Long queues at petrol stations disrupting traffic flows and gaps on supermarket shelves, caused by a national shortage of tanker and heavy-goods-vehicle drivers at the time of writing, are signs that the UK still has some way to go to return to pre-pandemic normalities. Teams turning away passengers for failing to wear a face mask on entering major London Underground stations are a reminder that Covid-19 has not gone away, although mass vaccination has done much to control its spread.
Nevertheless, businesses of all sizes in the capital city are striving to fully find their feet again. The London Metal Exchange is amongst a swathe of financial institutions that have had to modify their ways of working over the past 18 months, since the first governmental Covid-19 lock-down rules were imposed in March 2020, and endeavour to find new business opportunities following the gradual lifting of restrictions in recent months.
For the LME, one of the biggest challenges to its operations was the prolonged closure of the ring its famous open-outcry trading floor. Although the movement of all trading on to the exchanges electronic and telephone markets went smoothly, debate about whether that change should be made permanent or the ring should re-open has occupied much of the exchange managements time during 2021.
The release in January this year of a LME discussion paper tackling the future for the ring, and other aspects of the exchanges market structure, was the trigger for the debate, which highlighted, yet again, the often-polarized views and interests of its members and clients. A record 192 responses to the paper was one measure of the strength of feeling of all concerned, and also inevitably stimulated observers of the exchange to analyse its content.
Reviewing the LMEs year with Metal Market Magazine on September 21, just a couple of weeks after the ring actually reopened on September 6 to run under amended rules, LME chief executive Matthew Chamberlain said that after 9 months of exchange operations to the end of last year the first half of what became an 18-month period during which the LME ring had to remain shut he and the exchanges board of directors could not simply ignore the data that had unexpectedly been generated by the circumstances, explaining that fact was one of the key drivers behind the discussion paper that the LME distributed in January to consider potential market reforms.
The many responses reignited some of the arguments about the purpose and functioning of the exchange seen during previous periods of major change for it, such as its sale to HKEX in 2012, reforms of its warehousing system, and the launch of its major long-term Strategic Pathway document in 2017 all turning points in which Chamberlain played a significant role.
He was swift immediately to praise the resilience of the LMEs staff, members and clients in responding well to all the difficulties posed by a year-and-a-half of the Covid-19 pandemic, but he and the exchanges board have once again been obliged to navigate their way through opposing views on the LMEs market structure, put forward by financial institutions and larger physical users on the one hand, and the smaller physical market participants on the other.
In the broadest terms, the developments of the past year-and-a-half have provided an opportunity for those who see merits in further reforms to the LMEs market structure to argue that a global commodity trading world that has been forced successfully to embrace many aspects of digitalization simply to continue functioning during the pandemic, should now see the LME sweep away what they view as remaining anachronistic modes of exchange operation and make the practices and processes that have been successfully implemented remotely and electronically permanent.
Opposing that stance, those who greatly value the LMEs traditional modes of operation warn against the risks of damaging the exchanges existing role and worry about the perils of destroying unique features that differentiate it from other commodity exchanges.
Not for the first time, the LME board and executives have been obliged to find compromises.
Inhibitors to growth?
Chamberlain makes a direct link between the LMEs market structure and a fall in trading volumes seen on the exchange in the first half of this year (H1 2021 down 11% year on year), describing the latter as having been one of its biggest challenges.
We are a very fortunate business in that we are able to absorb a slowdown of volumes in our financials, so we accept that we are in a cyclical business and undoubtedly there were a number reasons and risks having seen people withdraw from the markets, but then picking up again in some cases. There were a number of reasons why volumes were slower in the first half of the year... but I think you also have to be honest and say that it also exposed some of the, perhaps, limitations around our market structure, because we do know looking for example at copper volumes on our competitor exchanges, they didnt see the same thing and in some cases they saw a pick-up around volatility.
