On 8 March 2022, the London Metal Exchange (LME) — the world’s leading (base) metals exchange — unpleasantly surprised us by canceling more than 7 hours of trading in nickel futures and closing the market for a week after nickel futures prices spiked dramatically. We soon came to the conclusion that without any serious improvements, we could no longer justify trading on the LME. After having traded their futures contracts for more than 30 years, we regretfully liquidated all of our LME positions. We gave a detailed account of this event in our March 2022 article Market integrity at risk – the case of LME nickel.
A lot has happened since then. Journalists, lawyers and judges investigated the matter and reported on it. The LME commissioned Oliver Wyman to conduct an independent review of the event. Regulatory bodies such as the Financial Conduct Authority (FCA) and the Bank of England (BoE), as supervisors of the exchange and the clearing house, conducted their own independent reviews of what happened. The FCA recently launched an enforcement investigation and the BoE recently announced its intention to appoint a skilled person to independently monitor, assess and report to the BoE regularly on LME Clear’s progress regarding the improvement of its governance, management and risk management capabilities, as the BoE found several shortcomings in these areas.
But unfortunately, one thing hasn’t happened yet. Clear guidelines and answers from the LME itself, mainly on how it intends to weather a similar storm should it happen again, have yet to be provided. In the past 12 months, we’ve discussed this matter directly with the LME as well as with various other stakeholders, including exchange members and end-clients. We believe now is a good time to provide an overview of the most discussed topics and our thoughts on them.
In short, we have lost confidence in the LME. The discretionary decision made by its management to cancel the trades of an entire trading session is in our view fundamentally at odds with the basic principle of well-functioning markets. With their decision, the LME has undermined the reliability and the integrity of the exchange and centrally cleared futures trading as a whole.
Commodity futures trading can only exist if physical market participants can be absolutely sure that their executed futures trades will stand and that they will not see part of a trade disappear into thin air.
In our view, canceling trades is bad for all market participants, not only for the financial ones. For the physical metals community, cancelations are an even larger threat as they might see a potential hedge disappear and consequently might face a much larger risk than intended. When market participants trade anonymously on an exchange, there should be absolutely no doubt whether an executed trade will stand. Exchange trading can only exist by virtue of this concept.
Already before the opening of the market on 8 March, the LME knew that various members were having issues with meeting margin calls on the 7th.¹ Various end-clients and clearing members, as well as LME staff, argued that prices had risen to unrepresentative levels. According to some, this could have been a valid argument to not open the market on the 8th. By opening it anyway, the LME implicitly trusted that the market would ultimately function in a normal and healthy fashion in which market participants would recognize too-high prices as an opportunity to sell. Which would then lead to prices falling back to more reasonable levels. And one could argue that this process indeed started to manifest itself on the 8th. When trading was halted, prices had already come down by more than 20 percent from the highs set earlier that morning.
An initial further rise — maybe not of the magnitude of the actual rise on the morning of the 8th — should have been foreseen as a possibility by the LME before it decided to open the market. Preparations should have included a list of measures that could be taken if the market would rise further. One such measure could have been to temporarily halt trading, even though the LME did not have standard circuit breakers in place. Given the major concerns around the ability of market participants to fulfill their margin calls and the belief that prices were already too high, another logical measure could have been to announce that no matter the level of traded prices that day, the settlement price would not be set above the previous day’s level. The LME has this discretion according to its rulebook.² We believe this would have discouraged various participants from buying at high prices.
Given the fact that there was no margin shortfall on 7 March end of day, no exchange members or end-clients other than perhaps some parties that bought at inflated prices on the morning of the 8th would have defaulted, had the LME communicated such a maximum settlement price. By instead canceling all trades executed on 8 March, the LME effectively also set the settlement price at the previous day’s level. However, the impact on the various market participants would have been much more appropriate without such cancelation:
Short position holders that acted responsibly and did not buy the market up in the rally would not have been impacted.
Short position holders that chose to close out positions would have taken a loss on the orders they executed at elevated prices.
Participants that bought in the rally to open new long positions in an attempt to profit from a short squeeze would have paid extra variation margin.
Participants that sold in the rally and by doing so brought the price down when it was too high would not have been penalized.
By canceling all trades executed on 8 March, the LME did penalize this last group of participants. These are exactly the market participants the LME relied on to correct the price down to a more reasonable level when it consciously opened the market on 8 March.
The LME’s actions undermined the trust in an orderly price discovery process. They set a very bad precedent and have created a significant moral hazard, while an alternative course of action was available.
While we are critical of how the LME decided to ‘solve’ this crisis, it wasn’t primarily the LME that caused it. For this, we should look at the participants in the nickel market that contributed to the short squeeze that lay at the basis of this crisis. These include the following:
The so-called “hedgers” (physical market participants) that built up substantial speculative short positions in nickel futures and OTC contracts that were larger than their spot inventory and/or did not match the LME required grade. They therefore couldn’t deliver the ‘promised’ underlying nickel and/or meet the margin calls of their clearing brokers or OTC counterparties.
