(The opinions expressed here are those of the author, a columnist for Reuters.)
By Andy Home
LONDON, June 27 The London Metal Exchange's (LME) open-outcry ring is a historical curiosity, a throw-back to Victorian London, when men in top hats met to do business in the coffee shops and alley-ways surrounding the Bank of England.
It is a baffling theatre of shouting and hand gestures, confined within a small circle of red leather seats and bound by a complex code of etiquette.
Yet what is Europe's last remaining open-outcry trading venue is still the primary price discovery mechanism for the world's nonferrous metals trade.
How it has survived for so long against the tide of history is a mystery, even to most of the LME trading community.
Few thought it would outlast the 20th century, expecting it to be swept away, like so many other trading floors, by the surge in electronic trading.
And even fewer expected it to survive a six-month review initiated by the LME's new owners, Hong Kong Exchanges and Clearing (HKEx). Particularly at a time when regulators the world over are scrutinising commodity pricing benchmarks.
Those other London pricing relics, the bullion fixes, are currently melting under the glare of regulatory scrutiny.
But the LME has decided to stick with its archaic trading forum "for as long as the market needs it", according to Garry Jones, chief executive. Indeed, ring-trading is one of three alternatives in the LME's pitch for taking over the silver fix from August.
So, what's so special about the ring that this historical curiosity will still determine the prices of metals such as copper and aluminium well into the 21st century?
The origins of the LME ring date back to the early 19th century when trading in metals spilled out of the overcrowded Royal Exchange into the nearby Jerusalem coffee house.
A merchant with business to transact would draw a circle in the sawdust on the floor and call out "change", at which point others would assemble to trade. Any unfinished business would be conducted outside on the kerb of the pavement. The "kerb" still denotes the two periods of trading that follow the LME's morning and afternoon ring sessions.
The ring remained the sole focus of LME business until the 1970s, when one pioneering house broke with tradition and started making a market in the morning. The collective ambivalence about such a revolutionary move has been frozen in time in the form of the moniker for this particular session.
It is still known as "the pre-market". Not to be confused with the "real" market that took place on the ring sessions.
The rings generated the "official" price, used by producers, merchants and manufacturers in their physical contracts, incentivising them to channel hedging business into the price-discovery process, a golden circle of liquidity.
And they still do. The LME "officials" remain the primary benchmark for industrial metal prices.
They are now complemented by the "unofficials", set in the afternoon trading session, originally a nod at the time-zone sensitivities of South American producers.
The afternoon "kerb", meanwhile, remains the key determinant of the LME closing price, against which positions are valued for margining purposes at the end of the day.
RINGING THE CHANGES
The LME ring today would still be largely recognisable to a metals broker transported from the middle of the last century to the present day.
He, and it would have been a "he", not a "she", might remark the absence of the large copper ashtray at the centre of the ring, a 1990s casualty of modern health dictates.
He would certainly notice the electronic pricing displays on the walls of the trading floor, which will be now be upgraded at a cost of 1 million pounds ($1.7 million).
The LME, like every other financial exchange, has seen electronic trading boom over the last couple of decades. But LMESelect, its bespoke trading platform, co-exists with both traditional ring-trading and inter-broker telephone markets on the exchange floor.
The most significant change since then and now, and the one that has posed most challenges to the ring's survival, is the number of brokers sitting on those red leather banquettes.
Just 11 of them.
Whereas once LME membership was defined by a company's presence in the ring, there are now several categories of membership.
And many LME participants have chosen to forgo the costs of maintaining a floor-trading team by opting for a lower-tier membership, particularly that of associate broker clearer (ABC), which other than ring-trading confers all the same trading rights. There are 26 ABC members, including most of the big investment bank players in the metals markets.
Floor-trading still confers a degree of prestige and, ring-traders would argue, attracts business from industrial users wishing to be closely involved in the price-discovery process.
But, despite the addition of China's GF Financial Markets at the start of this year, the inner club of ring-dealers looks small relative to the total number of LME members.
