6 April 2013
The London Metal Exchange
I recently organised a visit by The Worshipful Company of Marketors to the London Metal Exchange (LME). A colleague of mine at Criticaleye, Sir Brian Bender is also its Chairman and he kindly agreed to show a group of us around. The LME is the last ‘open outcry’ trading floor in the whole of Europe and we visited it at one of the busiest (and noisiest) times of day.
More than 80% of all non-ferrous metal futures business is transacted on its platforms. In 2011 this equated to $15.4 trillion notional, 3.5 billion tonnes, 147 million lots. The value of this trade represented a staggering 40 times world production. The LME brings together participants from the physical industry of metal producers and consumers and the financial community. The result is a dynamic, robust and regulated market where there is always a buyer and a seller, always a price, and always the decision to transfer or take a risk.
The London Metal Market and Exchange Company was founded back in 1877, but the market originated in 1571 when the Royal Exchange was opened. Before that traders conducted their business in London’s coffee houses using a makeshift ring drawn in chalk on the floor. These rings are replicated today in a ring of seats. Traders dressed conservatively in business suits are anything but conservative in their provocative gestures using an arcane hand signalling procedure to trade lots of 20 or 25 metric tonnes at a time. The metals are traded in rotation for five minute sessions. Towards the end of each session trading can become frantic. The traders are not allowed to leave their seats but a toe cap in touch with the edge of a seat leg is deemed sufficient to keep the trader on the right side of the rule.
At first only copper was traded. As it was mined in Chile, for example, and shipped from Valparaiso sellers would seek assurance of buyers and buyers would seek assurance of supply. Future prices would be transacted on the safe arrival of the ship. Of course, the risk of the ship not arriving through sinking or piracy would be hedged in a nearby coffee house opened by a certain Mr Lloyd but the nearby market that still bears his name is no longer ‘open outcry’ but all traded electronically or by telephone.
Lead and zinc were added but only gained official trading status in 1920. The range of metals traded was progressively extended: aluminium (1978), nickel (1979), tin (1989), aluminium alloy (1992), steel (2008), and minor metals cobalt and molybdenum (2010). Although over 95% of the trading is not actually for delivery the LME can arrange physical storage in 700 LME –approved storage facilities across 37 locations in 14 countries. It can also arrange delivery and 6.2 million tonnes are delivered in and out annually. Purchasers of contracts that are left to reach maturity receive a warrant for a specific LME approved warehouse to take delivery of the metal. Many deals are struck for commodities to be delivered in three months’ time. The custom stems from the time that copper cargoes took to arrive from Valparaiso in the nineteenth century.
To trade contracts in copper, tin, or any other metal listed on the LME, you have to trade through an LME member. Open outcry is the oldest and still most popular way of trading on the exchange. It is noisy and appears chaotic but is in fact highly ordered and watched throughout by the regulators, both internal and external. The ring is central to the process of price discovery, the method by which LME official prices are established for the world at large. Prices derived from the short ring trading sessions are most representative of industry supply and demand in a highly liquid market. The official settlement price is the last bid and offer quoted during the second open-outcry (or Ring) session before the bell is sounded to mark the end of the official ring.
Although only a fraction of contracts traded are allowed to mature the link with the physical industry and physical delivery means that the world gains a benchmark price that is widely trusted. This can be seen in contrast with the recent LIBOR scandal or the broader scandal to my mind of the foreign exchange markets where trading might represent multiples of thousands of physical exchanges of goods and services. When currency is traded for its own sake then it becomes unhinged from the real economy with consequent distortions in prices. Governments, too, seek to tinker with their money and today many countries are competing with each other to lower their rates of exchange to improve their export performance while of course raising the prices of imports.
Hedging, too, is something that can get out of hand. But hedging in a well-ordered market like the LME protects against price movements. Producers, i.e. those who sell the metal they mine and refine, are at risk of prices falling, and consumers i.e. those who buy and make things from metal, are at risk of prices rising. Hedging locks in margins and enables suppliers to offer long –term prices to customers thus allowing them to forecast with a degree of certainty. It can help turn inventory into cash or security for finance. It protects physical inventory against unexpected or expected price falls. Physical purchases can also be hedged in times of production difficulty. Hedging against price movements using the LME’s futures and options contracts enables the metal industry to focus on its core business – namely, producing metal and making things out of metal. In times of extreme shortage or over supply the LME also provides producers and consumers with a physical market of last resort.
The LME also plays a role in ensuring the quality of the products that are traded on its platforms. LME warehouse companies must meet strict criteria before they are approved and are typically located in high-consumption areas or logistical trading hubs for the shipment of material. All metals stored in LME-approved facilities on warrant must be LME-approved brands from LME-approved producers ensuring conformance to the Exchange’s strict rules on commodity grade, quality and shape.
The LME also provides a range of other services. For example it provides an extensive and worldwide programme of training courses for the metal and financial industries. These range from introductory courses which provide the opportunity to learn how to effectively manage the impact of price volatility through the use of futures and options, to more advanced courses in risk management strategy and market analysis. In addition it makes its data available. Pricing data can be accessed via the LME’s network of vendors including LMElive, its own real-time price and data source. This offers the opportunity to monitor price volatility either live or with 30-minute delay providing a comprehensive view of futures and options trading. The LME also provides market data and post-trade services to the precious metals community. It provides a forward curve data-set, published daily on behalf of the London Bullion Market Association bringing greater transparency to the world’s largest over-the-counter gold market.
After a fascinating visit we adjourned for a pub lunch in another market, the beautiful Leadenhall Market. In July 2012 LME’s shareholders voted to sell the Exchange to Hong Kong Exchanges and Clearing for £1.4 billion. Sir Brian, whom I first met when he was Permanent Secretary of the Department of Trade and Industry, told us stories of the negotiation and also what it had been like to chair a Board whose other directors were elected by the Exchange’s member companies and thus all had their own constituencies! It was good as Marketors to appreciate how a tightly defined market behaves and also to see another example of the leadership role the City of London still plays in the world.
Copyright David C Pearson 2013 All rights reserved