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10 December 2014

Initiatives, Plans and Projects - the LME Moves Forward



It almost seems that you can’t turn round at the moment without coming up against a  new LME initiative. RMB-denominated mini contracts, the prospect of tempting market-makers onto the trading platform, a greater role for the third Wednesday prompts - it’s as though the Exchange had been marking time for years, and now we get to catch up. Well, perhaps that’s not quite fair; I don’t think there is any implied criticism of the past in the surging enthusiasm of the new management. It’s probably more to do with the fact that to keep their shareholders happy they have to develop more ways of making money out of the business; if they rely purely on increasing fees without growing the underlying base from which those fees are drawn, then I think it would be fair to say they had failed. 

RMB Minis

Are the new ideas going to achieve their purpose? Indeed, do they make sense in the context of the market? Well, a couple of weeks ago Mei Xin Wang wrote here (http://bit.ly/1xCdiWa) about the internationalisation of the Chinese currency and how the first step for the LME to become an integral part of that was the introduction of the mini contracts. They have now been launched and active for a short while - too short to draw any significant conclusions, but they are attracting interest and the infrastructure behind them seems in these early days to be robust and effective. I think it would be difficult to over-estimate the importance of these contracts to HKEx; they may be small and not particularly attractive for hedgers - or in fact probably for traditional traders, for whom the only advantage they bring is the ability to trade the yuan, which lessens with each step towards full convertibility - but they are precisely targeted at the looming mass of Chinese investors, the promise to attract whom was an essential plank in the future picture of the LME that secured the deal for HKEX (well, all right, as well as the money). Were they not to succeed, that would be a big blow. But, so far, so good, and the intent is clear.

Paid Market-Makers?

I’m not so sure about the concept of inviting in ‘market-makers’, though. First, just to clarify, members have of course traditionally been market-makers. That has always been part of the business model, and the dual capacity implicit in it has been accepted as part of the Exchange’s way of operating by the regulators - perhaps reluctantly, in recent times, but nevertheless accepted. That function has been compromised by the emergence of Select as the trading mechanism of choice most of the time, and, as far as one can understand from the statements coming out of the LME, their desire is to see electronic market-makers play a part on Select. On the surface, that doesn’t sound too challenging, but there are layers to this. It would appear that one of the proposals being considered would offer payment (in the form of reduced fees) for the provision of liquidity and that the order-to-trade ratio would in some circumstances be waived. Again, that doesn’t sound too disturbing but I fear it could very soon become the thin end of an extremely dubious wedge. 

I fully understand that US equity markets and the LME have significant differences, but they also have considerable similarities in that both are places where financial assets are traded, and, importantly, both should be seen to present the same possibilities to all participants equally. I can understand the motivation of saying, ‘let’s get the volume in - liquidity is good”; but high-frequency, algorithmic electronic market-making, supported by exchanges offering discounts or actual payments, has distorted the way in which these markets work in the US. The Flash Crash, when the Dow dropped 600-odd points in five minutes and then recovered most of that twenty minutes later, didn’t happen because economic fundamentals pointed the way; it happened because of the activities of computerised trades. High-frequency, algorithmic, low-latency, co-located - we can use all the buzz-words, because all had a part to play; that’s the danger of inviting in business which has no economic basis apart from the desire to scalp a few ticks between other, legitimate activities. And don’t be fooled by the talk of ‘different regulatory frameworks’ - yes, the US and the UK do have different regulations, but that’s not going to stop the problem, if that business is invited in. 

I have several times before pointed readers towards Michael Lewis’ ‘Flash Boys’, and I make no excuse for doing so again - it’s a blow-by-blow account of the perils of HFT. The LME needs to appeal to the investment community, but not in such a way as to risk divorcing it totally from economic fundamentals; and anyway, it’s arguable whether the computer-game-style algo HFT business is indeed part of the genuine investment community.

Third Wednesday Prompts

The third issue I referred to above is slightly more difficult to address, because I don’t fully understand what is being proposed. Third Wednesday prompts are already prime dates; anybody who wants to trade them - and thus effectively use the LME as a monthly-prompt market - can do so; I’m not really sure why that needs any further emphasis. If the idea is to somehow make them a ‘separate’ deal from the existing combination of three months price plus or minus the relevant adjustment, I don’t think it would work, simply because that would seem - to me - to be trying to trade the same thing twice; not a recipe for success. If all that is meant is that the third Wednesday facility can be emphasised as an opportunity to potential market users, then it makes sense; that would be playing to one’s strength.

The Money's got to come...

So, some things good, some things not so good. But they’re all part of the same issue, really, summed up by Charles Li: “The returns are coming in but (there have) obviously (been) two years of pretty small returns, compared with the big amounts of money that we gave the members.” (Charles Li in a Metal Bulletin interview.) That’s the bottom line - the need to generate returns is the driving force - and quite understandably, in what is now a purely and fully commercial enterprise. And just read that last clause - “big amounts of money that we gave the members” - again; the return has got to be big, as well, and these won’t be the last changes.


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