This is not just a numbers game. The contraction in the ring-dealing elite has raised concerns about the ring's capacity to take on risk, particularly since, with a couple of exceptions such as Societe Generale and JPMorgan, most are small or medium-sized traditional metals brokerage companies.
The exchange has repeatedly tweaked its rule-book to ensure the ring sessions, first and foremost the "officials" and the "kerb", remain liquid and efficient forums for generating its global benchmarks.
Minimum default deal sizes have been set at 50 lots (for spreads) and 10 lots (for cash and three-month metal), while the risk-averse practice of "crossing" order flows, both in and behind the ring, has been constrained.
THE ART OF PRICE DISCOVERY
This series of incremental changes, and there have been more than 20 since 2010, appears to have worked. The LME this week declared its ring-trading format a "robust and transparent price-discovery process".
Critically, it also "meets the IOSCO Principles of Financial Benchmarks", a reference to what has become the regulatory seal of approval from the International Organisation of Securities Commissions.
This is not sentimentalism.
HKEx was studiedly non-committal about the ring's long-term future when it bought the LME in 2012. And while chief executive Jones has diplomatically toed the same line since his appointment last year, the word on the London street was that it was simply a matter of time before the new management consigned the ring to the history books.
That they have chosen not to says much about the durability of this little piece of financial history.
If the ring has one unique selling point, it is its capacity to capture price formation across the LME's bizarre and Byzantine prompt date system.
The LME is not a standardised futures market. Rather, in another throwback to those 19th century traders meeting in the Jerusalem coffee house, it is a forwards market. Every day between the cash and three-months dates can be traded. So can every third Wednesday beyond three months, all the way out to 10 years forwards in the case of the LME's major contracts.
There are up to 200 tradable dates per LME metal, which can generate a multiplicity of potential spread trades, only some of which will trade liquidly at any one time.
Determining the full end-of-day pricing curve is as much art as science.
The LME's Quotations Committee, charged with generating a coherent whole from the sum of many, potentially conflicting parts, "will not give priority to outright prices over carries or vice versa" ("Procedures for establishing closing prices," July 5, 2013).
"There are occasions when it will have to use an implied three months price to equate with a forward outright price which has transacted significant volume.
"Where appropriate, it will input a value against any Prompt Date it deems necessary. An interpolation process will calculate values between any two Prompt Dates where prices have been input to establish Closing Prices for all valid Business Days."
The very dynamism of the LME prompt date system, which has evolved to match the dynamics of its customers, renders it resistant to electronic replication.
LME trading has its fair share of high-frequency and algo traders, but these tend to operate on the one-dimensional playing field that is the exchange's anchor three-month price.
Spread trading is the exchange's bread and butter business, reflecting the industrial metals markets' historic tendency to average price risk across months or quarters, and spread trading is still largely the preserve of humans not black boxes.
And the rings are transparent.
Not obviously so to the uninitiated. But the bewildering bursts of trading action are translated into discernible price discovery by the LME's own floor team.
Peter Childs, who heads the team and also chairs the Quotations Committee, is "Lord of the Rings", acting as front-line regulatory enforcer.
The member notices section of the LME's website is liberally sprinkled with the names of those who have fallen foul of the complex code of rules covering ring-trading.
The Quotations Committee has similar wide-ranging powers, including disregarding "frivolous" quotes or those "which could have been made to try and influence closing prices".
Of course, it is in the very nature of wholesale markets that everyone will try and influence prices, particularly closing prices. The issue is whether a market is, and equally importantly, is seen to be, robust enough to withstand such pressures.
The silver fix is not. And there is now a major question-mark hanging over the gold fix. Both would have benefited from the sort of transparency and visible regulatory function that exists on the LME floor.
It would be ironic if one or both ended up being traded on the LME ring.
But then the ring predates both fixes by many years and, unlike the bullion market's price discovery mechanism, it appears to have just been given a clean bill of health by an initially sceptical new management team and, implicitly, by UK regulators.
The real test, though, will be if this ringing endorsement serves to attract more companies to the ring. That, ultimately, will determine whether this Victorian curiosity makes it to another century. ($1 = 0.5889 British Pounds) (Editing by Keiron Henderson)