He thinks that is an illustration of how the LMEs market structure, although having so many beneficial elements the daily date structure that is unique to us, the ability to do daily pricing, and a physically sized 25 tonne contract [for copper] they are all great things, but they can also be inhibitors to growth sometimes. He elaborated: If you look at copper during the first half of this year, there were traders sitting at home who were perhaps trading meme stocks because they had nothing better to do but were also reading a newspaper and saw that copper is an interesting story and thought I want to play the electric revolution story and I want to trade the Chinese growth story, so how do I go and trade copper. And what those traders normally find is that it is easier to go and trade copper on our competitors market structures, because they have standard monthly futures contracts that they are already connected to, and much smaller contract sizes, whereas they look at one lot of LME copper of 25 tonnes and, at current prices, that is a quarter of a million dollars, which is a big cliff for a smaller trader to look at.
Chamberlain said that revealed to the exchange some of the challenges that it has in its market structure, and the fact that although we do a really solid and strong job of serving the physical market, which is what we have always wanted to do, our structure is a bit of a limitation when it comes to helping those who perhaps want to trade trends, or for newer participants in the market, who find it harder to access our exchange than our peers.
That is something that we have always known, but I think it came into reasonably sharp relief in the first half of this year, he stressed.
Electronic trading worked
Such thinking was a key driver for discussing the future for the ring and making a case for doing more electronic trading in the LMEs discussion paper.
The first driver is the trend that we have increasingly felt during the course of the pandemic that we have seen trading move to other markets because of their perhaps easier-to-use market structure, and that was certainly a driver for the discussion paper. On the specific topic of the ring, the discussion paper had a number of ideas, and there was the fact that we could not ignore that in January, when we put the discussion paper out, we had had nine months of what we felt was quite effective electronic trading, Chamberlain explained.
If we go back to peoples perceptions of risk and our willingness to try new things, I feel comfortable in admitting that if the pandemic had not come along, I dont think anyone at the LME would have said that we should go to fully electronic pricing because although we were pretty confident it was going to work, given the pricing trial back in 2019 I dont think anyone, including myself, would have been the person to take the risk to do that, he added.
As 2020 progressed, we increasingly couldnt overlook the fact that, in our view, electronic trading was working very well. So, when it came to January, the board really felt that we had to go out to have that conversation in the discussion paper, because we did want to advance our market generally, but we now had this evidence we felt staring us in the face that electronic trading worked.
He said that is not to say that electronic trading was better than the ring, but in the sense that electronic trading worked, and that as I characterize it, we had two equally good means of trading ring pricing and electronic pricing and so it was right that we put the discussion paper out.
Chamberlain expected a big response, but said, I think it was always going to be the case that market opinion would be very divided, perhaps I had underestimated just how divided..., but people dont write in if they dont care.
Data on the responses about the ring showed that a lot of smaller players still like it, noted Chamberlain, but when the responses were weighted by levels of trading activity, views were split more or less equally three ways: a third to keep the ring, a third neutral and a third to close the ring.
That put us into an awkward position, because what do you do when your market is so fundamentally divided? he asked, noting that around the time of the LMEs April board meeting, it became very clear that a compromise would be needed, because when there is that polarization in the market, you have got to find a way through in which everyone feels that they are being listened to, and that was the hybrid pricing approach. Under that approach, the official prices are discovered in the ring, but the closing prices are discovered electronically. In many ways, it was quite a neat solution, because when you drilled down into the feedback, it was really the smaller physical users who wanted to keep the ring and so because they mainly use the official prices, we were able to return those to the ring; and as it was mainly the financial players that wanted the closing prices electronic; those have stayed electronic.
Chamberlain said it works well for the physical and financial market participants, because we have split the pricing world into two and they are both happy with what they have, but I think we are very conscious that the group who have the hardest time with this are the Category 1 [ring dealing] members.
