Trade & Forfaiting Review

作者: Peter Zaman

The Hong Kong Exchanges and Clearing (HKEx) has had its hands full since acquiring the London Metal Exchange (the LME) in 2012. Within months of its acquisition, the LME was at the centre of consumer outcry regarding the rising cost of free metal, came under intense scrutiny by regulators, and was the focus of journalistic curiosity.

All this attention was caused by the increasing load-out queues at certain LME-approved warehouses. HKEx’s response to this was the publication of a set of proposals on 1 July 2013 to reduce the queues in loading out metal from LME approved warehouses (the proposal). The proposal was followed by a consultation, the results of which were published on 7 November 2013 (the consultation report). The consultation report explains in great detail the reasoning behind what adjustments the LME will make to the proposal and why, despite contrary feedback in the consultation, it is not making certain other changes.

The purpose of this article is not to act as a summary of the consultation report or of the proposal, but to examine some of the perceived drivers behind the LME’s decision to go ahead with the proposal.

Load-out queue rules

As a reminder, the proposal was that, for warehouses with load out queues of more than 100 calendar days (in other words “affected warehouses”), there would be a rule requiring an increase in the minimum load-out requirements, based on the amount of new metal being loaded in. This increase is subject to a formula and adjustment process.

The rule would work in two phases, with each phase containing: 

  • ‘calculation periods’ during which, the amount of metal being loaded in and loaded out is measured, and 
  • ‘discharge periods’, during which excess metal taken in during the relevant calculation period is discharged from the affected warehouse(s).

As a result of the consultation, a key change made in the consultation report is to increase the number of affected warehouses by extending the scope of the rule to warehouses with load out queues of more than 50 calendar days. The other change to the proposal is to calculate the load-in measurements on an aggregate rather than daily basis. Other than that, the consultation report does not make significant changes to the original proposal.

The consultation report does, however, highlight a number of points regarding the metals market and the role of the LME within it. For example, the LME recognises that there are significant differences of opinion between market participants about:

  • whether there is a problem with the structure of the LME metals market; 
  • if there is one, whether it is caused by the long queues or something else; and 
  • the identification of the most appropriate fix for the problem.

Although the consultation report does not conclude that there “exists economic or market failure” (page 5 of the report), the LME goes on to state that the problem of warehouse queues nonetheless justifies their action. The question is, why?

Free metal and LME metal

The starting point is to recognise the “in-warehouse” nature of the LME contract. That is to say, at the settlement of the LME contract, the buyer receives a warrant of the metal in a warehouse which shifts the charges in relation to rent and load-out (for example, free on truck (FoT) charges) on to the buyer. By contrast, those purchasing ‘free metal’ do not bear the cost of the warranting structure or the warehousing costs. This leads to the practical effect of the price of free metal, as referenced against the LME contract for that metal, carrying a premium over LME metal (the premium).

Put another way, the LME contract is discounted to the free metal price for that metal. The presence of long queues at key warehouse locations has led to premiums increasing over recent years. Today, the LME prices need to therefore reflect not just the FoT charges and rent payable while the metal is in the queue but also the opportunity cost for metal owners of having to wait to withdraw their metal (in other words the frictional cost).

The long queues reduce the value of LME warrants. This is because the warrants in locations where queues are at the greatest are being used to settle the LME contracts (via the LME clearing system) and therefore, set the LME price. It is rational for this to happen as the warehouses with the longest queues are able to offer sellers the highest incentives to place the metal on warrant in the first place. This has led to a differential in value between the value of the hypothetical warrant from warehouses that have no queues (and are therefore not used for settlement) and the warrants from warehouses with queues (i.e. a warrant premium).

In theory, for metal in an LME warehouse with no queues, rents or FoT charges, the LME metal price should be the same as the price of free metal. This aim of convergence between high-quality LME warrants and free metal is therefore today measured as the convergence between the warrant premium and the producer premium. The relative impact of queues, to the impact of the producer premium over warrant premiums, therefore is what the LME has focused on. The inability to hedge the queue element of the premium is making the LME price more opaque and therefore less transparent as a benchmark reference price. This is, for good reason, a concern for the LME.

By causing queue lengths to fall, the LME’s expectation is that it will increase the average value of LME warrants used for settlement. This will happen because of warehouses not being able to afford incentives as before, leading to metal used for settlement going to warehouses with shorter queues. This also helps create a more level playing field between warehouses in the same location which is good for competition.

The LME does not accept that the length of warehouse queues has been a cause for the free metal price to have risen (or not fallen) despite the glut of metal over-production in the recessionary years since 2008. The consultation report instead concludes that since the majority of metals trading takes place outside the LME, it is the LME prices that are derived from the free metal price and not the other way around. Although the evidence exists that premiums have been increasing since 2008, the LME concludes that this has simply led to the LME prices falling. In short, based on this, the logical inference to be drawn is that should premiums come down, LME prices will go up (over the longer term).

