LME WEEK 2016 – INTERVIEW: Incentive schemes adding volumes, but physical market key – LME ceo
The London Metal Exchange is continuing to review incentive schemes put in place as part of its Liquidity Roadmap, designed to increase electronic trade on the LME. But criticism the schemes have failed is unfounded, LME ceo Garry Jones argued.
While some members had expressed concern that the programmes would favour the third-Wednesday over three-months, Jones said the schemes had actually resulted in a significant increase in three-month trade.
“We haven’t yet succeeded in developing strong third-Wednesday liquidity, but rather, a so-called unintended consequence has been that we have achieved a significant increase in three-month trades,” he told Metal Bulletin during an interview.
“At the moment it’s a chicken and egg – new participants come to the LME but they trade three-months because that’s the liquid point of the curve,” he said.
The schemes have added about six million new contracts, mainly as three-month Select volume.
“We are doing a review and over the next few weeks we’ll be thinking about potential improvements or changes, and talking to various committees. Many members are not as hostile as they were initially, having explained in detail what we are trying to achieve,” Jones said.
“At the end of the day, why would members be hostile to efforts to try and increase liquidity and price participation? If those efforts results in the destruction of an existing model that members do very well on, I could understand it, but I don’t think that’s the case,” he added.
So far this year, client business on Select is up 14% year-on-year, but Jones said any improvement is masked by the general decline in overall volumes.
Yet some argue that the schemes, which include periods of no or reduced fees for participants, are being subsidised by the members, a criticism that Jones refuted.
“The person or entity losing out from the incentive schemes is the LME - we are the only ones that take the discount, the client fee to the member is totally unaffected,” he said.
“Some of those LME members that have complained publicly have signed up more new clients from the schemes than others, because they still earn their side of it. When we offer people a period of free trading or reduced fees, it comes out of our bottom line - the member can still charge what it wants to charge, it makes no difference whatsoever to its P&L,” he added.
Jones was responding to members who argue the schemes will destroy the LME dates system and favour high frequency and algorithmic traders over traditional members, distorting trade flows in the process.
“The dates system is the bedrock of our business; why would we want to change it? We want to reassure people that we’re not ditching the dates structure – we’d be crazy to,” he said.
“We’re trying to improve our communications and explain that we’re not trying to destroy members’ business - we’re trying to increase their business as a whole. Some people say we’re trying to turn the LME into a US-style futures exchange and are thinking of ways to redesign contracts to favour this sector, and unequivocally we are not,” he added.
At the same time, Jones said the exchange needed to continue to seek new participants, particularly at a time of declining LME volumes and a lacklustre physical market.
“When people make ongoing comments about volumes, we’d be a bit crazy not to look at ways to increase them,” he noted.
But Jones said that does not mean the exchange will be deluged by high-frequency trades (HFTs) - the LME’s technology agenda prioritises stability first, then functionality and finally speed.
“Speed isn’t the top priority for the LME. It’s like having stabilisers on a child’s bicycle – we don’t need to take them off, we’d rather be stable. We’re not appealing to the ultra-low-latency crowd, but instead we’re trying to get more hedge funds and asset allocators to trade on the LME,” he noted.
“We have more people trading and accessing the LME electronically, but members are still the intermediaries. The LME never used to do this kind of business, and it is the kind of business that some of the traditional members of the LME are less keen on,” he said.
“HFTs dominate the Shanghai Futures Exchange (SHFE) and CME Group already, so the price of copper is already including their interests at the moment,” he added.
Average daily volumes have been declining through 2016, most recently falling 11.4% year-on-year in September. Jones attributes the decline to a number of factors, including a downturn in the physical market that underlies the exchange’s trading contracts; members point to a rise in fees on short-dated carries, critical also to industrial clients who roll positions daily.
The exchange responded by cutting fees on the member leg of short-dated carries by 44%, bringing the cost down to match the client fee of $0.50 per side, trading and clearing inclusive. The cut, which began in September, was one of a series of changes announced by the LME following months of discussions with members as well as debates during committee meetings.
“Saying volumes are down because fees have been increased and that if you lower the fees it’ll all come back is a very naïve argument. If people are intellectually honest about it, lower volumes are due to a whole host of factors,” Jones told Metal Bulletin.
“It is true at the moment that since we reduced fees, volumes have gone up. But I am putting no claim on the fact that they have gone up just because of this. We have always said there are lots of reasons and variables that affect trading volumes, and fees is one of them,” he said.
“At the end of the day, the biggest driver is real end-user demand. I feel that because we’re tied to the [over-the-counter] (OTC) market and its current cycle, things will naturally improve. If volumes improve by 10% between now and the end of the year, what arguments will people use then?” he added.
Volumes at the CME and SHFE, in contrast, have risen throughout the year. But Jones argued that the decline in LME volumes isn’t terminal, and that trading activity fluctuates in markets all the time.
“It’s a bit much to put all that on the LME. I’ve been in the financial markets a long time and have seen several cycles of massive increases and decreases in volumes, and they do reverse,” he said.
“At the end of the day it comes down to economic growth and trading, and in our business it comes down to how China is doing. It really is the biggest driver, and if you look at which LME firms that have seen their own volumes go down the most this year it tends to be those with stronger China businesses,” he added.
Jones said metals professionals are also concerned about rising regulatory and technology costs, including capital ratio requirements under MiFID II and Basel III which could dramatically alter the structure of the brokerage and trading business.
Will more fee cuts follow? “Let’s see how this goes,” Jones said.
“You could always cut fees on everything, and everybody will always be vocal about the bits that affect them the most. We went away and looked at it, had lots of meetings and feedback, and the areas we chose for cuts were the areas where there was more consensus on things that we ought to do,” he added.
