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22 February 2017

Calling Time

In a world where exchanges are commercial operations, required to generate profits for their shareholders, they have to focus their attention on seeing their business grow. No longer can they simply follow the waves and cycles of their underlying business, comfortable in the knowledge that as member-owned co-operatives, they have no basic profit-earning requirement. Come rain or shine they are expected to generate profits to pay dividends to shareholders whose interest is financial, rather than members who care more about their ability to facilitate business than they do about seeing profit created by the exchange. In members’ eyes, those dividends are money taken out of their business, hence the gripes about fees we have seen from LME members in recent times. 

Growing revenue

So, what to do? Well, increasing the costs for users is one way to grow revenue, but of course it may backfire. Push costs too high, and the users will begin to think about their own profits and vote with their feet, maybe heading for an existing competitor, or maybe supporting the creation of a new alternative. There’s only so far the exchange can go down this road before it becomes counterproductive. A better route is probably to seek new users for existing products, or new products altogether. In the case of the LME, we see them making overtures to the high-frequency trading community, and to the untapped group of speculative traders we all believe are poised in China. The latter is an interesting study, which we’ve looked at a couple of times, but perhaps it’s worth looking at the first option, that of creating new products (and then it’s natural corollary).

Success...and failure

The LME began life with copper and tin, and in the early years little was added. Then along came lead and zinc, and pig-iron. In more recent times, aluminium and nickel arrived, followed by aluminium alloys - AA and NASAAC - plastics, an index, cobalt, molybdenum and various iterations of steel. Of these, lead, zinc, aluminium and nickel have all become part of the furniture, as it were. They are all now an integral part of the LME’s product range, although they have had their difficult moments. Zinc was a favourite for a couple of well-known traders to serially squeeze in the late eighties and nineties and of course aluminium - particularly its storage - has caused furrowed brows in the consumer community. But the depth of the markets, and the importance of the LME price to the trade, has allowed such problems to be overcome.

They didn’t all develop successfully, though. Plastics, for example, came about because there was a number of influential people who thought that the way forward for the LME was to become the hedge market of choice for the automobile industry, and, well, plastics are a bit like metals, aren’t they? So why wouldn’t you devise a couple of plastics contracts for the London Metal Exchange? Actually, it was always a tough challenge, with close to zero industry knowledge and a product that is frankly a lot closer to the oil business than the metals business, but the exchange soldiered on, through day after day of virtually no trades and, as far as I was ever aware, no serious pricing interest. It was a long death, but eventually the exchange bit the bullet and called an end to it. The index contract looked like a good idea, but in the end the  timing was wrong and it has aways struggled with the availability of proprietary indices which are more developed. It fizzles along, with a whimper not a bang; a good idea, but one that doesn’t work. 

And that really brings us to my point. Instituting new products is a fine idea; obviously, they have to be properly researched, and that research has to show at least a fair probability of success, but I’d rather go for optimism than pessimism - try it, and see what happens. By and large, the LME are good with that and have the courage to try things. But they also need to show courage in accepting when they don’t work and scrapping them. Steel billet, for example, still lingers. With hindsight, it was always the wrong product; it needs to die, in order to allow the focus to be on reinforcing bar, which has a much better chance if success. Cobalt and molybdenum were brought into the fold at the same time. Cobalt may not trade a lot, but it does trade, and the LME price, although rarely used as a contract reference, does fit the market. Molybdenum, on the other hand, is the other way round - the price is used to a degree as a reference, and yet the contract barely trades. Wouldn’t it be better to put it out of its misery? Yes, there would have to be some kind of facility to migrate contracts onto another reference (probably Platts?), but then we could reach the natural end of a moribund contract. 

Be decisive

The LME does many things very well. It remains the world’s premier metal market, a position it has maintained for many years. One of the reasons for that, I would suggest, is that it has been very clear about what it offers - a global contract for the most widely traded form of each of its metals. By all means create new contracts, some of which will work and join the success story. But when they don’t work - in other words, when the world doesn’t seem to want them - surely it’s better to be decisive rather than having unsuccessful products hanging around, diverting effort and indeed potentially damaging reputations. At the risk of offending some, I would suggest that it would not be unreasonable to look at aluminium premiums in this light, and possibly even consider how the alloy contracts might best go forward…….. 

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