Death of the ring may be only the start of LME revamp

The London Metal Exchange (LME) proposes to close the last open-outcry trading floor in Europe and one of the last in the world.

The LME's iconic ring, dating back to when metals merchants drew sawdust circles on the floor of The Jerusalem coffee house in Victorian London, finally looks set to succumb to the electronic tide that has swept all before it.

In truth, LME ring trading, with its bewildering hand signals and old-school etiquette, has survived this long thanks only to the commitment of a dwindling number of ring-trading companies and a very British attachment to the past.

“The ring is a greatly treasured aspect of the LME's rich 144-year history, and its closure is not a decision we ... will take lightly,” said LME chief executive Matt Chamberlain.

Yet the LME market seems to have adjusted surprisingly well to its ninemonth suspension because of the COVID-19 pandemic, leading it to formally ask the membership if open-outcry trading is still needed.

It would be a mistake, however, to think this is just about the future of a circle of red leather seats. The “LME Discussion Paper on Market Structure” goes a whole lot further.

There is a lot of nostalgia for the ring in the LME trading community for the simple reason that so many started their metals careers there.

The transition from floor clerk to junior and then senior ring trader was a rite of passage for generations of LME men. And with a few honourable exceptions they have been mostly men.

Until the 1980s the ring was the LME's sole trading venue. The exchange's entire membership was represented around the red circle, heads of houses themselves often taking their seat to trade.

Today there are only nine ring-trading brokers and the price discovery process is largely reduced to setting the lunchtime “official” prices used by the physical supply chain to price metal and the “closing” prices used to value end-of-day positions and margins.

Trading in the LME anchors three-month rolling contracts that migrated to the electronic Select platform years ago, with a good chunk of spread trading going the same way.

However, the chances are that the ring would have continued to defy history had it not been for COVID-19.

A trial use of electronic settlement for the closing nickel price in 2019 was judged sufficiently inconclusive to leave things unchanged. But having a group of people shouting at each other in a confined space for prolonged periods is simply not possible in an era of social distancing and mask wearing.

The ring was suspended in March last year, since when both daily reference prices have been set electronically.

After nine months, the LME “is pleased with how pricing has worked in the electronic venue.”

Volumes have been consistently higher across the board, transparency has been increased and more entities are participating, the exchange said.

Time, then, to ask the question that has been hovering over the ring for many, many years. Is the ring the liquidity forum of years gone by or has it become a choke point for broader participation in the LME's reference prices?

The LME is pretty clear on what it now thinks but has handed the executioner's axe to its members.

There's no absolute guarantee they'll use it. Since no one has ever explicitly posed the question, forecasting the result is difficult.

The LME's proposals to drive more liquidity onto screens are not only about the ring. It is also looking at an overhaul of the inter-office part of the market, still largely conducted on old-fashioned technology — the telephone.

Deals negotiated by brokers with clients this way will be unaffected but inter-office deals between members look set to become more expensive.

The LME is proposing a 50-per-cent increase in fees for such contracts to encourage more trading on screens.

“Many peer futures markets operate a similar pricing model, where bilaterally negotiated transactions (where they are permitted) are often significantly more expensive,” it notes.

The carrot could come in the form of lower electronic trading fees, new forms of cross-trades and enhanced incentives for liquidity providers.

As with the ring, the LME has made clear its preferred direction of electronic travel.

The potential demise of ring trading does not mean the end of the LME's date structure, which also stretches back to 19th-century London.

While other commodity markets have evolved into standardized futures structures, the LME remains, in essence, the forward market it was when arrivals of Chilean copper or Malaysian tin were unpredictable and stocks of metal were borrowed and lent accordingly.

Daily prompts between the cash and three-month anchor price can generate a multitude of “broken-date” trades, let alone the spread possibilities along the forward curve beyond.

It can be bewildering to outsiders, but it fits well the pricing needs of a physical supply chain looking for pricing flexibility to handle changing real-world dynamics.

The LME agrees.

“It is important to highlight that the LME remains committed to the daily date structure, which is important in serving the needs of the physical market.”

However, it's the physical market that generates the potentially most significant proposals in the LME's Discussion Paper.

They're tucked away in the last section under the anodyne-sounding “additional considerations concerning market conduct.”

The LME notes that both European and United Kingdom regulators have identified stock movements on commodity exchanges as a potential source of insider trading.

The Financial Conduct Authority explicitly uses as an example of commodities insider trading the possibility of information about a pending large removal of LME aluminum stock being traded ahead of public disclosure in the daily exchange inventory report.

The evolving regulatory scrutiny of insider trading in commodity markets such as the LME is a slow-burn fuse to potentially very big changes in how things have been done in the past.

The LME itself “recognizes that knowledge of metals stocks and physical movements may advantage certain traders with better access to information on them.”

Ideas on how to level this information field are at a formative stage.

They include a disclosure mechanism to block trades until the stocks information becomes public, a new portal to allow close to real-time reporting of off-warrant stocks and even disclosure of physical market positions if they are big enough to affect exchange prices.

All of which could have major ramifications for how the LME operates.

But that's for the future. The big decision for members right now is whether to break with 144 years of the past and kill off the ring.

TREASURED ASPECT OF THE LME'S RICH 144-YEAR HISTORY.

SIMON DAWSON / REUTERS FILES The LME's iconic ring, dating back to when metals merchants drew sawdust circles on the floor of The Jerusalem coffee house in Victorian London, finally looks set to succumb to the electronic tide that has swept all before it.