Traders in turmoil over the LME

In the markets there are few principles considered more sacrosanct by traders than when a commitment is made to a deal, it should stand, whatever may.

Hence, there was an uproar in the global trading community over the London Metal Exchange’s decision to halt the global nickel market and cancel futures trades amid threats of a malicious “short squeeze” on a Chinese tycoon with potential billions in losses.

“This is one of the clumsiest moves an exchange has made that I can think of,” said Don Wilson, founder of Chicago trading firm DRW. Clifford Asness, founder of the hedge fund AQR, also railed against the decisions of the LME, tweet: “I’ve been doing this for a while. It’s one of the worst things I’ve ever seen.”

In one of the most controversial moments in its 145-year history, the LME canceled a trading day after nearly doubling its prices for nickel, a global benchmark for a metal used in stainless steel and electric vehicle batteries.

The rally had led Xiang Guangda, the tycoon behind Tsingshan Holding, China’s leading stainless steel conglomerate, to meet demands for extra cash on a huge bearish bet that backfired. The LME believes it would have put some of its smaller members at risk if it had forced the deals to go through, and its decision was “in the interest of the market as a whole”.

But US futures industry executives took a very different view at their annual conference in Boca Raton, Fla. this week. On the other side of trading with the Chinese tycoon were electronic traders trying to profit from successful bets on the value and direction of the nickel contract product. They are a key component of a deep and liquid modern market.

The alleged trader preference was demonstrated by the LME over the short sellers and the brokers who suffered losses from unpaid calls to provide collateral for trades. In Boca Raton, angry traders kept coming back to the LME’s decision to bust so many trades so late in the day.

The convention is to stand trades as traders usually back their trades with a bet in the opposite direction on another asset. Canceling a trade leaves a trader unsecured and exposed to losses. On the rare occasion that errant trades occur on exchanges, these prices are later adjusted to bring them in line with the prevailing market price. It usually covers a few trading minutes.

Rostin Behnam, chairman of the Commodity Futures Trading Commission, commented that the public and the market needed to have confidence that the agreed rules would be followed. “It’s extremely important that we don’t make up rules,” he said. He didn’t name names, but it was hard to avoid the conclusion that he was referring to the LME.

If the LME loses customers as a result of the excitement, there is a risk that the spreads between bid and ask offers for contracts will widen and the market will become less liquid, damaging the credibility of the exchange.

Many executives said they were looking at alternatives to the London benchmark for trading nickel. The Shanghai Futures Exchange has a nickel contract, but few have enjoyed tapping into the Chinese onshore market. US duo CME and Intercontinental Exchange could launch a competing version, but it could take months of discussions to gauge interest and agree on specs. Additionally, arrangements would need to be in place to cover supplies — no small feat in a world still suffering from supply chain issues.

These obstacles may make CME reform the easiest option, but it will take something radical to restore confidence. One suggestion from angry traders was that the LME might need a new owner to replace parent Hong Kong Exchanges and Clearing.

One intriguing answer that emerged from Boca Raton would be to consider futures based on blockchain technology. A smart contract could authenticate the quality and track shipment of the metal. Crucially, proponents say, it monitors customers’ market positions in real time. If someone does not have enough collateral to cover their trades, algorithms will automatically reduce and rebalance the client’s position. There are no margin calls, no favouritism. Crypto derivatives exchange FTX this month filed for US regulatory approval for futures contracts based on the exact model.

Another thing are futures transactions, which are settled with the physical delivery of a commodity. Nickel producers would need to be persuaded to put their wares on a blockchain. Even so, the LME will not easily forgive the clients it has taken to court. The heart of the nickel crisis may be in China and explode publicly in London, but the impetus for serious change is coming from America. Traders in turmoil over the LME

Adam Bradshaw

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