He noted that although they have come back to the ring to trade and discover the official prices, they are not getting the closing price business on the ring, because the exchange has made that electronic: We have to be honest and say that we have reduced the amount of business that the ring can necessarily transact.
Chamberlain acknowledged that there is a question being asked then about whether the LME is acting quite cynically in the sense that it wanted to close the ring, got pushed back, but then came up with a solution that meant the ring would close itself, because the exchange had taken away its bread and butter.
I can honestly say that is not how I feel. Having worked pretty hard to get to this compromise, I would like to see this compromise work. What I am conscious of is that it is now out of my hands. The question is, Does the model work for the Category 1 members?
He said that the LME is doing everything it can to make it work... We feel that a hybrid Category 1 model is feasible we provide them with the offices next to the ring: so they can trade in the ring and walk five feet into their ringside offices and trade the close electronically it is not as if you need two separate teams, one for the officials and one for the close, although it is up to the members to decide how they want to organize themselves.
Chamberlain said that, after two weeks, the exchange was pleased with the smoothness of the return to the ring. We are glad that we have been able to return to the ring, that the equipment is all working fine and that the [Category 1] members have been able to do a great job. The official prices have been discovered every day on the ring and I have not heard any concerns. But lets be honest, the numbers dont lie, the ring is now conducting less than 20% of the total volume than it did before they left.
He acknowledged that, for the official prices, on many days there has been more trading volume on those than there would have been pre-pandemic, but in the afternoon, people tend to trade electronically, given that the exchange has kept the closing prices electronic.
I dont think we should be surprised by the outcome. I think the ring dealers have done a very professional job on their return. I hope that they feel that the model has worked for them, but ultimately that has to be their decision.
Ring dealer participation in the ring since reopening has been made mandatory for the official pricing session (ring 2), but it is voluntary for the other sessions.
In the first week [since the return], everybody was turning up for ring 1, which is voluntary; everyone was there for ring 2, which is the mandatory official prices session, but then ring 3, ring 4 and the kerb, which are the afternoon sessions, had much less uniform attendance, Chamberlain elaborated. So its the morning sessions that they were there, when there is good liquidity and good pricing, but in the afternoon there is much more of a split, with some deciding to trade electronically, he explained.
Before the ring reopened in early September, Category 1 member Triland applied for Category 2 membership instead of its long-standing membership as a ring dealer. The exchange has put safeguards in place that would take effect if the number of Category 1 members were to fall below a viable level (fewer than six), but it has said that it will also take official prices back to electronic if the remaining members represented less than 75% of the pre-pandemic official pricing volume.
Consequently, while the ring-dealing members stay and continue to trade in sufficient volume for the official prices, the ring will continue, but Chamberlain agreed that the exchange has rather pushed the position back to the members.
Frankly, I believe that is where it belongs because its the members business model, not ours, he said. We feel we have done everything we can do to help, for example with a fee discount, but I wouldnt deny that we are now saying that we are very comfortable with this model, well keep the ring going, but it is ultimately now a decision for the members as to whether it is a model that works for them.
More than nostalgia
Observers occasionally portray the stubborn determination demonstrated by those wanting to keep the ring as little more than nostalgia for maintaining the last open-outcry trading ring in Europe and retaining a tradition that has lasted well over a century , but others point to the likelihood of ring dealers being concerned about losing business and perhaps a latent fear by the physical market that, by losing the ring, somehow by default the LME will lose its ability to serve their trade with price risk management and become just like any other cash-settled commodity exchange.
Chamberlain thinks all three considerations are in play. Clearly there is a degree of nostalgia. And I know that because I suffer from it as well. The ring is a very captivating spectacle, it is a big part of who we are and, as we have become the last one in Europe, it is even more a differentiating factor because nobody else does it in this time zone. So undoubtedly there is nostalgia I think we all feel that.