The banks and financiers that were financing these “risky” trades without prudent risk management.
The clearing members that were effectively supporting this practice, i.e., members with gaps in their risk management procedures and inadequate monitoring of their clients’ positions. When these members were confronted with the issues, they decided to close out positions at any cost, thereby further accelerating the price spike.
The financial participants that spotted the short squeeze and drained liquidity by opening long positions, thereby further accelerating the price spike and further distorting an already distorted market.
These parties were saved by the LME and became the biggest beneficiaries of the LME’s decision to cancel trades at the expense of the market participants that acted as a calming factor in times of adversity. In this light, we find it encouraging to see that the FCA has decided to open an enforcement investigation into some of the LME’s conduct (as well as systems and controls in place) in the period leading up to the cancelation and trading suspension decision on 8 March.
An end-client that trades in a centrally cleared product expects their counterparty risk to be transferred towards a clearing house and its clearing members. Only if both the clearing house and clearing member default on their obligations, the interests of the end-client should be at stake. This concept is well described in LME’s Member and Client Default Management Framework. And this is the foundation of central clearing. The long history of futures trading has proven this to be a particularly strong concept to preserve sustainable markets. Even though in the futures markets there have been individual participants that traded quite recklessly — just think about the Hunt brothers in the silver market, Nick Leeson in Nikkei futures, Amaranth in natural gas, or Einar Aas in Nordic power — in none of these cases the participants at the other side of the trades were dragged down with these crash pilots. And this is precisely why we predominantly trade futures contracts. We want to safeguard our clients’ money from reckless behavior of other end-clients as well as from reckless behavior of exchange members other than the ones that are clearing our clients’ accounts.
This foundation was undermined by LME’s decision to cancel all nickel futures trades executed on 8 March. The exchange’s leading argument for this decision has been that it had “serious concerns about the ability of market participants to meet their resulting margin calls, raising the significant risk of multiple defaults and a consequent reduced ability for market participants to continue to access the market and manage their risk”.³ As explained earlier, we believe the LME had a better option at hand to prevent this from happening. Instead, to prevent one or more of its members from defaulting, the LME effectively transferred counterparty risk from its clearing members to its end-clients — the very risk these end-clients expected to be protected from.
We’re still waiting to see if the FCA, the Prudential Regulation Authority (PRA) and the BoE approve such practices. If so, this would set a dangerous precedent. Market participants might then want to ask themselves how other exchanges and clearing houses will act in similar (potential) default situations. Who will they protect? The end-clients or the clearing members?
Only if both the clearing house and clearing member default on their obligations, the interests of the end-client should be at stake. This is the foundation of central clearing.
Taking legal action against the LME is something we considered. However, with the information available at the time, we made the decision not to pursue this route, among others because the likelihood of getting back our clients’ money seemed very small. Different aspects played a role here.
Firstly, however strongly we disagree with the LME’s decision to cancel, we believe the exchange had the right to do so. We recognize that the situation at hand warranted a managerial decision. And we believe that the decision made was within the scope of the LME’s managerial authority. Its rulebook provides the exchange with absolute discretion to cancel any trade.⁴ While we consider the use of this discretion in this particular situation poor judgement and reason enough to not continue trading on the LME, we believe it’s unlikely for a judge to rule against the LME for that.
Secondly, the damages (due to the trade cancelations) incurred by those that sold on 8 March were substantially higher than the LME’s financial position could handle. Even if legal proceedings will be successful and the exchange will be required to pay for all the damages, the most likely situation will be that the exchange and clearing house become insolvent. We would recover only pennies on the dollar, if any at all.
We also believe that legal action against the LME would ultimately not be in the best interest of the market. It creates an environment in which the LME cannot make the necessary changes and amendments to its policies and rulebook, fearing that such steps would be perceived as acknowledging previous mistakes. In the past 12 months, we’ve seen five cases of litigation against the LME (a pre-action disclosure case that was won by the LME; a case that is expected to go to court later in 2023 after a British court has granted permission for two parties to sue the LME, and three further legal actions that were filed a few days ago). It’s unfortunate that this has created a standstill at the exchange. This state of affairs is detrimental to all members and users of this marketplace.
We hope that the LME can make the necessary changes sooner rather than later. However, we are concerned that the LME will not act as long as the pending litigations against it remain unresolved.
We are strong believers of collaboration where market participants work together to create a better marketplace. For Transtrend, this among others means we continue to interact with various market participants to learn from this case and prevent similar scenarios from occurring in the future. Even though we stopped trading on the LME, we’re keeping the dialogue open. Among others through the participation of one of our employees in the LME’s User Committee, thereby representing the users of the LME’s services and advising the LME on strategic issues. Hopefully, these forms of collaboration will help the LME in making the necessary changes so we can entrust them with our clients’ money again.
