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COLUMN-We need to talk about the London Metal Exchange: Andy Home
February 23, 2017 / 2:53 PM / 10 months ago

COLUMN-We need to talk about the London Metal Exchange: Andy Home

(The opinions expressed here are those of the author, a columnist for Reuters.)

By Andy Home

LONDON, Feb 23 (Reuters) - It’s time to talk about the London Metal Exchange (LME).

The venerable old institution that sets the global reference price for metals such as aluminium and copper seems to be lurching from crisis to crisis.

Volumes are down. They fell 4 percent in 2015 and another 8 percent last year, the first time since the turn of the century activity has contracted over two consecutive years.

Discontent is up, particularly among the core broker community, which has bridled at higher trading fees and lambasted the exchange’s wooing of financial players.

The LME’s chief operating officer Stuart Sloan left in December. One month later came the resignation of its chief executive officer Garry Jones.

To lose one senior office is unfortunate, to lose two in such quick succession suggests deeper tensions with the LME’s owner Hong Kong Exchanges and Clearing (HKEx), which has been trying to monetize its massive $2.2 billion investment in the London exchange.

Rivals are lurking in the wings.

CME Group, which has historically only competed with the LME in the copper space, has been rolling out new contracts for other metals at an accelerating rate. Somewhere under the radar is a potential new metals trading platform project led by Jones’ predecessor Martin Abbott.

More pressing is the drift of trading liquidity into the over-the-counter shadows.

Is the LME broken? And if it is, how is it going to be fixed?

UNIQUELY COMPLEX

Jones’ departure has been the trigger for a bout of collective soul-searching among the LME’s members as they attempt to answer those two key questions.

At the heart of the debate is the Gordian knot of fee structure, date structure and trading structure.

The LME is a very strange institution. Electronic trading co-exists with both a telephone market and open outcry in the form of the talismanic leather-seated “ring”.

It trades daily prompts out to three months, weekly prompts between three months and six months and then monthly prompts thereafter, the whole system rotating around a continuously moving three-month “anchor” prompt.

Excepting the new steel contracts, it is not cash settled, which injects a credit dimension to an already complex ecosystem.

Let’s face. If you started from scratch, you’d never come up with such a labyrinthine format. But that’s the point. The LME was never consciously designed. Rather, it has organically evolved over a century of trading practice.

That rolling three-month date, for example, harks back to the sailing times of copper-laden vessels from Chile to London at the turn of the 19th century.

Which seems as anachronistic as dealers sitting around a ring shouting at each other just as they did a century ago.

But this weirdly wonderful market structure has not only worked but has proved remarkably resilient over time.

CUTTING THE GORDIAN KNOT

Until now.

The genesis of this crisis was the hike in trading fees at the start of 2015.

In particular the hike of fees on short-dated spreads, first and foremost “tom-next”, which denotes the spread between tomorrow and the day after.

The cost of trading “tom” had in the past been so negligible it was in effect a free trade for players rolling daily their inventory price risk.

When that stopped being the case, volumes nosedived. Total volumes in aluminium, the LME’s most liquid contract, fell by 9 percent in 2015 and by 10 percent last year, but aluminium “tom-next” volumes plunged by 24 and 23 percent respectively.

While industrial users voted with their feet, the LME tried to compensate for the loss of volume by opening its membership to new “liquidity providers” such as Chicago high frequency trader Jump Trading, deepening the rift between industrial and financial parts of the LME trading community.

The LME subsequently relented on those short-dated carry fees but for many it was a case of too little too late.

And the debate has since moved on to encompass other parts of the LME’s unique structure such as that rolling three-month “anchor” price.

Because unless a user trades in and out of the three-month date on the same day, it becomes a multi-leg trade with higher fees since the position has to be adjusted one day forward to catch that Chilean shipping time.

Reformists, many of them sitting in the financial camp, are suggesting an evolution to something a bit more, well, conventional, simplifying both trading and fee structure.

Traditionalists counter that the uniqueness of the date system is the “sine qua non” not just of the open outcry “ring” but of the whole market. Start pulling at the strings of the Gordian knot, they argue, and the whole thing will unravel.

Triangulating the debate is HKEx itself, which still needs to claw back some of that whopping 2012 purchase price but which has signally failed to deliver any tangible “China” dividend in return.

TEMPLATES

Squaring this problematic triangle will be the task of the new chief executive. Or, quite possibly, Matt Chamberlain, current acting chief executive and, on the LME “Street” at least, favourite to take the helm full time.

And the irony is he might not have to look very far to find a solution that could work for both sides of the change-don’t change argument.

Although not trading yet, the LME’s new gold and silver contracts offer an interesting template for marrying the old and the new.

They comprise a hybrid model of daily prompt dates over the front part of the curve together with more standard monthly future dates further along the curve.

That means industrial players can still roll their positions daily using “tom-next”, while fund players get the sort of monthly roll trades they use in other markets.

Those precious contracts are only due to go live in June but their structure has been designed to attract what is at the moment an OTC market, similar to that which feeds the LME’s base metals.

And there is also a template as to how to go about cutting Gordian knots on the LME. Chamberlain oversaw the reform of the exchange’s dysfunctional warehousing system, a similarly complex series of intertwined problems that split the LME community.

A key part of the process was the extensive series of consultations with stake-holders at every stage of the tortuous reform programme.

Right now this debate about the increasingly dysfunctional London dame of metal trading is taking place behind closed doors. It needs to be opened up and formalised.

It’s time for everyone to start talking about the future of the London Metal Exchange.

Editing by Susan Thomas

Our Standards:The Thomson Reuters Trust Principles.
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