(John Kemp is a Reuters market analyst. The views expressed are
By John Kemp
LONDON, July 2 The London Metal Exchange's
metastasising warehouse problem must be solved once and for all
by prohibiting warehouse companies from issuing more warrants at
affected locations until load-out delays have been reduced to an
The delivery problem has grown and morphed, affecting every
aspect of the way metals are traded and supplied. But rather
than adopt a bold solution, the exchange continues to tinker
with the existing, broken system, layering on more complexity
and creating more opportunities to game the system.
Any review of warehousing must start by recognising that
warrant holders own the metal - not the warehouse, not the
exchange and not the broker. Warrants are titles of ownership,
they are not trading "chips". It is the responsibility of the
warehouse operator, regulated by the exchange, to ensure the
owner can get access to his or her metal without undue delay.
Preventing warehouses issuing new warrants until queues are
brought down to acceptable levels would recognise LME-registered
warehouses provide a service, for which they receive a premium
rent, and a vitally important part of this service is timely
access to the customer's metal.
For the second time in less than four years, the LME has
been forced to launch a consultation about how to cut the long
queues affecting customers trying to obtain their metal from
Announcing the results of the last consultation in May 2011,
LME Chief Executive Martin Abbott insisted the problem "is
specific to aluminium and to one location; the LME does not have
a systemic issue with its warehousing network."
The exchange responded by increasing the minimum load-out
rates based on a sliding scale depending on how much metal a
company is storing on warrant at a given location.
Despite the reforms, the problem has spread to other
locations across North America, Europe and Asia, and affects
almost all the LME's main metals contracts, as my colleague Andy
Home has carefully chronicled over the last two years.
In October 2012, Charles Li, chief executive of the Hong
Kong Exchange, which bought the LME last year, caused
a stir when he threatened to aim a "bazooka" at the warehousing
The rhetoric has subsequently moderated. On Monday, Li wrote
in a blog that the problem "can't be solved with either a
bazooka or a surgical operation. Instead, a modest approach,
such as Chinese medicine, might be the cure."
On July 1, therefore, the LME launched a new consultation on
a proposal to "cut existing queues and prevent new queues from
According to the exchange's press notice: "If there is a
queue of more than 100 calendar days, the affected warehouse
would be expected to deliver out additional metal based on a
TERMS OF SERVICE
Warehouse operators are private businesses, not owned or
controlled by the exchange. But their right to issue special
warehouse receipts (LME warrants) for metal in their custody
which can be offered as good delivery to satisfy futures
contracts has always been subject to regulation.
Warehouses are free to store any metal they like
off-warrant. But if they want to store metal on warrant they
must comply with requirements set by the exchange.
The LME already regulates many aspects of warehouse "terms
of service" to provide assurance to exchange users. Rules cover
location, transport links, weight and quality checks, security
and even minimum load-out rates.
The exchange currently prescribes minimum acceptable
load-out rates related to the amount of metal the operator is
storing on-warrant at a particular location. The problem is that
the relationship is not close enough.
Following the last round of reforms, the LME introduced a
sliding scale. For a warehouse company storing up to 300,000
tonnes at a particular location, it must be able to load out a
minimum of 1,500 tonnes per day, rising to 3,000 tonnes per day
for operators with more than 900,000 tonnes of stock.
There are two problems with this system. The first is that
minimum load-out rates rise much more slowly than the amount of
metal in storage. An operator with 900,000 tonnes has three
times as much on-warrant as one with only 300,000, but the
minimum load-out rate is only twice as high.
The second is that the load-out scale takes no account of
new metal coming into the warehouse so stocks (and delays) can
continue to worsen even if the warehouse operator meets its
minimum load-out requirements.
In many instances, the minimum required load-out rate has
become a maximum. Warehouse companies (most of which are now
owned by brokers and banks that are members of the exchange)
benefit from queues because they can continue collecting rent on
metal during the lengthy waits for it to be delivered out.
Warehouses maximise their earnings by taking delivery of
metal and putting it onto warrant as quickly as possible while
delivering it out as slowly as the rules allow. The cynical
observer might conclude warehousing companies have no incentive
to resolve the delivery problem.
Warehousing companies have responded to demands for even
higher load-out rates by noting that load-out is subject to
physical constraints such as the width of warehouse doors. But
that has left customers incensed when they see operators
continuing to deliver new metal into the warehouse and put it
onto warrant while protesting they cannot get any more metal
The LME's latest set of proposals attempt to tackle this
problem of distorted incentives. Minimum load-out rates would be
linked to the average delay over the previous three months.
Warehouses with a queue of more than 100 days would be required
to load-out more than they load in, which should eventually
shrink the amount of stock in the warehouse and cut delays.
The LME believes the proposal will shrink existing queues in
the medium term and prevent sustained long queues from forming
in future. But it admits that "implementation is complex" and
100-day queues may come to be seen as acceptable. In the same
way minimum load-out rates became maximum ones, the 100-day
threshold could become a minimum waiting time for metal.
NO MORE WARRANTS
There is a simpler solution. The exchange could simply
prohibit warehouses from issuing new warrants (or refuse to
register them in its SWORD recording system) until delays have
been brought down below a minimum acceptable level.
The acceptable threshold could be set at 100 days, or lower
as 100 days is still a very long time for an owner to wait to
obtain their metal.
Forbidding warehouses from issuing new warrants until they
can assure timely delivery on existing ones is within the
exchange's powers. It would recognise that timely delivery is an
important aspect of the quality of service warehouses provide to
the owners of the metal - something the exchange can and should
It promotes maximum flexibility for warehouse operators.
Rather than cap the amount of metal an operator can store, or
impose a complex formula linking load-in and load-out rates,
warehouse operators would be free to receive and store any
amount of metal - provided they can continue to guarantee a
minimum service quality level by providing timely load-out
within a maximum number of days (averaged over three months to
maintain operational flexibility).
If a warehouse cannot cope with demands for delivery, it
should not be accepting new metal.
And if the operator cannot meet acceptable service
standards, it should not be allowed to issue more warrants until
it resolves the problem, either by allowing the volume of metal
to fall, or upgrading its facilities to permit faster load-out.
(Editing by David Evans)