One of the means by which the LME price is kept in alignment with the free metal price is through the arbitrage process.

In theory, if the LME price is higher than the free metal price, holders of free metal would load it in to warehouses and then sell the metal on LME. On the other hand, if the LME price is significantly lower than the free metal price, holders of LME warrants would want to cancel their warrants, withdraw their metal from the warehouse, and sell it in the free metal market. However, the presence of long load-out queues has inhibited this arbitrage from functioning effectively, thereby allowing a large spread between the LME price and the free market price to persist.

Unintended consequences

The consultation report concludes that the proposal will lead to a reduction of queues in the affected warehouses but also recognises the need for broader steps to follow on from the proposal. These are to ensure certain unintended consequences do not follow.

The most “widely-feared unintended consequence” of the proposal is that it will lead to higher rents at LME warehouses. To control rents, the LME has commissioned reviews to investigate whether European competition law would allow it to regulate rents and FoT charges, or allow it to take action such as adjusting the decay factor on a “per warehouse” basis.

However these are medium term measures which rely to a certain extent on what the law allows the LME to do. In the short term, the report suggests that warehouse operators are made aware of “political, regulatory and user pressure”, which would not react well to increases in charges. The avoidance of rent or FoT hikes is therefore, at the moment, reliant upon the good judgement of the warehouse operators. The LME has said that it could change the decay rate on a global basis on the grounds that affected warehouses with queues are most likely to lead on rent increases. However, this could create issues if only some rather than all affected warehouses increase their rates as a response to the new rules.

Other unintended consequences include reduced clarity and understanding around the impact of missed slots for load-out. The consultation report deals with this by recommending that slots rejected by metal owners count towards the warehouse’s load-out requirements.

However, in other areas of unintended consequences, such as the potential for the lack of short-term warranting, the LME is relying on non-affected warehouse operators to act “rationally” by meeting demand that is not being satisfied by affected warehouses reluctant to take in more metal. The consultation report recognises that the proposal might in fact disincentivise investment in warehousing facilities, as operators become concerned that their warehouses will eventually develop queues which lead to more stringent load-out obligations.

As discussed above, the warrant premium is driven by sellers making the least valuable warrants available for settlement. Furthermore, an additional inefficiency in the LME clearing process is that, at settlement, the clearing process spits out warrants to buyers in delivery points and brands other than the brand they contracted for or in locations where they may wish to actually take delivery.

Therefore buyers have to go to the broker over-the-counter (OTC) market in order to swap a warrant for one at the location and of the brand that they require. It is easier to see why the difficulties in hedging such warrant premiums are a concern to the LME, as one of the primary purposes of the LME is to enable metals market participants to hedge their risks. This is especially important for those participants that have difficulties passing on the premium component of their cost to consumers. However, the solution to this could potentially be the development of premium hedging products rather than measures to reduce queues. The LME has committed to a full investigation on the feasibility of premium hedging solutions.

Other things the LME has agreed to investigate further include taking action to ban rent in queues and the possibility of making warrants fungible through the creation of a warrant exchange market.

Pricing and transparency

The LME believes that the reduction of queues will lead to the raising of the LME price but will not mean the free-metal price will change. It believes this because according to its findings, the free metal price drives the LME price. But what if this is not the case, at least in the short term?

The consultation report recognises the inevitable link between the length of warehouse queues and the ability of such warehouses to offer great incentives for storage of metal in those warehouses. It is difficult to predict whether the consequential decrease in the ability for such incentives to be paid by warehouses with queues will lead to the surplus metal going into other LME warehouses, non-LME warehouses, or into the free metal market.

If in the short term the metal goes into the free metal market, this could lead to a reduction in the free metal price rather than an increase in the LME price, which may impact the price curve and the current contango (where the futures price of a commodity is above the expected future spot price). Such a decline in the free metal price could have negative impacts for metals producers, especially if it is compounded by the demand for metal from financiers also falling (for example, in a backwardation market). On the other hand, if the surplus metal goes into financing deals on non-LME warehouses then this could lead to less transparency in the market.

Given the perceived importance of some of the unintended consequences of the proposal, including the potential increase in LME rent or FoT charges, the revisions to the proposal could be an indication that the LME’s own concerns about the political and regulatory environment have outweighed the caution about unintended consequences that it had expressed in the initial proposal. In this context it is interesting to note that the Financial Conduct Authority has endorsed the LME’s measures by saying that it sees it as the “first step towards strengthening the LME’s warehousing arrangements and increasing the transparency of the market”.

The conclusion that the LME price does not set the free metal price is a surprising admission for the LME. Most commodity exchanges desire to be the benchmark reference point for the price of their commodity. In fact, the proposal was originally premised on the fact of ensuring a desired convergence of the LME price to the free metal price. The admission that the LME price is not driving the free market price suggests either a politically convenient way to push the regulatory focus away from the LME, or raises a critical question as to whether the LME today is as transparent a reference price source for base metals as it used to be.