But he also highlighted the business-rooted reasons: From the physical trade, I think there is a sense that you can come to London, you can stand on the mezzanine [at LME headquarters in Finsbury Square] when Covid-19 rules allow it see what is happening down there [on the ring] and that that is a more transparent and accessible model than the pricing formed on a computer.
Now, we could sit here all day and argue the pros and cons of that, but really its not for me to do that because the customer comes first, right? If that is what the physical customers are telling us, it is not for me to tell them that they are wrong, he added. I am very happy to convince them that we do trade and price electronically and during the pandemic we did and showed that is very reliable but ultimately it must be their decision, and if that is the kind of transparency they want, then more power to them and were happy to accommodate that.
He added that, from the perspective of the ring dealers, Obviously there is a degree of commercial self-interest, but I cannot criticize that because I operate in the LME, so we should never criticize anyone for that! But he also thinks it goes deeper. I think the ring dealers do genuinely believe that, with the complexity of the date structure, it is easier and more efficient to price that curve through open outcry rather than electronically. I dont necessarily share that view, but I accept that however you price the curve it is difficult... I fully understand that.
New contracts launched
While deliberations over the future of the ring have overshadowed the LMEs long-term outlook, and, of necessity, have reduced the amount of time that the exchanges executives have had available to pursue other initiatives, some projects have proceeded as planned.
The exchange launched six new cash-settled futures contracts in July this year, including lithium hydroxide, two regional ferrous scrap contracts, European hot-rolled coil, aluminium scrap, and a duty paid European aluminium premium contract. To date, four have traded the two regional steel scrap contracts, the HRC and aluminium premium contracts and two await their first trade, which Chamberlain said is broadly what the exchange expected to see.
Of the ones that have traded, three belong to our ferrous suite and we are pleased with what we are building in that area, with European scrap and rebar contracts we have been building out, and China hot rolled coil, and now more scrap contracts in India and Taiwan, he said.
The others are newer markets, such as lithium, with the Fastmarkets price that we are pleased to be partnering on, he added. We have been talking to the market for over three years about lithium. And we ran a market-wide tender process, which resulted in the market selection of Fastmarkets as the optimal price. He said: Lithium is a market that is very much in development and we are ready to serve it as and when that comes. With steel contracts, you can more or less guarantee that they will trade on Day 1 and in the other areas it is more exploratory, he added.
On other, pre-existing, less-liquid LME contracts, Chamberlain said that he thinks that the best solution to increase trade is spot trading platforms. We increasingly feel that a product like alumina would benefit from a spot trading facility before we get a really effective futures contract going. Spot trading is an interesting area in commodity markets generally, and specifically for the LME on less liquid commodities like alumina or newer materials like green aluminium as well, he said. We are going to progress that idea of spot trading and we hope to have some reasonably interesting news on that in the near future, he added.
New platform in 2023
When Chamberlain spoke with Metal Market Magazine a year ago, he enthusiastically outlined work under way with LMEs parent, the HKEX group, to build a new electronic trading platform for the metals exchange.
We continue to push ahead, he updated this year. The trading platform itself is proceeding very well and we have early versions in test, and they are working as we would expect. We have taken the opportunity to refresh not just the trading platform, but our entire internal messaging architecture, Chamberlain said.
At the LME, we have many systems that talk to each other the trading system, the matching system, the clearing system, the market data system and over the years they have been built up in a rather hodgepodge way and they talk to each other through their own little connections, he explained. So, at the same time as this external piece of work, which is the trading platform, we are also revising our internal architecture and building whats called an event-streaming platform, which is effectively an internal message bus that effectively moves messages between our systems, including the new trading platform.
In view of the extra work of doing those two things together, the exchange has now given May 2023 as the launch date. That is later than the LME had originally anticipated, because, Like all IT projects, it is a little bit more complex than we had first realized and also because we are taking the opportunity to rebuild the internal systems as well, said Chamberlain
When you put a trading system in, the regulator and the board are obviously very keen to ensure that it is going to work, he added, noting that, There is a lot of external assurance that checks we are on the straight and narrow. He said: They are telling us we are building the right thing and that May 2023 is a realistic target.
