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22 July 2015

Limit Up/Limit Down - Coming Soon to a Market Near You?



Recently, a rather strange rumour has begun to emerge - I’m not sure where from, originally - that the LME may need to think about introducing price movement limits to bring itself into line with other exchanges around the world. It’s an interesting thought; for years, the LME steadfastly refused to have anything to do with limits, its stance being that it was a free market, and interference in the free market was not something it would countenance. A growing clamour in the wake of the Sumitomo affair brought about a limited change of view. Pressure came from various places, not least the metal trade - those in whose interest the market was supposed to operate - who (when quite legitimately hedged short) were vulnerable to violent nearby backwardations, with the threat of that happening more and more frequently as more and more speculative money moved on to the Exchange. So after a lot of debate, the Exchange took the view that tom and cash backwardation was not conducive to running an orderly market and introduced the lending guidance system. There was at the time some resistance, but by and large market participants accepted the logic of the innovation, even if some cast a wistful eye over their shoulder at the passing of one of the ways to make money. But outright prices were left free to find their own level and volatility. That’s the position at present - there are mechanisms (‘limits’) to protect shorts against untoward tom or cash backwardation, but there is no general way - apart from specific Board intervention, which is always allowed within the rules - to limit the movement up or down of price.

Limits

Not so elsewhere, where it is quite common to have a maximum limit by which the price may move before it triggers a pause in trading. That’s been the default position of the US commodity markets, specifically for metals, Comex/Nymex. More recently, it’s been the approach adopted by SHFE. Outside metal markets, it’s also largely the case that price movement has limits. So, the argument goes, the LME will ultimately be forced to fall into line with the rest of the world, in the interests of preserving markets from excess volatility. 

Market of Last Resort

That may be a laudable aim, but one could argue that it potentially creates as many problems as it solves. After all what is it that the LME has always been proud to call itself? ‘The market of last resort’ for base metals. The implication of that is that it is the place where, if all else fails, you can still find a market to close a position. Imposing trading limits puts that simple ambition at risk. After all, the limit doesn’t prevent the market from falling or rising precipitately, but it does potentially create gaps where trading is impossible; there is no certainty that a market will not immediately fall, or rise, again, straight after the resumption of trading, so the net effect can very easily be to lock traders out of the market. That’s a big step to take.

And is it necessary? The reality is that the LME has seen extreme price movements in short periods of time. Yet it still functions, margins get paid and investors/traders celebrate, lick their wounds or, in occasional cases, go bust. But the market survives and we shouldn’t forget that the obligation on the Exchange is to ‘maintain an orderly market’; that means a market where traders can conduct their business. It doesn’t mean creating an environment which protects them from the movement of prices in which they may be invested. After all, the LME is primarily a forum for price discovery. If the price goes down, it probably means there is an excess - real or perceived - of supply; if it goes up, then we are looking at an excess of demand. Adjusting margin requirements has in recent years been seen as (at least) a part protection against extravagantly violent movement; that’s certainly helped to keep the LME functioning.

Different Pressures

But could it be that there is actually another force at work here? Something which changes the existing status quo I have described? The volume of algorithmic trading (and, although some may prefer not to think about this, HFTs) in the market has increased massively in recent years. Whereas traditional users of the market (producers, consumers, traders, investors) have on the whole been driven by their picture of supply and demand in the wider non-ferrous marketplace, the same is not necessarily true of the new breed of player. Their models are, certainly at times, based on their own artificially constructed picture of supply and demand in the very short term - in other words, a picture of volume on the trading platform, not liquidity in the wider market. That creates a different perspective.

I’ve argued the toss about the prevalence of algo trading on the LME and what some of its effects are many times before, so I’m not going to go over all of that again. But before making decisions about whether or not movement limits should be introduced, I would suggest that it is worth also considering what is the force creating the environment where they may be necessary and what is the overall effect of that force on the market as a whole.

 To their credit, so far the LME are simply restating that they are confident they have a robust market. The likelihood, though, is that the pressure to conform (not least with parent company HKEx’s own plans) will grow.


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