Will the 140-year old London Metal Exchange survive the 21st century?
07 August 2017 by Christopher Clemence
There is no question that the London Metal Exchange (LME) is the biggest metals exchange on Earth. However, questions have lately arisen as to whether the 140-year-old exchange is fit for purpose. The members-only exchange is, in some ways, a throwback to the old days of financial exchanges. It is one of the few markets in the world (and the only one in Europe) that still uses “open outcry” trading in the course of price discovery. Though a majority of contracts are settled in other ways, the global price of each metal for a particular day is established in one 90-minute and one 20-minute flurry of shouts and hand signals between sellers and buyers.
Though it is located in the United Kingdom, the exchange trades using the United States dollar, and trading is brisk indeed – in 2016 the LME traded 157 million lots totaling 3.5 billion metric tons for a total price of US$10.3 trillion. The primary method for trading metals on the LME is via inter-office trading, which takes place throughout the day among Ring Dealing Members (who are so named due to the fact that they are the only organizations whose agents may trade in the pit during open-outcry sessions). Trades between and among Ring Dealing Members are carried out via LME Select, an electronic trading platform inaugurated in early 2001. Though most trades take place using this platform, the process still uses a significant amount of paperwork, which has become more and more of a liability as the rest of the financial world relies ever more heavily upon digital solutions.
Since the summer of 2012, the Exchange is owned by Hong Kong Exchanges and Clearing, which snapped it up for £1.4 billion. Though perhaps innocuous on its face, ownership by the HKEX has been seen by some to be problematic. The government of Hong Kong is HKEX’s single largest shareholder, owning 5.8% of the exchange and plays a key role in the ownership and operation of the HKEX. Politicians name the company’s chairman and five of its directors, or half of the company’s executive management. In addition, the company’s articles require any of the HKEX’s other investors to obtain permission from the government if they wish to acquire more than 5 percent ownership of the company. Despite assurances by the company’s then COO that the Exchange maintains the highest levels of corporate governance, commentators have questioned how giving a minority owner such wide-ranging power could be considered proper in any corporate setting, especially given Hong Kong’s ties to China.
As the global appetite for metals has increased, the LME has had difficulty handling the volume that is bought and sold on its trading floors. Lines for metals at warehouses have grown longer and longer as the years have gone by, with some buyers waiting up to three years for delivery of the metals bought on the exchange.
Pushed by buyers to find a way to shorten the long wait times, the LME finally acted in 2012 to implement rules requiring warehouses to limit wait times for delivery to a maximum of 50 days. However, the move was questioned by Rusal, taking LME to court to stop the move out of fear that the new policy would throw open the warehouses’ doors and unleash a tidal wave of aluminium upon the market, deeply depressing the price. Even though the company lost on appeal, the suit helped increase transparency in the market.
Criticisms of the LME focus largely on the antiquated forms and methods the exchange uses. The standard contract on the exchange is a three-month contract, which represents the typical transit time a load of copper takes to travel over the ocean from mines in Chile to the ports of London. No other commodities market conducts trades in this manner, as most have moved to monthly contracts that require delivery on the same date each month. The long contracts used by the LME have been shunned by most hedge funds due to the difficulty of finding a willing buyer who is prepared to purchase the metal on a specific date, opting instead for contracts that can be bought and sold instantly with a few clicks of a mouse.
In addition, larger banks have begun offering its clients extremely liquid contracts for LME metals over their own platforms, muscling out brokers in the process. Reformers have encouraged the LME to offer monthly contracts to investors while keeping three-month contracts for physical users. Though agreeing with the change in theory, the LME has been extraordinarily slow in implementing such changes. The exchange implemented a monthly gold futures contract earlier this year as a sort of trial balloon, and by all accounts trading of the contract has been brisk.
Responding to such criticism, the LME’s new head Matt Chamberlain commissioned a top-to-bottom review of its system, with results expected to be released next month. The report will offer a new strategy for the LME, with a possible cut in fees to be implemented at that time as well. However, according to sources who have seen drafts of the reforms under consideration, the document is entirely too broad, lacking concrete steps for bringing the Exchange into the 21st century. In addition, the LME is expected to make a long-desired fee cut contingent upon assurances by brokers that they would bring their business back from the more modern and convenient exchanges to the LME. Whether those brokers are willing (or even able) to bring business back to the Exchange remains to be seen.
Although the LME has long been the primary method for trading industrial metals, the bourse has seen volumes steadily fall over the past several years, especially after fees increased in 2015. To some veteran traders, this is a situation that offers an opportunity to develop alternatives to the Exchange – and two such alternatives have arisen in 2017. The first is the Non-Ferrous Exchange Markets (NFEx) and is spearheaded by Martin Abbott, the former head of the LME, who will serve on the five-member board overseeing the operation. NFEx hopes to capitalize on the growing number of metals traders who, between tighter credit credentials and higher trading costs, have found themselves left out in the London cold.
An exchange that offers lower fees would likely attract a good deal of traders on that premise alone, but that is not the only advantage NFEx hopes to provide. The upstart exchange will conduct trading on a cloud-based platform that is expected to be more flexible than the system offered by the LME at present. NFEx is also expected to feature a traditional route to market with a multilateral trading facility (MTF), though government approval is still pending at the present time. The exchange will also operate on a member-broker model, thereby limiting participation by high-frequency traders.
Though not yet trading in aluminium, a second competitor will enter the metals-trading ring next month. Open Mineral is a cloud-based exchange headquartered in Switzerland that began with the stated aim of changing the way commodities trading is conducted by offering a more user-friendly interface for both buyers and sellers. The exchange was founded by two Harvard Business School alums who cut their teeth at Glencore.
Stating that their aim is to bring buyers and sellers together in much the same way eBay and Amazon did for the retail market, Open Market’s founders say their system puts analytical tools once only accessible to traders in the hands of miners and smelters, thereby making upstream operations more involved in trading, and more profitable as a result. The new platform also brings in trade services like transportation, quality control, and insurance as well as providing messaging, electronic document exchange, and know your customer (KYC) services.
The LME has long reigned as the undisputed champion of metals-trading platforms. Through the years the champ has lost a step however, and has been backed up against the ropes by younger, quicker opponents, as well as by mining companies. Does the LME have a second wind that will push it through to a successful title defense, or is it destined to fall back among the contenders and pretenders in the never-ending battle to remain relevant? Only time will tell.