What Price the Reference Price?
It’s long been taken as a truism that the jewel in the LME’s crown is the global reference price it publishes each day for each metal. Why, is quite clear. The world prices its physical metal transactions on that number, and its clarity and integrity have enabled it to keep its place even in a rapidly changing commercial world. But over recent years, there have been murmurings about whether or not the aluminium price, in a market dominated by metal storage trades rather than – broadly – producer/consumer ones, has continued to be genuinely representative of the deals being done in the ‘real’ market. Actually, I guess very few people would argue against the proposition that something had gone seriously amiss in the relationship between physical and LME prices for a period, but, to their credit, the LME executive, admittedly after several attempts, have seemingly got the beast pretty much back under control. What is encouraging for the LME in that story is that the industry cared enough about the LME price to be concerned when it appeared to be falling out of line with their experience of their own physical business. In other words, the need for the primacy of the LME price appeared to be upheld, despite several ominous predictions that the industry might desert it; a demonstration of its continuing relevance, if you will.
There is a “but”…
But – and there has to be a but – there is a different problem emerging, I would suggest. Volume on the LME has been falling in recent months, and just like in any other business that’s not good; it needs to be replaced, not least because the Exchange needs to generate income. I know the defensive argument here is that the parent company is understanding, and there is no pressure, but I would suggest that that situation can only last for so long.
So where is the volume to come from? Well, the trade is unlikely to provide it. Of course, as markets pick up globally, which they do show signs of doing, so the volume of trade business will probably grow. However, that is a relatively limited incremental growth, rather than a serious step-change. That step-change – as has been pretty much broadcast to the world by certain executives – is most likely come from a growth in speculative business from China or computerised traders. Indeed, that’s almost the only reasonable expectation. But that’s OK, isn’t it? Volume is volume, after all, and the combination of trading methods the LME has in its armoury – Select, Ring, telephone (more, incidentally, than any of its putative competitors) – should give it every opportunity to capitalise on anybody’s desire to trade base metal forwards. Should be a win-win, really; if one part of the business is slack, then of course one would look to other parts to boost growth.
Up to a point…
Well, up to a point that may be true. Being all things to all men is not an impossible dream to have, but it is difficult, and my view, for what it’s worth, is that at some point, probably quite soon, the LME will have to make a strategic decision about what it prioritises.
There is another issue, though, that goes back to my opening point about the importance of the reference price. You see, I don’t believe the out-and-out speculative end of the business really cares about that; if your business is straightforward speculation on price movement – and this applies in spades if you are an HFT – what possible concern would you have about the need for the forward and spot price to converge on the cash date? It’s totally irrelevant. We saw in aluminium what can happen when the two sides of the price lose their ‘correct’ connectivity; that time, it was caused largely by a particular coincidence of economic factors and, as I said above, the LME eventually got on top of it. What may happen, though, when there is a whole segment of market users who have no interest in whether or not that ‘correct’ relationship is held or lost for ever? If we take a line through equity markets, we should at the very least expect significantly increased volatility – whether it’s ‘useable’ volatility or not is of course a different question. There is a double-down effect here too, in that if the trade sees the reference price becoming compromised – or less representative – because of an influx of business that has no interest in it, then surely they will begin to look a bit harder for possible alternatives.
I think one has to have sympathy with Matt Chamberlain – the interim CEO since Garry Jones’ departure – because while that word ‘interim’ is still there, it may be difficult to undertake significant strategic changes. And yet, time and tide wait for no man. He’s got a tough juggling act right now.