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TREVOR TARRING: The baby and the bathwater

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“Don’t throw out the baby with the bathwater” is a well-known adage.

It warns those contemplating a major overhaul of a company or organisation to be sure of its core values before they start on slash and burn reorganisation. Otherwise they might close down what’s really valuable at the same time as shedding low-value peripherals.

Looking at the contenders in the race to acquire the London Metal Exchange, it looks as though the baby and bathwater idea is one they would all do well to keep in mind as they contemplate how they would tweak its operations to yield more profit. True, there are potential benefits of synergy and much-enhanced footprint for all of the external bidders. But we must recognise that making money is their main aim.

And, no, I have not forgotten that one of the contenders could well be the existing owner-members if they decide not to sell. For one could assume the bids would have given them a sufficient fright that they would immediately return to some of the issues about LME operations currently seen as needing reform. High on anybody’s list of such issues would be the LME’s relationship with its listed warehouses and the vexed question of load-out rates.

I first alluded to this baby and bathwater concept (without actually then quoting the adage) some twenty years ago, when the LME was contemplating an operational change that might have impacted on the settlement price, and so would have interrupted the flow of those numbers that all the industry’s price-takers had an established pattern of using.

I pointed out that many of these companies in downstream sectors of the industry had no other dealings with the LME except as takers of its prices. Operating in volumes or forms of the metal too far removed from an Exchange warrant to be able to hedge, they gave no business to brokers and made no contribution to the market’s liquidity. But by their use of the LME’s quotations as the basis for many millions of dollars’ worth of business, they conferred a cachet on those numbers that was unquantifiable – unless they stopped doing it. Only then would the true worth of this endorsement of the LME and its price-discovery function be established.

Much has changed in the world of futures since then, most notably the speed, duration and predictability of the average cleared transaction. When the LME’s founding fathers 135 years ago established an organism to facilitate the hedging of risks that were being precisely measured to the nearest day, they could be excused for not foreseeing today’s algorithm-driven trades – measured in nanoseconds and their occasional contingent need for massive, sudden movement of warehouse stocks.

So, as far as the LME has come, especially in the current century, it clearly has further to travel, starting now.

It is at this point that the substantially different cultural backgrounds of the bidding exchanges, as well as the much-evolved balance of interests of LME’s members and clients, become highly relevant. When the Exchange itself has several times visited the question of whether to retain the Ring and has greatly developed its electronic trading platform, it would surprise no-one if each of the external bidders already had a programme to push that question to a prompt resolution.

Even the LME’s daily prompts are freely spoken of as potentially up for close examination by a new owner. Since these do not figure in the experience of any of the external bidders, that is hardly surprising.

So, here’s the core question: what is really “baby” and what “bathwater”?

Peeling the onion
Working inwards from the outer layers of the onion, those price-takers for whom I spoke up 20 years ago must be one of the first for scrutiny. True, the exchange makes money from the dissemination of its prices, but this is small beer compared with brokerage revenues. Then we come to the warehouses, already a difficult contentious issue doing nothing for the LME’s popularity. Nobody else has the same problem, because nobody else has set up their warehouse service in such a trade hedger-friendly way.

This brings us to the strategic question of where growth in LME business is to come from. With world production and consumption of metals finite numbers, there are ultimate limits to the volume of trade hedging business that can be given to the Exchange. No such constraints apply to trades by hedge funds, banks, sovereign wealth funds and the like. And with the thrust of legislation towards much more clearing of what is now OTC, and thus off-Exchange, business, the balance can only swing further towards financially– rather than industrially – motivated transactions.

So no more than two layers of the onion down, we are looking critically at trade hedging. It is already clear it is no longer dominant in the outlook for volume. How important is it going to be to retain all the anomalous (on a global perspective) facilities that are necessary for trade hedging to continue as hitherto? Is it actually bathwater?

The importance of trade hedging
Just as I declared an interest twenty years ago on behalf of the price-takers (and they are still all with us), so I must now declare an interest on behalf of trade hedgers.

The one thing they have demonstrated through 135 years is their permanence.

Indeed, when you recall the third quarter of the last century and the strenuous efforts made then by some major base metal producers to steer clear of the LME, trade hedgers actually have a growth history.

Such a conclusion cannot yet be reached about financially-motivated trading, partly because its history is so short. Even the prospect of more OTC business being forced to be cleared, as mentioned above, is not a guarantee of a commensurate growth in Exchange business. And the LME is still a couple of years off having its own clearing house.

More importantly, nobody can guarantee that financially-motivated metals trading will not, at some time in the future, shrink as rapidly as it has ballooned.

I might concede that trade hedging is no longer the whole of the baby (or soon won’t be). But I am certain that it is still, and will remain, an important part of it, and definitely not bathwater.

If I was an LME member evaluating the merits of the external bidders, and I wasn’t too near to retirement, I would be looking very closely at their respective performance in, and recognition of, trade hedging. And I hope that I would then cast my vote on that basis, and not the price bid.

Trevor Tarring is the former chairman of Metal Bulletin plc

Trevor Tarring
editorial@metalbulletin.com



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