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03 February 2021

Into the Ether?



This article was written by Steven Spencer. All views and opinions expressed are strictly his own. 


The LME’s proposals announced a couple of weeks ago bring up some intriguing possible scenarios for the future of metals trading in London.


Could the Ring go into the ether?

While the rationale for abolishing the Ring is understandable – it only has nine members, keeping a team on the floor isn’t cheap and there are issues over price transparency – is there a real risk that the Ring might instead replicate itself in the ether?

No broker or major trading financial institution relishes parking their working capital at LME Clear, who still haven’t the capability to manage margins on a real time basis. Clients want credit lines and most sensible ones understand the cost and are prepared to pay their broker for that. Brokers are constantly developing faster and more efficient electronic trading platforms vis-à-vis their clients and are able to benefit from the bid-offer spreads on carries and outrights. What, then is the incentive to trade and hedge via Select where large orders are difficult to execute amid the hidden depths of algorithm driven orders and where co-location of servers can gain a trader a millisecond’s advantage over a competitor?

As algorithms get better and better at adjusting risk and bias, exposure and delta, there is little to stop the brokers from running a virtual ring “in the ether”, trading with their clients as principals and then hedging with each other as principals if they need to. Most brokers would be happier to have another major bank or financial institution risk on their books than to leave millions in cash at LME Clear.

Why would an increased trade fee of a few cents a ton over Select costs dissuade brokers from making 25-50c a ton on cash carries and spreads or a couple of dollars on outrights?


Could blockchain help eliminate the LME's warehousing system?

Another thing is the regulatory position on potential insider trading on stock movements. Why does the market need LME warehousing at all? It’s expensive to administer, expensive to be a registered warehouse and there is so much more metal stored far more cheaply and equally securely off warrant, even in warehouses owned and controlled by LME registered warehouse companies.  It would be simple to devise both a deliverability/quality list and a delivery point list including a blockchain security system. Once metal is in a reputable warehouse in a safe location and is registered on the blockchain system, it can easily be financed with a bank and the financing hedged in a contango trade with a broker. No warehouse statistics would need to be published. There goes the potential “insider trading from stock movements” problem. If a short position comes to maturity it can be delivered electronically via blockchain by a client to the broker with whom it is hedged and likewise picked up by another client.


Will there be a function for LME Clear?

The LME, in their eagerness to become a fully EU regulated and passported financial futures market, failed to make their case in 2012 with the Bank of England and the regulators for being an exception as a physical commodity market. As a result, EMIR/ESMA regulations and the establishment of LME Clear as a Central Counter Party (CCP) clearing house brought the introduction of cash margining. At a stroke, the smaller brokers were effectively cash margined right out of the market. The small Category1s and Category 2s had to match and give up their trades through bigger bank/brokers and ensure their trades were matched in time before they could continue trading, as otherwise the LME’s direct payment system would deduct margin directly from their bank accounts, leaving them with insufficient working capital to execute further orders. It became difficult for any small broker give credit lines to clients and simultaneously to trade sufficient volume to cover their overheads.

This gives rise to the possibility that eventually LME Clear would have only a dozen or so big financial institutions as their members, all carrying the vast majority of market risk. In the event of another melt down in the financial markets, LME Clear might suffer significant collateral damage.

Before LME Clear was set up the LCH used to net cash flows rather than margins.  The real strength of LCH to the City was its very breadth of activity, covering all the markets, until that was undermined by various exchange executives realising they could make additional revenue by setting up their own disparate CCPs at the cost of wider efficiency for members. 

That enabled smaller clearers to survive and allowed those with balanced risk across their credit lines to clients to keep trading, effectively spreading the risk across a wide spectrum. A clearing house that only matches and clears trades in one sector – metals – runs the risk that there is no offset and as we know, if metals go down they generally all go down together. Is the LME sufficiently widely diversified for its own CCP?  

 

What could the future look like?

It may be that the result of these proposals is that eventually the Ring will devolve into a virtual ring with a few dozen major financial institutions all preferring to trade as principals to their clients and with each other. If the biggest brokers and banks don’t use Select and LME Clear and can rely on blockchain for security of assets, the LME would have no function. 

Is there a need for another cash cleared market that is exactly the same as Comex, ICE or CME?  

Be careful what you wish for…. 



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