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16 March 2022

Badly done, LME

It used to be so simple, so obvious. The London Metal Exchange was a chalk circle, drawn on the floor, around which a bunch of independent traders stood to shout their buy and sell requirements. They codified it, set standards for quality and delivery and so on, and founded the basis of a remarkable market that has lasted and grown since the mid/late nineteenth century. 

There have been bumps in the road along the way - world wars, market squeezes, market corners, the tin crisis, the Sumitomo affair amongst them - but the market and its integrity and status as a viable, neutral and fair marketplace has weathered all of these and kept its place in the modern world of twenty-first century algo/HFT/electronic operations without compromising its primary function as the non-ferrous metal world’s market of last resort and price-setting mechanism.

Mmmm. Last week in this column, Martin Hayes wrote that the recent events in the nickel market do not represent a tin crisis for the twenty-first century, and I agree with him. The tin crisis was created by an international, governmentally-sponsored commodity price support scheme (engineered in origin to help the economies of otherwise relatively poor producer nations) being subverted by some of those governments choosing to abandon their responsibilities under the treaty which established the ITC. The LME may have dithered, and the crisis ushered in a multitude of changes to strengthen the actual structure of the market; it wasn’t easy, but the LME had to react to - frankly - rather unethical behaviour by a number of governments. What the LME most certainly did not do then, though, was retrospectively cancel trades entered into by buyers and sellers in good faith. That was reserved for the beginning of last week, in the nickel market.

So let’s just consider for a moment what had led to this unprecedented step. (And it’s worth noting here that the real reason the LME Rules give the Exchange the ability to take this action is so that it has the equipment to handle a “fat fingers” error, not to cancel trades because somebody doesn’t like the price.) We need to go back a while, and look at the market. 

Nickel should be a primary beneficiary of the shift to electrification, given its part in lithium-ion batteries, whose use has been growing apace. But the nickel price didn’t actually move that much, for some while, as it was weighed down by an LME stock figure which obstinately stuck somewhere around 250000mt. With that stock not really changing, it’s probably fair to say the price performance was a tad disappointing. However, eventually the stocks did start to come off, in a period of, if I remember correctly, something like six to eight months, when that 250000mt figure reduced sharply to around 75000/80000mt. And the price began to rally, and the spread began to tighten.

That’s fair enough, that’s what happens in markets - they go up, they go down as demand waxes and wanes. But since before Christmas, the war drums over Ukraine have been beating louder and louder, and anyone with knowledge and experience of the nickel market knows that the production of the Russian company, Norilsk, is the oxygen that keeps the LME contract alive. Just look historically at the make-up of the material on warrant.

So in the face of a tightening market, due to perfectly reasonable developments in the physical world, a war threatened on its neighbour by the state of - probably - the most significant producer in LME terms, potentially leading to sanctions that may cover the export of metal from that company, what does the LME do? It sits and watches as a Chinese entity builds a short position of - unless I’m very wrong here -  something like 20-25% of annual global nickel consumption.  Now, I know the generalist press is calling Tsingshan “the biggest nickel producer in the world”; well, it’s not. It is a stainless steel producer, which also produces NPI (nickel pig iron), which is not, in LME terms, nickel. They cannot deliver their own product against their short. 

Well, you say, that’s perfectly legitimate, and happens all the time in LME markets. Yes, of course it does, but layer that on top of the other factors I’ve just pointed out, and the responsible action to take to preserve an orderly market would be to increase initial margins, substantially. Initial margin is there to protect against a customer building a position they can’t finance. Nickel margins should have been raised and raised again, well before we reached the stage of the beginning of last week. Not doing that is what caused the disorderly market of last Monday/Tuesday night.  

And then compounding that error by retrospectively cancelling trades has simply made the uncomfortable position of the LME worse;  this affair will do serious, long-term reputational damage to the Exchange. How will users trust the LME contracts, if they can see that they can be cancelled hours after they have been executed?

Is this “should’ve, could’ve, would’ve”? I don’t think so; I think there was a lack of foresight in looking at and understanding the factors that were building up to play in the market, which prevented the logical, prudent course being taken. And the retrospective action that was taken seems to be protective of the short.

Wait for the lawsuits…………. 

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