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15 June 2016

Why would you want a new LME?



Last week, I wrote about the possibility that an alternative to the LME, while by no means any kind of certainty, was perhaps a little more now than just a glint in the eye. I thought this week it might be interesting to have a look at why that should be, given the way the Exchange has so proudly held on to its position as the world’s premier metal market for so many years. Why now would there begin to be question marks? 

In answer to that, I think there are broadly two threads to the issue, both of them ultimately traceable back to the same event - the change in ownership and the new structure that has brought.

Cost

I suspect that the first consideration amongst those who may look for change would be cost. Now, that thought leads to a picture of the trader’s mind. When HKEx made its bid, it was, frankly, pitched at a level that caused many executives of member firms to pinch themselves. It was an amount of money that it would have been irresponsible to refuse, whatever one’s feelings about the fate of the Exchange. Or put it another way; many members had an affection for the LME as it was, but not that much of one. So they made the rational decision, and took the money. That was done in the full knowledge that there would at some point come a reckoning. That’s where the trader’s mind comes in. Offer most (if not virtually all) traders a large sum of money today, with the proviso that they will have to face a more difficult future and they will (at least the ones you would want to employ) take the trade, in the expectation that somehow, with their abilities to duck and dive, they will be able to manage the future; and the prompt cash will broaden their horizons. So the LME members knew when they took the cash that there would be cost increases in the future, as the new owner had to be able to demonstrate profit growth to its shareholders, but nevertheless it was a more attractive option than turning down the new riches. But of course now, when the piper needs to be paid, it’s all a lot less comfortable - particularly as the economy is not taking the strain by generating growth.

Direction of travel

The cost issue is straightforward; the price of using the LME has risen, exactly as predicted. It was money now versus higher future costs, and really no-one should pretend that wasn’t glaringly clear. The other strand of the argument promoting the search for an alternative is a bit more nuanced, though, and is to do with where the LME appears to be going. I don’t think this issue would have arisen, if markets had been stronger. But the continuing soft nature of the global economy has meant that the traditional trade element of the market has been stuck in the doldrums, showing little signs of growth (or, to be honest, even of interest a lot of the time). In the old, mutual days, that wouldn’t necessarily have mattered. Like everything else, the business goes through cycles - everyone accepts that. But in the particular case of the LME, just demutualised and looking to grow profits for the shareholders who had paid a lot of money for it, that won’t work. Growth has to be found, in volume as well as profit. So if the trade is not there, it has to come from somewhere else. Hedge and more general investment funds also suffer from the slack economy, so in the end the LME has been pushed in two directions. 

Access

One is the retail market in China. Well, that may work; some members have a good network to tap into that sector, but they have to do it now in the face of direct competition from the Exchange itself which offers - in some, admittedly not all, circumstances - direct access to the electronic platform, which in turn effectively cuts the members out of the execution business, leaving them to clear and provide credit and while that’s always been a part of their business, for most of them it’s not their raison d’être. But at least that initiative brings some flow business into the market. The other area that it looks as though the LME has targeted is the high-frequency algo-trading community. They will only work with direct access, and, for reasons that I, amongst many others, have highlighted before, their trading volume rarely benefits the market as a whole. I’ve talked often enough about the difference between volume and liquidity; I’m not going to do it again here - suffice it to say that they are emphatically not the same.

Experience

So there are my two reasons why there may be a search for alternative trading platforms; rising costs and falling available business, while the Exchange happily chases players who will be of no benefit to its members. And experience from the equity market tells us that ultimately players are prepared to desert conventional exchanges in favour of, even, dark pools if the cost structure works and the liquidity they seek is there. Technology is pointing to a whole new path - possibly.

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