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14 November 2013

Benchmark Blues

The Libor rate rigging scandal has followed a familiar pattern. The banks agree to pay large fines. Emails are produced as evidence of malfeasance. Junior traders are charged. With a few notable exceptions, the spotlight always seems to fall largely on the junior traders. Rarely their bosses, or those at the regulator who failed in their market oversight, or those who bought and sold the product linked to whatever concocted rate it was. They might all be culpable in their own way but don’t expect to hear about collective responsibility. Instead enjoy juicy quotes from the traders’ emails that were used to skewer them. Then it’s onto the next scandal.

Circus yet to hit Metals

As Lord Copper pointed out in a recent posting, this circus has yet to make it to the metals market, but it will. And when it does it’s not going to be pretty, because the market has yet to accept that it is complicit in a system that does not work and probably never did. 

Use of benchmark pricing – prices determined by a variety of publications – evolved in the off-exchange metals market because consumers didn’t trust producer prices. These prices may be no more trustworthy than what they replaced, but it has suited everybody to ignore that inconvenient truth. They might not be perfect, but so long as everyone else is trading on the benchmark, that’s ok, goes the theory.

With much business done on a formula contract linked to a benchmark, very small tonnages are used to set the price that the bulk of the market has agreed to use. Those who know how to work the system do very well. The silent majority, meanwhile, largely puts up with what it gets because it cannot or will not play a role in the price setting process.

It’s easier not to ask questions about a benchmark’s methodology. If you do, and don’t like what you hear, what then? Sometimes there is no other benchmark to use. Or if there is, you need to convince management, customers or suppliers that it’s worth changing. There’s no reward for taking a brave decision and every incentive to stick with the status quo.

Freeport's Decision

Freeport McMoRan’s decision to use the LME cobalt price rather than a price assessor’s cobalt benchmark is a momentous event for that market. Rising trading volumes and record open interest have persuaded the company that using the LME price is less risky than the benchmark. It took a long time to get to this point but now that Freeport has broken cover, others are sure to follow. Some because they want to, some because they will be swept along by a major force in the market dictating the new terms under which it will do business.

In years to come, the debate over benchmarks will possibly be considered the trigger point at which trading volumes in the fledgling cobalt contract soared. Paradoxically, though, there is a risk that cobalt’s transformation to a modern market will have little bearing on the future of other metals.

Cobalt stands as an exception and its escape route from its old benchmark is not a path that other metals can take. From an exchange perspective, cobalt was seen as an adjunct to other contracts already trading and the LME was prepared to take a long term view, nurturing the contract through low volumes in the early months. From a market structure point of view, there was a diversified production, trading and consumption base with a high percentage of spot physical sales. It also helped that there was a single benchmark price that wasn’t especially popular.

Quality of Data

If the spot market is not diversified and active, then the quality of data available for benchmarking purposes is going to be weak. Some have taken this as a call for exchanges to become involved. If the market can’t work out its own prices then an exchange should show them how it’s done. In reality, though, all the reasons why a benchmark price is failing should serve as a warning for any exchange to enter that market. If a benchmark doesn't work because there are too few participants trading the commodity in the spot market, either because it is a tightly controlled market (for example, coal and ferrous products) or because the market does not want full transparency (precious and minor metals), then why should it work on an exchange?

This holds true whether a putative contract is to be physically settled or settled against a published benchmark. For contracts that are settled against benchmarks, exchanges need to be doubly careful: they must be certain there is sufficient liquidity in the underlying price but also that they do not commit money and stake their reputation in chasing an illiquid product that will never translate into a futures market.

That won’t stop exchanges from coming under pressure to provide a solution. This is likely to lead to disappointment for the market, the regulator and exchange shareholders.

Benchmarks can provide transparency if done right but those demanding it need to understand that there are some markets that are suitable for neither benchmark pricing nor exchange trading. Exchanges should leave those markets alone, publishers should not offer prices that they know cannot be substantiated, and buyers and sellers should simply set their own prices.


If done wrong, benchmarks achieve the opposite of transparency. So forcing a market onto a benchmark it doesn’t want is counterproductive. The debate that must be had is how willing are participants in markets that are suitable for benchmark prices really to engage in the process. Publishers and ultimately exchanges will no doubt stand ready to help but the first move must come from industry itself.

The initial publicity after the Libor scandal led some companies to withdraw from pricing surveys in other markets, which can only serve to render benchmarks even less representative. Demands for transparency have led to less transparency. As companies manage their own risk, they increase risk for the entire market.

The furore around Libor has served to sharpen minds. At least those using benchmarks should now understand the risks they are running. If it means that dud benchmarks are dropped and unrealistic expectations for or by exchanges are scaled back, that’s a good thing. The danger is that in those markets where benchmarks should be workable it is no longer possible.

You get out what you put in

Engagement in published benchmarks across the market was always patchy and must change if those benchmarks are to continue in use. If you want to use a price then you have a responsibility to contribute regularly and honestly to its formation. It used to be said of industrial relations in the UK in the 1970s that management got the unions it deserved. Today, the metal markets have the prices they deserve and only those actively trading, buying and selling in the market can change that. Until then, there’s nothing that the regulators, the exchanges, the benchmark publishers can do, or arguably should do, to help.

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