Next year (2022) will see the start of a lot of user testing in advance of the launch.
Opportunity awaits in China
HKEX saw a new Group CEO of its own start work in May this year, but Chamberlain said the approach of the LME with HKEX remains quite similar. Nicolas Aguzin, who joined HKEX from J.P. Morgan, is very committed to the commodity project, and the LME in particular, said Chamberlain. Its good to know that we still have a lot of support from Hong Kong and a supportive parent organization, which is extremely valuable for us, he observed, adding that the exchanges want to work more closely together.
We have seen more volume pick up on the Hong Kong minis contracts, which are the cash-settled versions of the LMEs prices, which is our product for smaller Asian investors. And for QME, Qianhai Mercantile Exchange, we increasingly see that as being able to play a role in some of those economic and political developments in China, said Chamberlain. There is a lot of focus on the so-called Greater Bay area, which is the bay of the Pearl River Delta: so Macau, Hong Kong, Shenzhen and Guangzhou, so QME is increasingly getting pretty good traction with government officials seeing it as the interface between the physical metals industry of the Greater Bay and the financial world, he added.
Chamberlain also said that it is also worth noting that the Hong Kong government has taken a stake in the new Guangzhou Futures Exchange (GFEX), which is part of the Chinese government development plan for the Greater Bay area. He pointed out that is the first time that a non-mainland entity has owned a stake in a mainland exchange, which is quite an exciting opportunity in the Greater Bay area and the role that we can play in servicing the economy.
We have been very open. We probably havent penetrated the China opportunity as quickly as we would have liked to with the LME acquisition back in 2012, but we have always said that it is a long game and that our strategy is to be ready for China and to be Chinas partner as and when they are ready to work with us on commodities. And I think particularly in spot physical pricing there is more and more opportunity.
Responsible metal sourcing
Tuned in to the megatrend of major manufacturing companies, financial institutions and end-consumers increasingly demanding greater information and transparency about the source of metals and the environmental impacts, the LME has pressed on with its plans to make the exchange an instrumental part of delivering both of them.
Our work on responsible sourcing is to embed OECD due diligence guidance on responsible supply chains into the LMEs brand listing rules, he reminded. The exchanges aim is to use the power of the LMEs brand list to ensure that metals delivered on the LME are not associated with child labour or conflict finance. Chamberlain said that even physical metals trade outside of the exchanges markets will know that they can use the LME brand list in quite a broad way to determine acceptable metals for purchase.
He highlighted that January 1 was an important milestone this year because all the LMEs brands now need to be collecting their data on their supply chain. Come the end of this year, they will have to format that into their first report, and then they have a variety of different ways to show compliance. They can either publish that data, with transparency as a safeguard, or they can get it independently audited, or they can join an industry programme, such as the Copper Mark program, which embeds the LMEs requirements, Chamberlain explained.
So that is all under way and the brands are doing the work, he noted, adding that there will not be a mass delisting of LME brands, as some initial critics of the LME scheme had suggested that there might be when it was mooted. These organizations realize that not only the LME is asking for it, even if they are just selling in the physical market, other people are asking for it too. Increasingly, they are saying to me that the LME is providing a useful role here because, in the same way that the LME branding confers metallurgical status, it can also provide ethical status, so that is going well.
On the other aspects of sustainability, and low-carbon is the term that is on everyones lips at the moment, Chamberlain observed, We have said that we dont think it is right that we take an in/out approach because there is not enough low-carbon aluminium production in the world, so we shouldnt exclude metal simply because it is not low-carbon, but there it is about transparency, which is provided by LMEpassport.
