HOTTER ON METALS: Covid-19 to kill the LME ring

Covid-19 appears to have claimed another casualty: the London Metal Exchange ring trading floor.

The closure of the floor, now entering its 144th year, has been proposed in a discussion paper issued by the exchange earlier on Tuesday January 19.

The open outcry floor may be old, but it didn’t appear to have serious underlying health issues.

It has successfully fought back against talk it was set to permanently close since the LME introduced its electronic trading platform, LMESelect, in 2000.

For sure, LMESelect won the battle over time to become the primary venue for trading outright three-month contracts and shared the majority of carry trading with the inter-office telephone market. But ring trading continued to produce what are arguably the most critical reference prices: the official prices - in particular the official cash price used for physical supply contracts, and the closing prices used to margin LME futures and value trading portfolios.

What the ring didn’t bank on was its temporary closure last March due to the global pandemic, allowing LMESelect its first ever opportunity to demonstrate that it could effectively replace the floor.

According to the LME, volumes directly contributing to the reference prices have been consistently high, and significantly higher than when these reference prices are discovered in the ring. It has also praised the increase in participants with direct access to LMESelect due to the open nature of electronic trading.

To be fair to the floor, the data comparisons are not like-for-like; the exchange compares ring volumes for the period September 23, 2019 until the ring’s temporary closure due to Covid-19 on March 20, with electronic volumes for the period June 12 to December 9. But the data shows LMESelect volumes were 130% higher for aluminium than when the ring was closed, as well as 169% higher for copper and up by 176% for nickel, 223% for lead and 12% for tin.

With the last vestige of arguments against moving to electronic trade ripped away, it seems the evidence was too compelling for the LME to ignore.

It is no secret that its owner, Hong Kong Exchanges & Clearing (HKEX), had been pushing since it acquired the LME in 2012 for the metals exchange to evolve. Garry Jones, former LME chief executive officer, was tasked with attracting financial and investor market participants as part of a “Liquidity Roadmap” designed to boost transparency and increase trading volumes.

He constantly faced opposition from LME members who argued it had become prohibitively expensive to use the LME and that incentive schemes to promote electronic trade on the third-Wednesday date would destroy the LME dates system and favor high frequency and algorithmic traders over traditional members, distorting trade flows in the process.

Even after his departure from the LME, Jones maintained a dogged belief that future growth for the exchange would come from electronic participants. Perhaps he was a man ahead of his times after all.

The LME has said in its discussion paper that it has no plan whatsoever to change the dates structure, nor to tinker with the system of dual capacity, which permits members to act both in the capacity of market maker and broker, an operating style that is not replicated in other global derivatives exchanges.

Incumbent CEO Matthew Chamberlain would, in all likelihood, have little desire to be remembered as leading the team that closed the ring. It’s a mantle that no CEO in the exchange’s history would have deliberately sought out.

It will win him no friends among many of the exchange’s Category I members, who will feel it is an unnecessary betrayal of the LME’s culture and history, to say nothing of the likely job losses and changes to the member business models.

But, as Chamberlain said in an interview with Fastmarkets, the exchange cannot ignore the fact that LME trading has gone well for the last 10 months and there is objective data to demonstrate this.

“The ring has been fantastic for 144 years, with great data showing it works really well. What we’ve never had before is any data showing that electronic trading either works or doesn’t work,” he said.

Regulatory pressure
Rumbling on in the background of all of this has been the ever-present hand of the regulator.

This is largely the United Kingdom’s Financial Conduct Authority but also includes the European Securities and Markets Authority (ESMA), Europe-wide legislation including the Markets in Financial Instruments Directive (MiFID) I and II, and the benchmark rules by the International Organization of Securities Commissions (IOSCO).

While it’s highly unlikely that the regulator asked the LME to close the floor, its beady eye has turned increasingly to market conduct.

While there is nothing to suggest the floor as a method of price discovery is anything but robust, a number of complaints to the FCA regarding potential market squeezes plus the $850 million lawsuit brought in 2017 by Red Kite against Barclays have ratcheted up expectations for processes in the ring in recent years.

The allegations by Red Kite included misuse of confidential information and other illegal activities including breach of both contract and duty of care, breach of fiduciary and statutory duty, and negligent misstatement.

If there’s anything to alarm a regulator, who watched as floor and FCA records for the period 2010 to 2013 were requested under subpoenas, it was exactly that.

The suit was settled out of court in 2019 and the floor has continued to meet regulatory expectations since. Nonetheless, the bar has been hiked increasingly higher and the cost to members as well as the exchange has continued to rise.

These headwinds have been there for some time, but Covid-19 has brought them to the fore.

While there will be opponents to the plan, there will also be supporters, including financial investors and banks that prefer direct access and say liquidity would significantly improve.

There are two chances of reprieve for the ring – if the floor can safely reopen before the exchange approves its closure, and if responses to the discussion paper highlight resounding opposition to the closure plan.

Time to see if the LME ring has life in it yet.

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