First of all, the LME should reestablish trust as soon as possible by:
Improving its governance: The LME should provide a clear description of how it will deal with similar situations in the future. We suggest to improve the rulebook and provide clear guidelines on how to deal with:
-- potential member defaults;
-- discretionary powers such as the ability to cancel trades and the ability to deviate from the standard procedure to determine a settlement price under special circumstances; and
-- position reporting and position limits for exchange and OTC positions.
All staff at the exchange and clearing house — from Trade Operations to Risk Management to top-level management — should embrace a culture where the interests of the end-clients come first.
Improving its clearing member base: Clearing members should be creditworthy and strong enough to weather a crisis. The capital requirements of all clearing members should be considerably enhanced. They should be able to demonstrate prudent risk management, taking into account concentration risks and how to handle client defaults and forced liquidations.
All of this in addition to Oliver Wyman’s recommendations to avoid a similar situation to reoccur as well as the recommendations that have been or will be made by the regulatory bodies such as the FCA and the BoE.⁵
As the saying goes, never waste a good crisis. Some of the current characteristics of the LME market mainly benefit a select few members while not being in the best interest of the end-clients. This could be a good opportunity for the LME to make some further structural changes that may already have been considered for some time and that could benefit end-clients in the long run. Some examples are:
Create a regular monthly rolling futures contract (i.e., establish a standardized and active 3rd Wednesday futures market wherein parties do not have to adjust to a 3-month forward contract).
Improve the electronic central limit order book.
Move from a Contingent Variation Margin model to the industry standard Realized Variation Margin model.
There are various alternatives to gain exposure to price trends in base metals. In our view, the success of a futures contract is determined by various factors which should be considered when listing a contract.
Firstly, contract specifications should meet the needs of the physical market participants. Futures contracts should provide a true hedge against price risk. As an example, we understand that most of the nickel that is physically traded is of a lower grade than is currently included in the contract specifications of futures exchanges like the LME.
Secondly, a market should have a well-balanced mix of different market participants with different interests trading at different time horizons. For example, mining companies typically hedge themselves by taking short positions, while financial participants are often on the opposite side of that trade. Having both types of participants active in the futures market leads to tighter bid/ask spreads and the ability to transfer risk at any time during the day.
Thirdly, for the price discovery process to function well, the contract should not be dependent on the functioning of a similar contract on another exchange. For instance, if the final settle of such a contract is linked to or even defined by the settle of an LME contract, it is not a credible alternative.
A market should have a well-balanced mix of different market participants with different interests trading at different time horizons.
This is a nice challenge for exchanges worldwide and we invite them to work together with (potential) market participants to find solutions. The Chicago Mercantile Exchange (CME) has a very successful copper futures contract that we’ve been trading for many decades. In the aftermath of the LME debacle, we decided to allocate a larger risk budget towards this contract. Furthermore, the CME recently listed various other base metal futures contracts. Although we started trading aluminum at this exchange, the product has yet to gain traction within the wider metal and trader communities. Iron ore futures on the Singapore Exchange (SGX) are another successful example of a product that we’ve been trading for some years now. We also increased the risk budget for this market. We are considering other exchanges too, such as the Shanghai Futures Exchange (SHFE), as China is gradually allowing foreign investors to participate in the onshore futures markets. If the SHFE wants to challenge the position of the LME as the world’s base metals benchmark, it’s a necessity to open up to non-Chinese participants.
It’s unfortunate that we have to consider these alternative routes. The LME is still the benchmark for base metals globally. In physical transactions — ranging from raw materials to finished goods — it is customary for metal users, traders and financiers to reference LME prices. The LME still has an extremely strong foundation, but the building requires renovation. We remain very motivated to contribute to that.
¹ Oliver Wyman’s Independent Review of Events in the Nickel Market in March 2022 – Final Report January 2023; Page 19 — Description of Events.
² LME Clear Limited Rules and Procedures, Clearing Procedure Part A: “LME Clear reserves the right to amend any prices that it considers do not accurately reflect the current market price.”; and London Metal Exchange — Rules and Regulations, Part 3 — Trading Regulations, Article 6.3: “The Exchange may, subject to consultation where appropriate in the circumstances, determine that the methodology and/or source of data to be used for determining the Closing Prices of any Metal Future or Premium Contract (and in respect of any Prompt Date of any Metal Future or Premium Contract) shall be changed, either on a time-limited or on a permanent basis.”
³ LME Notice 22/057.
⁴ London Metal Exchange - Rules and Regulations, Part 3, Article 13 — Trade Invalidation and Cancellation.
⁵ We refer to the notices from the LME and LME Clear containing some recommendations: LME notice 23/037 and LME Clear Clearing Circular 23-007.