The exchange launched LMEpassport from a technical perspective at the end of August, so it is already up and running. Chamberlain described LMEpassport as a hybrid of two things. The first is a digital workflow solution of Certificates of Analysis (CoAs), which records the metallurgical data for aluminium initially, and will then move out to all of the exchanges other metals, except copper, which does not have CoAs.
We already have about 79,000 records from over 1,200 CoAs uploaded into LMEpassport, even though it is not mandatory until October 1, but as of that date every time that you cancel aluminium out of an LME warehouse, you will have that guarantee that the CoAs will be in the electronic format on LMEpassport, he explained. So there will be no more need to leaf through paper certificates, faxes or photocopies, the data will be there, he added.
What I am even more excited about is the voluntary part of LMEpassport, where producers can log sustainability data, and we are seeing real interest in that. I think that is natural, because producers want to highlight the good things about their metal, and things that can differentiate it, and sustainability is probably right at the top of the list right now. Everybody who takes hold of that metal will be able to see whatever sustainability credentials a producer wants to log, he elaborated.
Liquidity provider program
Beyond the ring, another element of the LMEs discussion paper distributed in January was a specific liquidity provider program. The first element was about the ring, and I think its fair to say that perhaps it took a little longer than we anticipated to bring that one to a conclusion and get to a compromise position, so that means we havent focused so much on the second element yet, which was enhancing electronic liquidity, but we will probably put out a next discussion paper about it later this year, Chamberlain updated.
There is this area where we know that we have highly liquid contracts and, as we said in the [January 2021] discussion paper, we do believe that the market would benefit if they were traded primarily on screen. This is not a ring versus electronic thing, this is a telephone market versus electronic thing.
Whereas the ring and the electronic markets are transparent venues for metal trading, the inter-office market does not have the same degree of transparency because the market does not know about a trade transacted via that route until after it has already been made, he explained, adding that the LME believes that if there was more transparency on the screen for these liquid dates and liquid spreads that would beget more liquidity because it would give other traders an opportunity to see it and be able to participate in trading them too.
He said the LME will put out another discussion paper on that over the coming months: That would have a number of elements, including very likely a liquidity provider scheme to encourage even more liquidity on screen for those instruments.
The electronic future
In whatever way the LMEs overall market structure evolves in the coming year, there are other areas in which increased electronic trading will offer advantages, Chamberlain noted.
One is implied pricing, which is already operating and that ties into the electronic trading in that the more electronic trading that we can get, the more implied pricing we can do, because it needs the raw materials the raw quotes to work, and it will hopefully help with the electronic liquidity, he said.
Another area is options. We had a huge run on options earlier in the year whenever there are volatile markets, people will use options, so thats good. The next step in our options development roadmap is to have electronic on-screen options where we can get more liquidity and that is facilitated by the new trading platform, he explained.
Overall, Chamberlain said that he is optimistic about the future: I think commodities and metals are a good place to be. Because of the nature of our market structure, for those speculative flows of what I describe as the foothills of the super cycle, we perhaps dont see those quite as much if you are on copper although, actually, I think [considering] the aluminium price increases that we have seen recently, we have seen more of that business recently because we are more naturally the home of aluminium in western markets as that flows through.
He said that as that transfers through from the smaller financial investors to the more institutional financial investors, through to actual physical demand, that more and more hits our platform because we know that we serve the physical and larger financial institutions much more than the smaller institutions, so I think we really advance there. So, as we see the super cycle, or green copper revolution or whatever it might be reaching the [trading] floor and physical market, we will see the upshot and upside from that, so I think we are well positioned.
Our challenge is to make sure that we have done the right amount of market structure evolution to capture that business without disenfranchising our physical players or reneging on our commitments to prioritize the physical market, and similarly to make sure that we have built enough ancillary services be that dematerialized warrant policies, LMEpassport or spot trading so that we can actually maximize the return that we get off every dollar of metal that is traded. And really that is how I see the future.
I think it has been a year of challenges, but I am pretty optimistic looking towards the future of the business, he concluded.
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