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
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
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 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
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.