***LORD COPPER v DUKE OF DEPTFORD: hot money and the LME (UPDATE)

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.

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. 

LORD COPPER: The Duke has made a couple of points that are perhaps more generalised than a debate about how beneficial e-trading is. But we can widen the discussion.

It is not too difficult to be the “most successful contract the LME has launched in the last ten years” – the competition is plastics and steel, neither of which have yet set the world alight with activity, although I make no comment about how they may develop in the future.

I would suggest the majority of LME members are more interested in a marketplace enabling them to transact their business efficiently than they are in the changing value of their LME shares.

The value of the LME shares is an item that barely registers as a pinprick on the balance sheet of most members’ ultimate holding company. It is nice if it goes up, but it in no way justifies LME membership.

While I fully understand the concept of the LME creating tools and leaving it up to the members to decide how they use them, surely this neatly avoids consideration of rules.

We can, technologically, make cars that comfortably do 200mph, but we still have speed limits. In other words, we control the technology in the wider interest. Anyway, my point really is the difference between the LME-built tool – Select – and the computer-driven applications linked straight to it.

That’s where we need to look at the framework of rules.

So think about this: as customer order flow through dealer books becomes sparser and sparser (because it’s going directly on-line), those dealers who previously made their money from customer order flow still have to generate something.

What do they do? They increase their own speculative activity. That in turn increases the risk profile of their companies – and don’t we all have a fairly cynical view of the ability of institutions to manage financial market risk?

Comment from a senior category II broker: I see merit in both arguments. But as ever, this is simply a variation of the old maxim “you can please all of the people, some of the time; some of the people all of the time, but not all of the people all of the time”.

Investor value via a rising share price while important is not the driver for the majority of ring and clearing members. But it might be construed as the ultimate goal of senior Exchange management, and I am sure this will be the measure of their success in the future.

There is merit in their argument that a strong, product-diversified LME will ensure members interests are best served going into the next decade, with the rise of China as a natural competitor to the LME now a far greater threat than that presented by more traditional competition, like the NY Merc or the CME.

Once established and once liquid, these new products will attract a valuable new source of revenue, as well as establish a different platform that is both prompt deliverable, cash settled and OTC cleared.

The LME needs to be well funded and self governed if it is to compete effectively in the future.

Over the years, many different geographical regions have cast envious eyes at the LME’s franchise, from the likes of Hamburg to the likes of Dubai and Singapore’s SMX. But it is China that will be the future benchmark and one whose growing volumes are already affecting global prices from behind what is an effectively a closed door to the rest of the world.

If the LME can provide a combination of cleared futures, indices and OTC products in the hard commodities, then I see nothing against this and plenty of arguments for it.

The addition of bulk contracts in the likes of iron ore and perhaps coal allied to freight would make an interesting addition at the top end of the spectrum, while a range of minor metals contracts at the other would offer an unparalleled global product line to fight off the competition and ensure that London and the LME remains at the forefront of global pricing.

On the question of funds, investment money, algo trading and the like; speaking as one who competes to offer these services on a daily basis as a voice broker service, one might expect some derision from me. But this is not true: I am pleased to see more daily liquidity coming to the market.

However, getting the balance right is the issue here too.

Select is a fine tool but its evolution and use by third parties via members’ own platforms has created a rod for its own back at the expense of the traditional market maker.

While the exchange loves the volume turnover increase, I feel much of the criticism laid at the streams of one-lot trade prices on both sides is to an extent justified – notwithstanding the various member platforms’ ability to place ghost or iceberg orders, or even run different algorithmic sequences.

The problem is in the volatility that this illiquidity can generate when machines are left to trade with each other without any kind of human logic filter.

I am told by our DMA experts that it is much easier to write code sequences in one lot trades as apposed to cancelling and re-inputting different volume orders. Something to do with latency I believe.

Personally, I would prefer to see larger bid offer sizes onscreen rather than play this cat and mouse guessing game. Perhaps we should redress the balance by making the online trades a minimum of five lots with anything smaller invisible. This way – at least for those who watch every tick trade go through – there is at least liquidity to quote against.

I realise that times are changing and there are many who would like to see all trading go electronic, but turning over the business entirely to the investment community would drive all the real-trade hedging off market completely at a time when the regulators would seek to have increased transparency and risk control.