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09 September 2020

A Breaking Wave



Martin Hayes and I have both written on here before about the likelihood (or not) of the LME Ring ever returning to our lives. It’s now give or take six months since the Executive took the decision to (temporarily) halt open outcry trading, and as the coronavirus and its contagion stubbornly remain present, we would have to assume that it will still be some time before they start thinking seriously about a re-opening. After all, if choirs can’t meet and perform because of potential voice-borne infection, it is difficult to see full-bodied vocalisation across the Ring being rushed back to life.

In such circumstances, it might make sense to think ahead a little, to begin some mental preparation for the event that the Ring does not return. 

The LME (well, commodity markets in general) and equity markets may look the same to the layman, but in fact there are significant differences between them, not least in the very basic underlying reason for their existence. However, with that caveat and also noting that the increase in investment (as opposed to hedging) has brought them closer together, it is nevertheless perhaps interesting to look at how similarities may grow if the LME’s (now) unique style does indeed disappear.

When the equity market in New York became to all intents and purposes an electronic exchange, one of the most notable developments was a surge in the fragmentation of liquidity, as dark pools operated in the main by investment banks grew and grew to take trading away from the official market and onto proprietary “exchanges”. Fair enough, one may say; it really doesn’t matter where a trade is executed, assuming adequate security, as long as the price achieved is competitive. Two things have historically protected the LME from seeing such fragmentation of liquidity. First, the crown jewel of the reference price made sure that users were to a fair extent tied to the Exchange. Secondly, the members had a vested interest in the success and longevity of the Exchange - in other words, it was in the interest of Metallgesellschaft, Rudolf Wolff, Billiton, AMT et al to see the Exchange prosper, as they were directly its owners. 

To deal with the second point first, that interest clearly went out of the window when the members ceased also to be owners; now, I would suggest, economic concern would dictate that what matters is the ability to transact a trade easily and cheaply, not where it happens. Does that change the LME’s position? Well, I would argue that it probably weakens it, in the face of actual and potential competition.

But surely, you cry, the reference price will come galloping to the rescue, as always. Mmm, that’s been changing for some fair number of years now, initiated by the influx of money from the (largely at the time US-based) investment community, for whom the five o’clock close is for time zone reasons more suitable. And, it’s worth noting as an aside, other markets pretty much all take the at first sight logical view that the obvious price to use for overnight valuation and mark-to-market is the last one of the official day, not one timed to suit the lunching habits of predecessor generations. This compromises the hitherto crystal clear position of the reference price, which, I would again suggest, weakens it. And it possibly gets worse: I also understand, anecdotally, that swathes of the metal processing industries are currently not too bothered about LME pricing, because they see it as out of step with the realities of their business. We have, of course, seen that before, mostly at times of extreme backwardation or fun-packed warehouse games. This time, though, the uncertainty and disconnectedness brought about by the coronavirus and necessary closure of the Ring will make it far more difficult to refocus minds.

To use a nautical analogy, the Executive are sailing through difficult waters, under reduced sail; if they looked behind them, they would see a big wave about to break. They will need all their skill as well as a lot of luck to navigate their way through this one.



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