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20 May 2015

Scratching an Itch



LME Week, 2013, the CME announces it will launch an aluminium futures contract, aiming to take advantage of the LME’s troubles in warehousing. LME Week Asia, 2015, the CME announces it will take on the LME in zinc as well.

If we’re being generous, I suppose we should congratulate the CME’s PR team for putting the LME on the spot once again. Back in 2013, it presumably made sense to someone on Wacker Drive, Chicago to announce a contract that couldn’t possibly work. Two years later, though, will a CME zinc contact stand any more chance of success than aluminium?

The answer is no.

The same flawed logic was undoubtedly applied by CME to both contract launches: the LME is wounded, warehousing queues have wrecked price convergence of the LME’s contracts in the USA, a home grown exchange could do it so much better etc. You can imagine the pitch, a brutal combination of powerpoint and patriotism, to be delivered to once loyal LME users in a bid to persuade them to try something new.

Except they won’t. The lamentable record of the CME in converting its compatriots to trade its aluminium contract speaks for itself. Third time lucky, the relaunched contract barely trades. CME might argue that there is a more convincing reason for a home grown contract now. Even if one accepts that point of view (and I don’t), CME has confused its offering by also marketing an aluminium premium contract. The premium contract has traded marginally better, probably because it can be financially settled against an existing benchmark. It has no future, though, as spot trading volumes in the physical market are thin, premiums are tumbling and consumers don’t want to hedge.

Consumers are notoriously reluctant to switch to new contracts or pricing benchmarks. Regardless of how flawed a benchmark is, a market will most likely persevere with a price until it has no choice. No doubt, many in the market might have said to CME they would use it over LME for aluminium, but faced with the reality of an illiquid contract they chose to stay put. It’s unfair, but the LME’s incumbency favours it ahead of any challengers.

Consequently, brokers are very reluctant to spend time and money promoting new contracts. New contracts are hard work for LME brokers – plastics, steel – and only remotely attractive if the volumes in the core product suite are falling. Promoting a replacement CME zinc contract would require brokers to think that the LME zinc contract was dead, or dying. Last year’s LME zinc futures volumes were up slightly, so no joy for the CME there either.

Moreover, the CME’s decision to offer physical settlement contracts further complicates matters: no doubt CME would claim its warehousing operation is superior, but metal will still need to be attracted into warehouse for the contracts to trade and, as we have seen, once metal is in a warehouse it is sometimes difficult to get it out, taking us back to square one again…

Still, zinc is the LME’s third largest contract and represents a large market in the USA, so it is clearly a legitimate target for the CME and the cheeky timing of its announcement will no doubt irritate the LME bigwigs intensely.

As a strategy, being irritating has its limitations. Ironically, if the CME wanted to move beyond publicity stunts and provide more competition to the LME it has the means to do so. It already has a solid metal market presence with its copper and gold contracts. It also has an underutilised clearing house in London, perfectly situated to take on clearing of LME lookalike contracts and other metal trades.

Maybe the CME is waiting to announce an initiative on clearing at the LME dinner in October. Now, that would be properly irritating for the LME, and the wound would require a whole lot of zinc cream to soothe. Meanwhile, this week’s miracle cure for the zinc market will most likely remain on the shelf alongside 2013’s medicine for the aluminium market.


This article was written by Colonel Contango. All views expressed are strictly his own.



 




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