LME rips up its free-market rule-book to tame wild metals

LONDON: You can tell the London Metal Exchange (LME) is new to price limits.

The venerable 145-year-old institution’s first attempt to restart its broken nickel market was over in chaotic minutes on Wednesday as the price immediately fell to – and briefly through – the lower 5% daily limit at $45,590 per tonne.

Thursday’s restart with a widened 8% price band also misfired.

The LMESelect electronic trading platform evidently hasn’t read the memos and keeps allowing small numbers of trades to be executed outside of the new limits.

These trades have been cancelled as were those booked on the March 8 melt-up prior to the market being suspended.

The system’s inability to react to the new trading reality is symptomatic of the tectonic upheaval playing out in the forum for global metals pricing.

The LME has for years epitomised the United Kingdom’s light-touch regulation of its financial services sector but a history of last-minute intervention in disorderly markets looks to be over. The last few days have brought time-spread caps, daily price limits and cancelled contracts.

This is in part due to the LME’s own dysfunction. The nickel crisis has exposed fundamental flaws in the exchange’s regulatory scope.

But it is also because industrial metal markets have turned ever wilder since the start of 2021. The LME may be a damaged lens right now but it is showing up an equally dysfunctional metals market.

BLIND-SIDED
The nature of the short squeeze in nickel – a margin meltdown as China’s Tsingshan Group tried to collateralise its huge short positions – has exposed two regulatory blind spots.

The LME has come in for understandable criticism that it waited too long to suspend the nickel market. The exchange’s compliance department, which has unique insight into trading flows, should surely have seen that something ugly was brewing.

But the LME can only track what it sees. Exchange flows are but the tip of a much bigger metals pricing pyramid, most of it trading over-the-counter (OTC) between producers, merchants, banks and users.

The price risk embedded in often bespoke contracts is channeled to the LME via banks and brokers, who net off differing positions as much as they can before trading any residual risk in the LME system.

What the LME compliance department gets to see is a risk landscape that has been distilled multiple times. Perfect vision on a very narrow screen.

The LME has pointedly noted that “the widely reported large short positions (originated) primarily from the OTC market”. If Tsingshan was sitting in the OTC shadows, the sheer size of its short position may not have been obvious at all.

Nor would any parallel OTC trading strategy. Lost in the media frenzy around Tsingshan and its ebullient owner Xiang Guangda was a March 7 announcement by Zhejiang Huayou Cobalt, Tsingshan’s industrial partner, that it too is facing losses on its nickel positions.

SHORT SIGHTED
The LME’s difficulties in discerning the true state of positional play have been confounded by a rule-book that interprets market abuse exclusively through the prism of dominant long positions and their ability to squeeze cash metal availability.

Alan Whiting, the executive director of the UK Treasury’s regulation and compliance department, wrote the LME rule-book and even he conceded in 1998 that “while the exchange does not seek to favour shorts, backwardation limits do penalise longs, whereas there is currently no equivalent financial penalty on the misuse of dominant short positions.” (“Market Aberrations: The Way Forward”, October 1998)

The LME explored the possibility of imposing penal margins on dominant shorts but that would require a determination of when a short position is “abusive”, a semantic and regulatory dead-end.

The nickel market’s independent decision to impose its own penal margins on Tsingshan, the trigger for this whole sorry saga, underlines the regulatory dilemma of how to handle a big commodity short position held by a big industry player.

WILD METALS
Nickel’s breakdown is intricately tied up with the current crisis in Ukraine, specifically concern around the continued supply of Russian metal to the European physical and LME storage markets.

The exchange cited “geo-political news flow” as one reason for its decision to suspend the contract and what Russia calls its “special operation” in Ukraine is undoubtedly one reason all six core LME contracts are now in special measures.

But Doctor Copper turned wild in October last year, forcing the LME to intervene in its flagship metals contract as available stocks fell to just 14,150 tonnes.

Tin spreads had already gone stratospheric at the start of 2021, the cash premium flexing out to an extraordinary $6,500 per tonne.

Indeed, measured by time-spread turbulence, every LME metal has become much more unstable since the pandemic as global supply-chains have buckled.

Metals such as tin are now pricing in genuine supply scarcity. LME tin took some collateral damage from the nickel suspension, tumbling 21% on March 9. But at a current $41,680 it would still be off any historical chart.

If you believe Goldman Sachs, copper is also heading for scarcity as government spending on green infrastructure accelerates pandemic recovery.

Look beyond the LME and both lithium and cobalt prices have also been on a tear as a rapidly expanding battery supply chain stocks up. Indeed, it was the battery pull on LME nickel stocks that laid the foundations for the short squeeze.

There has been a lot of talk about a metals supercycle and it was starting to take tangible form even before markets had to factor in the possible loss, or at least diversion, of Russian supply.

Higher demand means higher prices and they come with higher volatility.

The LME’s history of laissez-faire regulation rested on an assumption that markets could efficiently be left to price themselves barring the occasional “aberration” requiring intervention.

The synchronised price turbulence across all six base metal contracts challenges that assumption to the core.

That’s why the LME has ripped up the old rule-book. Changed metal markets need a change in rules.

There are some who think it might be time to rip up the LME after last week’s rolling fiasco but the underlying pricing risk won’t go away. Indeed, if the last year is a taster of the metals cycle to come, it’s only going to increase.