials Center. “There are lots of wild cards here.”

As early as last year, state regulators called on local authorities to “clean up and rectify” privately run exchanges throughout China. A provincial regulator in Yunnan singled out Fanya for rule-breaking behavior, although it did not provide details.

“The risks are huge,” it said.

Those risks became clear in April when investors placed a wave of sell orders, which the exchange later admitted caused liquidity problems. Looking to make good on the promise of instant redemption, investors wanted to switch their money into a stock market rally.

Seeing a rush to sell, many investors were reassured their money was safe when the Yunnan government issued a statement saying Fanya remained a legal entity engaged in legal operations. Some continued to put money into the plan.

CITIZENS ARREST

For the investors in “Rijinbao” the saga was far from over. Courts and police refused to hear their case.

In August, frustrations boiled over in dramatic fashion as more than 60 investors camped outside the luxury Jinmao hotel in Shanghai where Fanya chairman Shan was staying on the 63rd floor.

“We were all middle-aged or retired people who had invested everything, even our retirement funds, in Fanya, and we just wanted answers,” said an investor from Shanghai surnamed Wang, who witnessed the event.

The group bundled Shan into a car and drove him to the local district police station. He was released the following evening. The Shanghai police did not respond to questions about the incident and Reuters could not reach Shan for comment.

“He’s just an ordinary guy and he was trembling,” said Wang. “He was terrified and shocked when he saw us, and was probably really surprised that we had got hold of his travel route.”

Protests were held outside regulatory bodies in Beijing and Shanghai, hoping to persuade them to intervene.

In October, a plan to assemble in Beijing at the central government’s petitions office while the Communist Party held a plenum to set a five-year development plan for the country was foiled as security was stepped up throughout the capital.

Many investors were stopped from leaving their hometowns and those who made it to Beijing were apprehended at their hotels and sent back to the airport. Some were detained by the police.

“It was crazy,” said an investor based in Kunming, who traveled to Beijing on Oct. 25. “About 20 minutes after checking in, there were three policemen at my door.”

Protesters also sought redress at the 31st storey representative office in Shanghai of the Yunnan government. At one point, the lifts of the building were reprogrammed to block access to the 31st floor.

Most account holders in “Rijinbao” were smaller investors who put 300,000 yuan or less in the scheme.

“There were so many different kinds of investors involved, from top managers at big firms all the way to blind masseurs and retirees and farmers - there are all classes,” said a Shanghai-based investor surnamed Yang.

Despite the investigations, Shanghai-based Mike Zhou, 45, is unsure if he will see his 20 million yuan investment again.

“Life will continue,” he said. “We have to face the problems and deal with the difficulties in life, but we will not give up in finding out the truth about Fanya. We do not want to simply accept that we are the losers.”