European metal trading is getting an overdue spring clean. A month after the London Metal Exchange (LME) suspended nickel transactions and cancelled trades amid an epic short squeeze, the Bank of England, the Financial Conduct Authority and the LME itself have launched reviews into what went wrong. They will need to substantially strengthen the world’s premier metal trading venue if it is to survive likely future turbulence.
The reviews come at a critical time for metal markets. As a key component of electric vehicle batteries, demand for nickel of sufficient quality is likely to outstrip supply over the next decade, according to Bank of America. The pandemic dislocation, the pariah status of key producer Russia, and rising power prices that are stalling production of metals such as zinc and aluminium are also forcing traders to deplete warehouses. The total amount of metal stocks in the LME’s global storage network fell 65% in the 12 months to February this year.
Lasting imbalances will lead to volatile prices, raising the risk of a repeat of last month’s short squeeze, which saw nickel prices momentarily double to $100,000 a tonne. Chinese producer Tsingshan, which had taken on large short contracts to hedge its future production, could have faced $8 billion of losses had its banking counterparties forced the issue on huge margin calls.
For the reviews to be credible, there needs to be a frank admission of what went wrong. One big problem is that LME bosses could only see a fifth of Tsingshan’s overall short position, because the group had entered into “over-the-counter” (OTC) deals with various banks conducted off the exchange. With better disclosure, the LME might have understood Tsingshan’s true exposure, and could have taken steps to limit losses in advance. But the reviews also need to explain why LME Clear, the LME’s clearing house, was slow to impose higher margin requirements even after media reports had already indicated the scale of the short position.
One key step forward would be to ensure that the LME’s rules are keeping up with changes in the metal market. Take nickel. While production is now nearly 3 million tonnes a year, under half of that can be employed to settle LME contracts: the rest is lower-quality nickel pig iron (NPI). That may have helped drive up prices in March, as traders scrambled to get their hands on the right nickel to deliver in futures contracts. Yet increasingly a key global source of the metal has to come from turning NPI into a higher-quality product. Finding a way to render this inferior metal eligible for LME trades would reduce the risk of future price spikes.
The LME will also need to improve its crash mats. The venue has already made some improvements: one major shift is that it now imposes 15% daily limits to the extent to which prices can rise and fall. Yet disclosure rules need beefing up. Since nickel’s implosion last month, the exchange has required clients to disclose their nickel positions in the OTC market, but such transparency should apply to other metals too. Finally, the LME needs to ensure its under-fire surveillance operation communicates effectively with LME Clear. That would help ensure changes to margin, for example, happen in a timely fashion.
All these moves would help reassure jaundiced users to stick with the LME, rather than decamp to rival trading venues like the Shanghai Futures Exchange. Yet they will also need faith in the LME’s judgement, the precise commodity that it just very publicly lost. The LME has made few changes to its governance or management since the debacle. Departing Chief Executive Matthew Chamberlain is set to be replaced by an insider. Bringing in fresh senior management and board members might be a better look.
Equally, current owner Hong Kong Exchanges and Clearing (0388.HK) needs to reassure the market that the LME acts in the interests of all stakeholders, including those that found themselves on the right side of the short squeeze. If it sees metal trading as more trouble than it’s worth, it should investigate selling to a credible owner like Intercontinental Exchange (ICE.N), or even open up ownership to key banks and commodity houses via some sort of remutualisation.
If traders feel that a robust and durable market is no longer possible, they could withdraw from the market. That would continue a trend that has seen the total number of outstanding aluminium, nickel and zinc trades plummet, and raise the prospect of London surrendering its lead on metal trading to rival venues. It would also make recent volatile prices of some of the most vital metals for decarbonising the world an ongoing headache.
Source: Reuters, April 19, 2022