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Hot investment money and algotrading on electronic platforms have disenfranchised traditional users of the London Metal Exchange: that is what MB columnist Lord Copper believes. But the Duke of Deptford, the nom de plume of another veteran LME broker, contends that such concerns are beside the point. Which do you agree with? Email with your comment or post on his Twitter page. He’ll pass your arguments on to the duke and they will use them as ammunition in the next round of the debate
LORD COPPER: The introduction of the London Metal Exchange’s electronic trading platform Select almost ten years ago has undoubtedly changed the face of LME trading.
It has enabled – or encouraged – previously cautious investors to get involved in non-ferrous metal trading to an extent that would have been unthinkable, even as recently as the 1990s.
Trading volumes on the LME have risen stratospherically, the number of participants has increased many-fold and industrial metals have become a legitimate investment, even for pension funds.
Obviously Select is only a part of the story, which also encompasses low interest rates, large amounts of cash and an ever-expanding investment universe.
Alongside this has come a great surge of computing power applied to investment.
There is nothing new in quantitative analysis applied to investment decisions. What is new, though, and has developed significantly in the last decade, is the way such analysis is applied.
Previously, the quant analysis would produce the strategy, which would then be implemented by a trader or group of traders, working with either OTC or exchange-traded products, or a combination of the two.
Electronic access to markets has changed that model, so that the computer which is running the algorithms that generate the trading demands can now place its orders directly onto the electronic order book of the exchange.
The important point here is the lack of human input – the operation is entirely computer-generated and operated.
This is not the place to consider all the pros and cons of algotrading, but what we should consider is the specific impact on the LME of such trading routed through Select.
Initially, Select was an inter-broker system which mimicked the traditional telephone market between LME members.
The advent of order-routing technology changed that significantly in that it bypassed the brokers. Customers of the exchange, providing that they had access to an order-router, could place business directly onto the exchange order-book. Now, computer is trading directly with computer, through the exchange.
But consider this: liquidity in commodity markets is finite, unlike, for example, interest rates or FX, which behave for most intents and purposes as though liquidity is quasi-infinite. I know that is a simplification, but for the point of discussion it will hold true.
What effect does the combination of large amounts of money looking for a home, the milli-second speed of computer trades and a market of limited liquidity have?
We can see it every time we look at the Select trading pages. Prices lurch up and down, reams of one-lot orders clog the system and dealers pull their hair out in frustration at the seemingly random nature of the movements.
True, it’s a market and markets move, and nobody has a right to trade at a particular price, just because it suits them.
But one significant issue is that a number of traditional users of the market are, to an extent, being disenfranchised.
Take, for example, a scrap trader who buys a parcel of metal on an LME price formula. In the time between concluding the deal, deciding his hedge volume and calling his broker to put his hedge on, the price could have lurched $50, maybe $100.
Of course, this could have happened at any time in the 100-plus years of the exchange’s existence, but we all know it happens far more frequently nowadays.
The scrappie is a small player. Perhaps in the turbo world of the hedge-fund business, we can afford to ignore him.
But is this market, which still claims to serve the interests of the non-ferrous trade, not becoming just another playground for the world’s hot money and in doing so disenfranchising its core purpose?
THE DUKE OF DEPTFORD: Lord Copper highlights the issue of what the LME is for. Is it to provide a venue for turbo-charged hedge-fund business or to serve the interest of the non-ferrous trade?
Actually, Lord Copper it is neither, and hasn’t been for some time.
In 2008 the LME changed its model from being a utility, to a for-profit organisation. It made its first dividend payment in April 2009 with respect to the financial year 2008.
The ownership rights, LME A Shares, are the most successful contract the LME has launched in the last ten years.
LME revenue is driven by the fees it charges on every lot that passes through the exchange.
It does not launch new contracts in plastics, steel and cobalt from an altruistic feeling for the traders in those markets, but to increase and diversify its revenue stream.
The owners of LME A shares are not the non-ferrous trade or hedge funds, but hard-nosed bank-based companies who buy and sell their memberships depending on their profit expectations.
For the LME to favour any one interest group would undermine the for-profit responsibility of the LME directors.
The modern role of the LME is to provide as many tools for its users as possible, and to let its users create from that what they will.
Comment: The Lord and the Duke are both right. But I side with the implication in the Lord’s remarks that it will all end in tears.