The imperative to secure ownership of the LME by Chinese entities will come as no surprise. The Middle Kingdom now accounts for 42% of global metals consumption; Chinese companies already trade on the LME through member firms; and several LME members have opened offices in Hong Kong. Newedge, whose 15% to 18% market share by volume makes it the largest LME ring-dealing member, even has a joint venture with Citic, the Chinese financial conglomerate, through which qualified customers can trade on the Shanghai Metals Exchange, the regional market for the same metals that dominate trading on the LME: aluminium, copper, zinc and lead.
Shanghai still takes its opening cue from LME closing prices, but the relationship between the two exchanges has evolved into a two-way street—traders now track closing prices and trends in Shanghai before they set opening prices in London the next day. If the Shanghai market were to open up to foreign participants, John Fay, global head of fixed income, currencies and commodities at Newedge, expects overall trading volume would grow but does not see business migrating from London to Shanghai. “Liquidity moves to where the capital is created,” he says. “The markets in China will continue to grow, but it will be complementary to growth on the LME. It will be additional volume.”
Unlike other futures exchanges, LME operates three trading systems that work in parallel: a continuous electronic trading platform open 24/7, ring dealing sessions on the exchange floor, and OTC trades negotiated off the floor. No matter where trades take place, they are centrally cleared by LCH.Clearnet, at least for now. The LME plans to set up its own clearing house by 2014, an initiative HKEX supports and to which it can bring its own expertise in clearing (albeit not in commodities). Self-clearing will give the LME greater flexibility to launch new products and may enable the exchange to take as eligible collateral assets not acceptable to LCH.Clearnet for initial and/or variation margin.
The LME also offers a wider range of delivery dates than other futures exchanges: daily “prompt dates” out to three months, weekly out to six months, and thereafter monthly to 15, 27, 63 or 123 months forward depending on the metal. HKEX has committed to retain this structure at least until 2015, but Fay is keen to see it preserved in perpetuity. “It is the model our customers want because it is built for size or speed,” he says. “They want to go to the floor for price discovery and liquidity, to be able to trade electronically or over the counter (OTC), and they want it all cleared.”
The LME model is unique, but may not remain so. In fact, it offers a viable template for trading financial OTC derivatives on an exchange: the prompt date flexibility eliminates the mismatch between quarterly contract expiration dates and the dates to which commercial participants need to hedge. “The LME model is an answer to Dodd Frank,” says Fay.
HKEX intends to help the LME expand in Asia through a combination of enhanced data distribution, the introduction of futures contracts denominated in renminbi (RMB) and additional warehouses. LME operates a network of more than 600 licensed warehouses around the globe in which market participants can deposit deliverable material in exchange for a bearer warrant for the number of contract lots the metal represents at that location. None of the existing warehouses are in mainland China, however; Chinese companies typically deliver to warehouses in South Korea if need be, which is typically in times of tight supply.
Michael Overlander, chief executive of Sucden, a ring-dealing LME member that accounts for between 10% and 15% of trading volume, says past efforts to license warehouses in China have foundered on doubts about the rule of law in the country. If someone presented a bearer warrant to the warehouse at an inopportune moment, would the operator honour the obligation?
“In countries where the LME does have warehouses the warrant would never be questioned,” says Overlander. “I think fear of the unknown legalities has prevented the LME from putting warehouses on the ground in China.” Local warehouses would no doubt improve liquidity and attract more Chinese participants to the LME, but while HKEX can help the LME cut through bureaucratic red tape it may not be able to resolve the legal difficulty.
HKEX wants to leverage its existing renminbi-based trading and settlement infrastructure in Hong Kong to support new LME futures contracts denominated in the Chinese currency. Although these products would be another step toward the internationalisation of the renminbi, Overlander does not see them as an immediate precursor to free convertibility. “The Chinese government has shown a great reluctance to take the handcuffs off the RMB,” he says. “It will first have to relax the controls to get people excited about a currency with limited uses.”
Both Sucden and Newedge own shares in the LME but, at just under 3%, their holdings are far smaller than their market shares of exchange business. Maintaining the business model should be more important to both firms than the price at which they can sell LME shares, but few people are altogether immune to the lure of money. “I would be lying if I said the equity isn’t important,” says Overlander. “It would be hard to see the value of our shares topped in the foreseeable future. It was a relatively easy decision for us to support the transaction: we were satisfied with the buyer and the price.”
The losing bidders—Intercontinental Exchange and CME Group—must now explore alternatives if they wish to expand in base metals. For ICE, it would be a new business line, while CME has a copper contract traded on the Comex that competes directly with the LME. Apart from copper, CME has historically focused on precious metals—gold, silver, platinum and palladium—that do not overlap with LME products.
The LME’s dominant position represents a significant barrier to entry, however. Market participants have great confidence in price discovery on the LME, so much so that prices for physical contracts (which are not traded on the LME) are usually based on LME prices. The LME warehouse infrastructure would be hard to replicate too. “Virtually anywhere in the world, metal can be stored in exchange for a negotiable LME warrant. Warrant holders can have almost instant access to material on whatever day they want,” says Overlander. “The warehouse network is just one example. It would be tough to knock the LME off its pedestal.”
The reaction in some quarters to the LME sale—another British champion passes into foreign hands—may be more Sinophobic than xenophobic. Nobody claimed that American interests would interfere with price discovery in London when ICE bought the International Petroleum Exchange or NYSE Euronext took control of LIFFE. Chinese influence in London is likely to grow if Chinese companies do more business on the LME but Overland insists Chinese ownership will not affect market operations. “Whatever the rationale for buying the LME, it was not to manipulate prices in favour of Chinese buyers,” he says. “The LME will still have to comply with FSA rules that govern regulated investment exchanges, which are designed to make sure the market has the confidence of users.”