LONDON (Reuters) - If you want to understand why some members of the London Metal Exchange (LME) are so unhappy with the way things are going that they are considering forming their own metals-trading platform, look no further than the latest exchange notice to members.
Dated Monday, the LME said it has received an application for exchange membership from Jump Trading Futures LLC.
If accepted as a Category 3 (“Associate Trade Clearing”) member, Jump Trading will be able to trade and clear its own business on the LME but won’t be able to issue client contracts or trade on the open-outcry ring.
Chicago-based Jump Trading describes itself as having been “at the forefront of algorithmic trading since its founding 15 years ago”.
It is symptomatic of the new breed of player trading on the world’s oldest metals exchange. It is also precisely the type of company being targeted by the LME as it seeks to boost liquidity in the face of reduced volumes from its industrial user base.
That in itself might be enough to disconcert traditionalists, who fear that the LME’s drive to capture more financial players risks marginal the producers, merchants and consumers who have historically been the back-bone of the exchange’s pricing dominance.
But Jump Trading’s potential membership poses another, more clear and present danger to LME brokers.
It is not only an existing customer of the market but a very big one indeed.
Quite evidently, if it gets the rights to trade on its own behalf as an LME member, it’s going to mean a loss of commission fees for all those who have previously brokered its business.
THE BROKER SQUEEZE
LME brokers are facing something of a double squeeze on their core business.
Both derive from the changes introduced to the market since it was bought in 2012 by Hong Kong Exchanges and Clearing (HKEx).
HKEx has sought to claw back some of its $2.2 billion outlay on the LME by raising trading fees. nL5N18L4G4
The impact of the fee hikes has been particularly evident in some of the short-dated spreads, such as “tom-next”, which literally means trading tomorrow to the next day.
“Tom-next” has historically been a highly liquid spread, not least because it was in essence free to trade under the LME’s old mutual limited-profit model.
That’s no longer the case. Brokers face the unwelcome choice either of absorbing the cost of trading it or passing that cost through to the customer.
The net effect is that “tom-next” volumes in the aluminum contract, for example, have slumped since the fee changes were brought in early 2015.
The LME, meanwhile, has introduced a number of changes intended to boost electronic trading, particularly for the benchmark rolling three-month delivery price and the spreads between that price and other major prompt dates in its spreads spectrum.
The biggest carrot being offered proprietary financial trade houses such as Jump Trading is the ability to access directly the LME’s electronic trading system Select rather than go through a broker. A carrot Jump has just taken.
From the LME’s perspective, it is a way of opening up the arcane London market to the types of operator already populating other major financial markets.
From the perspective of LME brokers, however, it represents another nail in the coffin of the old market with all of its weird and wonderful features such as open outcry trading and plethora of spread trades.
PAST FORM, FUTURE FRAGMENTATION
Which is why a number of them, just how many we don’t know, have asked Martin Abbott, former LME chief executive, to oversee a feasibility study on the viability of a new trading forum.
There has for some time been plenty of low-level chatter on the LME Street about just such a move but the inference from Monday’s formal announcement by Abbott is that there are sufficient numbers interested to justify the cost of a study.
But is it anything more than displacement activity for those that feel disenfranchised by the recent direction of travel of the new LME?
There are grounds for thinking that there might be.
Firstly, there is a precedent for LME brokers adopting an entirely new trading forum if they feel it is in their interests to do so.
Spectron launched an electronic metals trading system in 2000 to capitalize on the LME’s lagging efforts to get its own offering up and running.
It seemed a tall order to persuade a naturally conservative brokerage community to embrace a new form of trading seemingly designed to put at least some of them out of business.
But Spectron enjoyed remarkable success until the LME belatedly caught up and rolled out increasingly enhanced versions of its own Select electronic trading system.
Within a year Spectron could boast 30 contributing members, just about all of them from the core LME membership, and transactions worth over $16 billion.
A powerful reminder that LME brokers work for themselves and not the LME, particularly if they feel that their interests are not aligned with those of the exchange.
Secondly, the rapidly changing landscape of exchange trading may allow much greater freedom of movement for potential disruptive upstarts.
One of the LME’s core strengths is its clearing function, which has been tailored to suit both its own non-vanilla spread structure and the requirements of its users, allowing them, for example, to post metal as collateral.
It would be time-consuming and costly to build from scratch a replica.
But thanks to new regulation, there may not be a need to.
MIFID II, the multi-pronged regulatory package being assembled by Brussels regulators, represents an overhaul of the way commodity trading has been conducted in the past.
One less-discussed aspect is the concept of “open access”, in effect breaking up the sort of vertical clearing-trading model in operation on the LME.
Clearing houses must be able to access trading venues and trading venues must be able to access clearing houses.
The grounds for refusing such access will be drawn very narrowly.
The LME has already “called on regulators to think carefully about defining the grounds for denying access”, fearing potential “liquidity fragmentation”. (“European regulatory change; What it means for the metals market”, LME, October 2015).
Arguably, such liquidity fragmentation is already starting to happen, witness the range of new products being rolled out by the LME’s would-be U.S. competitor, the CME, at least partly in response to regulatory change.
The contest remains, for now at least, largely one-sided thanks to the LME’s historic franchise as global benchmark for base metals pricing.
A break-away market by the LME’s own membership, however, would represent an entirely different form of challenge.
And it if still seems highly unlikely, it’s worth remembering that the apparent conservatism of what can at times feel like a private members club masks an acute sense of self-interest.
That self-interest is being challenged by the LME’s reform process and Spectron is a reminder that, when pushed, the club members can be surprisingly ambiguous about the benefits of belonging to the club.
Editing by William Hardy
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