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01 November 2013

Of New Contracts and Commitment of Traders



Amongst all the he dissatisfaction with the LME’s aluminium market expressed by some of the big beasts of the aluminium world there have actually been a couple of interesting new ideas to help make the market as a whole more transparent. I don’t think there’s a great deal more to add to the warehouse in-and-out flow debate for the moment; the jury of market opinion will have its chance to judge when the full details of the new proposals drawn from the LME’s consultation progress are made public. Until then, that subject has probably been exhausted. However, some of the other suggestions that have been made are worth looking at.

New Aluminium Contract

CME Group have thrown a hat into the ring with their plans for a new aluminium contract, quite clearly targeted precisely at the LME. On the surface, perhaps not a bad idea. So far, however, detail is disturbingly short. Yes, we know its going to be a 25 tonne contract, with the possibility of physical settlement. We know that CME are keen to point out that they will control their warehouses in a way that the LME – it is claimed by many – have signally failed to do. But we don’t know much more, and that seems to me to be something of a problem. The plan was presumably not simply dreamed up a few moments before it was announced, so why not give the detail? Presumably starting from a blank sheet of paper, and with the benefit of having seen the issues facing the LME, it should be possible to design a methodology of getting metal into and out of a warehouse in a more equitable fashion. 

How will Liquidity be Created?

However, that’s not the only consideration. Before such a system could demonstrate its efficacy, there would in the first place need to be stock to be moved in and out, and the CME proposal makes no mention of how they intend to attract that stock. Look at it this way; right now, one of the major gripes of the consumers of aluminium is that the premium they have to pay for metal is artificially high, and it is pushed to that level by warehouse incentives. Aluminium producers are commercial operations, so it seems to me that they will continue to sell their metal to the highest bidder – after all, they owe that duty to their shareholders. So in order to attract metal, surely the CME warehouses will have to match prevailing levels of incentive? If they don’t, then presumably they will have no physical liquidity, which basically scuppers the contract before it starts. It’s a nice idea to take on the power of the banker/trader/warehouse conglomerates, but to be convincing, CME need to give a lot more detail to their proposal, otherwise the suspicion will remain that it’s not fully developed. I hope they can give a convincing answer to the problem; competition is broadly a good thing. But they have only a short window to make their case, before the market dismisses it as an irrelevance. 

Political Dimension

 There is, however, just a little thought at the back of my mind that there may also be a political dimension to this; if the US regulator can be persuaded to ‘encourage’ US corporates to use a US exchange, then the picture looks very different. That may be underpinning the CME hopes of success.

Improving Transparency

Some of those aluminium players who are ambivalent towards the effect of warehousing changes have been promoting another sort of change to ‘make the market more transparent’ – the introduction of Commitment of Trader reports. These have been used on US exchanges for many moons, and I guess most readers are familiar with looking at Comex and Nymex reports on copper, gold, platinum and so on. They’re interesting, but I've never really been totally convinced that they add a huge amount to our understanding of the market. It’s so difficult to make a valid differentiation between hedgers’ and speculators’ positions when the underlying motives of those involved can be so intermingled. That’s always been the case. 

Changing Markets, Changing Needs

Now, however, there is an added dimension, because the advent of algorithmic and high-frequency trading has changed the dynamic of the market significantly. With positions being held for nano-seconds, a conventional commitment of traders report would fail completely to recognise what was happening. Likewise, the increase in static long-only funds (‘I must have exposure to this market, but for asset allocation not trading reasons’) means that the conventional method of measuring hedge versus speculative positions is superseded. A meaningful report in today’s market would need to pick up the flow of trades as they hit the market, not measure daily open positions. Put it another way – in a market where short-term momentum is very often the major feature, an attempt to understand the forces driving that market by trying to divide it into hedgers and speculators would be doomed to failure. The major forces acting on the market today are electronic – algorithmic and high-frequency trades. Knowing that – for example – producers are short and traders are long will not really help us to peer through the fog that currently obscures the market; to do that, we would need to understand the flows of business rather than the static end-of-day positions. A report showing the dynamics of the market would be a useful tool – but building the technology to run it is far more complex than copying the existing US-style commitment of traders reports. I suspect there may be some brokers who are looking at this kind of approach, but I’m not sure the Exchange is there yet.

New contracts, new reports of who’s trading what; good ideas to improve transparency, but still needing a lot of work to be valid.


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