The go-ahead for the LME to cut initial margins for LMEClear is expected this year, with full sign off from all regulators required.
The reduction, which needs the approval of both the domestic and European regulators, is estimated by market participants to cut initial margins by around 30%.
Jones said the cut will be a “substantial reduction, particularly in copper and aluminium” and that the higher charges were only imposed in the first place because LMEClear had very high credit standards when it was launched.
“The margins have been where they have for a reason, it’s not that the LME has mandated them. We had a ten-year lookback, while the LCH was at least half this,” Jones said.
“So we have gone back to talk to regulators, although not to have regulatory arbitrage where one clearing house offers better terms than another so everyone moves there, that is not what this is about. It’s an ongoing discussion with the regulators about what is an appropriate level,” he added.
LME margins are higher than in other locations, in part due to the two-day liquidation periods built into European calculations versus the one-day liquidation period in the USA, as well as the issue of gross settlement in Europe versus net settlement in the USA.
Discussions have also been ongoing with the LMEClear board and board risk committee, as well as an independent risk committee.
Jones said that year-to-date, an estimated $850 million has been given back to the market as the ten-year timeframe has moved and historical risk requirements have been reduced.
“The default fund has come down, lots of things have changed. We’ve been trying to look at different risk models with the regulator and what’s happening now is we’re waiting for the green light – it should be this year,” Jones told Metal Bulletin.
A major initiative for the LME going into 2017 will be to move towards giving the market more access to clearing non-standard contracts, including clearing averaging contracts, Jones noted.
Discontent over fees reached fever pitch in June, when major users of the exchange started a working group to explore the viability of setting up a trading venue to rival the LME. As of the start of LME Week, no further announcement has been publicly made on where the potential venture stands.
“It’s always difficult to start a new venture - it’s a massive investment for starters. The LME was sold for GBP1.388 billion ($2.2 billion), and it is difficult to replicate that venue without significant investment in technology, infrastructure and so on,” he said.
“It’s a question of what members want to do – they can’t have it both ways. If they would like pure cash-settled futures contracts then we can go to that model quickly, but I don’t think it is want they want. A lot of the LME members make decent money out of the existing exchange structure, so I respect the competition from potential alternatives, but I do believe that it’s quite hard to get to the same standard [as the LME],” he added.
A key priority for the exchange now is LMEprecious, a suite of exchange-traded and centrally-cleared precious metals products set to launch in the first half of 2017.
The venture with the World Gold Council is backed by Goldman Sachs, ICBC Standard Bank, Morgan Stanley, Natixis and Société Générale as well as proprietary trading and electronic market making firm OSTC.
“Having firms that will commit to use the system and make markets gives the venture a better chance of succeeding. All partners have different obligations, all are contributing in different ways to the success of the venture,” Jones said.
“We haven’t just decided to go into precious metals – we’ve always had the ambition, in fact LMEClear when it was formed had permission to clear OTC gold and silver, that was approved at the time it was set up,” Jones told Metal Bulletin.
The launch will happen “as soon as we get regulatory approval and as quickly as all the partners are ready to go,” Jones said, adding: “We’re already authorised to clear OTC gold and silver, it would be quite unexpected for the regulator to say we can’t have listed precious metals clearing.”
The new contracts will be centrally cleared by LMEClear, the clearing house for the LME. LMEprecious will have a separate, opt-in default fund, instead of sharing the $600 million default fund that currently exists.
“The reason for the separate default fund is firstly that the market wanted it that way, but also because there is no positive correlation between say aluminium and gold – in fact it is negative – so there are no offsets,” Jones said.
“If you’re running a default fund and the amount of trading increases, the default fund requirements as a whole rise and all members have to contribute. If you had one default fund merged and gold trading really started to succeed, all the members of the default fund, even those not trading gold, would have to put up more money in the default fund,” he added.
Not every base metals clearer will opt to clear precious metals, but Jones said the exchange is seeking as many participants as possible.
“Very importantly, the trading fees and structures are the same whether you are founding partner or non-partner, so there is no special deal for those firms,” he added.
The London Bullion Market Association has committed to building a trade reporting platform which Jones said will be “venue agnostic, so all trade should flow into it, including the LMEprecious trades.”
Response has been positive, Jones said, and a number of LME members are keen to become LMEprecious clearing members. The LME is bringing in its MiFID II changes at the same time as launching LMEprecious, he added.
Intercontinental Exchange (ICE) will introduce a London gold daily futures contract in February next year, a move that Jones said was unsurprising given that the US futures exchange administers the London gold auction daily and that he does not consider it a hindrance to the LME’s own efforts in the area.
But Jones said perhaps one surprise was that the ICE contract will be cleared in the USA, a move that sources familiar with the situation said is the most capital efficient for customers in terms of margin requirements. The contract will be physically-settled in London and will therefore adhere to LBMA good delivery rules.
“I’m not sure whether European regulators will be thrilled at clearing in the USA and taking the contract out of the MiFID requirements,” Jones said.
“Is it a bad thing to have clearing around the auction? No. Whether the market as a whole supports that, I don’t know. The same participants that are not keen to have a central marketplace may have an issue with that,” he added.
This week marks the fourth LME Week for Jones, who joined the LME on September 30, 2013.
“I am really proud of where we are for three years; a lot of the things we set out to do are done, particularly warehouse reform, and I don’t think we’re given enough credit for that as an exchange,” he said.
“We moved mountains to get to this stage [with warehouse reform]. It’s been a massive focus for us for so long. The vast majority of the market appreciates where we are with it, and the regulators are incredibly supportive about it,” he added.