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13 July 2022

LME/OTC - I'll be watching you



This article was written by Martin Hayes. All views and opinions expressed are strictly his own.

From July 18th, the LME will introduce weekly OTC position reporting across the spectrum of its physically-deliverable metals markets – a requirement on its members and, indirectly, their clients that had been pushed back little more than a year ago.

Ironically, it was the March meltdown (or should that be melt-up?) in the LME nickel market, the subsequent recriminations and flurry of investigations that hastened this measure, despite the reluctance expressed by many respondents in what was a short consultation exercise.

Given what happened in the nickel market in March, when a price explosion from around $30,000 per tonne to a level of $100,000, before trade was suspended for around a week, and when the prime driver behind the market was the influence of an enormous off-market (and invisible) short position, the LME is justified in exploring ways of preventing a similar occurrence. 

The LME has regulatory obligations for its markets, which for the most part are commodities that are volatile in nature. But now because of the aftershocks of the pandemic on supply/demand patterns, soaring global energy prices, the return of unbridled inflation and the war in Ukraine, metals are likely to be increasingly susceptible to increased and sudden price volatility.

Given this background, it is safe to assume that another nickel-like event – with invisible inter-bank OTC business flourishing now – could happen on the LME again. If so, this is probably the right time to bring in OTC position surveillance, the first global exchange to do so. 

It is worth remembering the route that the LME has been on in recent years - it has had to tread an increasingly fine line between allowing free-markets to operate unhindered, while occasionally intervening when market conditions show signs of getting out of control and prices becoming unrepresentative.

To achieve this delicate balance, some element of market monitoring is needed, and, not just in the last few years, but over decades the scope and depth of this, and resulting transparency has grown, not without some opposition at times.

It is fair to say, too, that the LME has travelled a considerable distance in living memory from the purist, trade-orientated exchange that it was for most of its 100-plus years.

It might be difficult to believe now, but up until the early 1980s, basic LME warehouse stock movements were issued just once a week, every Monday at 11:00 AM. And when what was quaintly described as an ‘undesirable situation’ developed in a market, the LME Committee would ‘call in the cards’ – the ring-dealers trading books – to scrutinise what might be happening. 

If action was needed, a senior Committee or Board member would sit in the ring next to the trader who represented the firm deemed to have a position needing adjusting, ensuring that he did the ‘right thing’ by smoothing out the situation.

Of course, the Tin Crisis of the mid-1980s and the Copper Scandal in the mid-1990s blew away this old-fashioned gentlemanly behaviour, and the LME evolved into a more-tightly regulated and compliance-positive exchange, albeit while largely retaining its uniqueness, and without the more-interventionist measures commonplace in other futures and financial markets.

Warehousing reports now encompass metal both on-warrant and stock earmarked for removal, while an element of off-exchange inventory reports came in a year ago. Warrant and futures banding, trader commitment reports, and automatic lending rules are also part of the data armoury.

But even with all these tools, the LME was still blind-sided when the nickel market spiralled out of control in the first week of March. Put simply, the major short position held by China’s Tsingshan Holding Group was spread across OTC deals with several LME members and clients. And Tsingshan did not produce an LME-deliverable product to meet its short commitments.

Perhaps if the LME had been aware of this ticking timebomb, it would have taken steps earlier and not have had to cancel trades on March 8 – the action that has sparked what will be costly and time-consuming lawsuits from disgruntled hedge funds.

What has been proposed and will be implemented after a short consultation exercise seems reasonable – a weekly OTC report is not over-intrusive but should raise more-timely red flags in the event of a re-occurrence of the nickel situation. 

It is fair to say that this has not been warmly received by many in the market – some of the 27 respondents opined that it would be better to hold off while the various reviews run their course. But this will take time and given the uncertainty surrounding the market right now – volumes are falling – it is perhaps better to tick this box now.

After all, events like nickel in 2022 and the Ebullio-tin fiasco of 2010 are relatively rare. So, although OTC monitoring might seem over-the-top for a bastion of the free-market, a lot of the time it will be a case of ‘nothing to see here, let’s move on.’


 

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