January 22, 2018 / 1:55 PM / in 5 months

COLUMN-London Metal Exchange stops the volume rot, but CME challenge grows: Andy Home

(The opinions expressed here are those of the author, a columnist for Reuters.)

* LME Volumes long term: tmsnrt.rs/2DYHDFs

* LME Volumes by contract: tmsnrt.rs/2DXPTWa

* CME copper positioning: tmsnrt.rs/2DZ77m6

By Andy Home

LONDON, Jan 22 (Reuters) - Trading volumes on the London Metal Exchange (LME) increased by a marginal 0.5 percent last year.

Not exactly the most exciting headline in the world of commodities trading, but after two years of contraction, even this modest turnaround will be welcome news for both the LME’s management and its owner, Hong Kong Exchanges and Clearing (HKEx).

The LME slashed some of its trading fees last October in a bid to revive flagging volumes but broader market conditions have arguably been just as important a driver of improved activity.

Nor is the exchange yet out of the woods.

Performance was highly mixed on an individual contract basis, new products helping offset pockets of weakness elsewhere in the LME portfolio.

The challenge from U.S. exchange CME, meanwhile, continues to grow, both in terms of new contracts and the oldest contract of them all, namely copper.

Graphic on LME volumes long term: tmsnrt.rs/2DYHDFs

Graphic on LME volumes by contract: tmsnrt.rs/2DXPTWa

TENTATIVE TURNAROUND

The mini bounce in volumes last year, 0.5 percent at a headline level and 1.0 percent on a daily average basis, will be seen as a vindication of the LME’s U-turn on trading fees.

But the fee cuts were only initiated in October and there is little evidence that they have yet had much of a direct impact on volumes.

Short-dated spreads, meaning those between one and 15 calendar days, were specifically targeted by the LME. It slashed fees on this part of the forward curve to pre-2012 sale levels.

“Tom-next” is the shortest-dated spread of them all and the sharp drop in activity after fees were increased in 2015 became totemic of the broader debate about the cost of trading on the LME.

“Tom-next” volumes, however, have shown no significant improvement since fees were cut again in October. Activity on copper and zinc fell by almost 18 percent year-on-year in the last three months of 2017, while “tom-next” volumes on aluminium were down by almost 26 percent.

Quite evidently, the pick-up in volumes is happening elsewhere in the LME’s arcane trading structure.

Neither LME nor brokers will care too much about the specifics but the link, or non-link, between fee cuts and volumes is far from academic.

The exchange has made it clear that it will increase fees again if volumes do not return. What happens if volumes pick up, but not on the specific spreads subject to fee reductions, is a moot point.

NEW CONTRACTS, OLD CONTRACTS

Part of the LME’s improved volume picture last year is down to new contracts.

The exchange launched both gold and silver contracts in July and cumulative volumes reached 639,546 over the rest of the year, gold activity outpacing that on silver.

The LME’s two steel contracts notched up their second full year of trading in 2017 and experienced exponential growth. Activity in the scrap contract surged to 307,532 lots from 49,099 lots in 2016, while rebar volumes totalled 64,430 lots last year, up from 8,637.

Both precious and steel contracts are simple cash-settled futures products and the robust performance, particularly of steel scrap, will reinforce the LME’s ambitions to roll out more such products in the next year or so.

The LME’s core traditional base metal contracts had a more mixed performance.

Zinc, nickel and lead all registered volume growth, suggesting that broader market conditions have played an important part in the LME turnaround story.

It’s surely no coincidence, for example, that zinc saw the strongest performance with a 10 percent increase in volumes in a year characterised by a series of fresh 10-year trading highs.

The other main contracts all saw volumes drop year-on-year, albeit in most cases with signs of stabilisation over the closing months of 2017.

Only the aluminium alloy contract looks in need of emergency restorative action. Volumes slumped by 52 percent last year, marking the sixth consecutive year of decline.

In broad brush terms, though, the LME will take heart from a positive headline performance after two years of decline.

Graphic on CME copper contract: tmsnrt.rs/2DZ77m6

CME TURNS UP THE HEAT

The exchange will still be casting a nervous eye over its shoulder, however.

Across the Atlantic the CME has been rolling out ever more products in competition with the grand old London lady of metals trading.

Some of these, such as the aluminium, zinc and lead contracts have shown only minimal activity.

CME’s four aluminium premium contracts, by contrast, all saw volume growth last year, led by the European duty-unpaid contract, in which activity more than doubled, and the U.S. Midwest contract, which grew for the fourth straight year.

Also worth noting is the CME’s alumina contract, currently the only futures contract for this part of the aluminium supply chain.

Launched in 2016, it traded only 200 lots in the first half of 2017 before seeing a sharp rise in activity over the second half. Full-year volumes ended up totalling 6,685 contracts with open interest surging to 2,710 lots from just 60 a year earlier.

The real stand-out among CME’s base metals offering, however, has been its oldest contract.

Copper volumes grew by 26 percent last year, in sharp contrast to the 7.9 percent fall in LME copper volumes.

The accepted wisdom is that this is primarily down to new speculative players, particularly those in Asia, gravitating towards the CME because of its simpler structure, facilitating arbitrage with the Shanghai copper market, and its cheaper transaction fees.

And it’s true that rising volumes on the CME copper contract have coincided with money manager positioning hitting historical highs.

But there’s an interesting flip side to this phenomenon. Producer and merchant short positioning has also experienced a step-change over the same time frame.

CME stocks of copper surged by over 111,000 tonnes to 191,575 tonnes last year. They are now bigger than those registered with the Shanghai Futures Exchange and almost as large as those in the LME warehouse system.

This unusual development may well have started as a physical merchant play to get ahead of potential U.S. import tariffs from a protectionist Trump administration.

But the trend now seems to have taken on a life of its own with traders actively directing spare units to CME warehouses in Arizona and Utah to capitalise on cheap rent.

The inference, borne out by the leap in producer and merchant short positioning, is that they are now using the CME contract to finance inventory.

That may be a far more worrying prospect for the LME than a new generation of Asian wealth managers using the CME copper contract.

The LME, after all, likes to differentiate itself from both CME and Shanghai markets by highlighting its industrial rather than speculative user-base.

That demarcation line is starting to blur. (Editing by Adrian Croft)

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