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Commodities

A structural problem the London Metal Exchange can fix: Andy Home

LONDON (Reuters) - Some problems you can’t fix yourself.

Chilean President Michelle Bachelet (green dress) watches trading with Peter Childs (L), head of price discovery at London Metal Exchange and CEO Garry Jones (R), after officially opening new offices at the London Metal Exchange, London, Britain, May 13, 2016. REUTERS/Paul Hackett/File Photo

The London Metal Exchange (LME) today finds itself operating in “business continuity” mode with open-outcry ring trading migrating east of London to the disaster recovery site in Chelmsford.

That’s because of “a structural issue” within the Exchange’s new home in Finsbury Square. The building remains out of bounds until at least Wednesday, July 20 as “the landlord, building manager, structural engineer and other relevant parties (work) to establish the extent of the issue, its implications and resolution.”

Other structural issues, however, you can do something about.

The cost of storage in the LME’s warehouse network has been a bone of contention for as long as anyone can remember.

It has historically been viewed much in the same way as the problem with the building at 10, Finsbury Square, a structural issue over which the Exchange itself had little control.

With no powers to stop a long-running upward spiral in rental and load-out charges, the LME was fearful of the legal consequences of trying to give itself such powers.

The default policy for the last two decades has, therefore, been to do nothing other than try and cajole warehouse operators into a semblance of self-restraint.

That is now about to change.

The LME on Thursday opened up a formal consultation on freezing maximum warehousing charges for five years and then capping future increases by linking them to consumer price indices in the countries hosting exchange warehouses.

THE PROBLEM BEHIND THE QUEUES

The LME has spent the last few years steadily chipping away at the load-out queues that have bedeviled its good-delivery function.

Minimum daily load-out rates have been increased, per-metal load-out rates have been introduced, warehouse operators with queues have been forced to load out more than they load in and rent has been capped for anyone caught up in a load-out queue beyond 30 days.

The steady accumulation of anti-queue measures has largely worked. As of the end of May there was only one queue, at LME warehouses in the Dutch port of Vlissingen operated by Access World (previously Pacorini Metals).

But queues were only ever the symptom of the LME’s core warehousing issue. Which has always been the cost of LME storage relative to off-market storage.

That, after all, was why there were queues in the first place.

Players engaged in stocks financing deals were incentivized to find the cheapest storage option for their metal. The resulting rush to move huge amounts of material, particularly aluminum, out of expensive LME sheds overloaded a system designed for limited manufacturer rather than near unlimited financial demand for physical units.

Moreover, the queue model, pioneered by warehouse operator Metro in Detroit and then upgraded by Access World at Vlissingen, laid bare the underlying imbalances at the heart of the LME’s warehousing business.

A warehouse operator’s customer is not the person paying the maximum rental charge prior to paying the load-out charge to get metal out of the system.

Rather, that person is funding the operator’s ability to attract its real customer, the player prepared to deposit more metal into its sheds.

In this looking-glass world the load-out charge is nothing about the cost of loading out, but rather the generator of the incentive that can be paid to get stuff in.

While warehouse operators compete aggressively on attracting fresh metal, there is little room for negotiation on exit charges.

And since “out” charges fuel inflows, there is a strong economic logic behind the super-inflationary cost cycle of LME warehousing. Any operator trying to fight it would simply find itself disadvantaged relative to others with higher charges.

LEAST WORSE OPTION

The outcome of this curiously counterintuitive business model is two decades of ever-rising storage and load-out costs.

The LME’s only power to stop it has been that of persuasion. A call for “restraint” in 2014-2015 reduced the rate of increase in that cycle to a stock-weighted average of three percent for rent and two percent for load-out charges.

Restraint, however, was in short supply in the annual increases for the rent cycle running from April 2016 through March 2017. The weighted average rent went up 10 percent and the load-out charge 12 percent, and that after a couple of operators were given a one-off chance to lower their charges.

So the LME is finally going to act, choosing one of five potential measures detailed in an April discussion paper.

The preferred solution, now open to formal consultation, might be described as the least potentially disruptive.

Charge capping “was seen as a good compromise, a reasonable measure to bring the market back to a more realistic charge comparison, easy to implement and likely to be acceptable to warehouse companies, who would have time to earn back the majority of historically paid incentives,” the LME noted.

In particular, the nuclear option of switching all LME contracts from in-warehouse to free-on-truck, in essence wiping out the load-out charge, was deemed to be too difficult to implement and too unpredictable in its potential side effects.

Not entirely surprisingly, since it has been considered several times before and rejected on the same grounds

REACTION?

How will warehouse operators react?

In truth, there will be plenty who will welcome, albeit quietly, the advent of charge capping.

The resulting transparency would consign to history the flawed way in which headline charges are currently set, a game of collective spoof that can go disastrously wrong. That was why two operators asked for special dispensation to resubmit their charges for the current rent cycle year after realizing they had set them far too high.

Smaller operators would also welcome the leveling of a playing field that is currently tilted heavily in favor of bigger players.

But the key question is whether anyone might react by legally challenging the LME’s right to cap charges.

Fear of European Union competition law has been the main reason for the LME’s historic inaction.

For its part the LME is now taking the view both that “it would win any challenge” and that getting the detail right would mitigate the chances of court action.

But the danger is nonetheless a real one, given charge capping will inevitably impact many operators’ existing operating models.

The LME, however, has to run that risk.

This particular structural problem has been allowed to fester for too long and without the sort of drastic measure currently countenanced, there is no reason to believe that the upward cost spiral wouldn’t just continue.

As it has done, remember, for the last 20 years.

Now, as for that other structural issue at Finsbury Square, well, that’s really one the LME can’t fix itself.

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

Editing by Susan Thomas

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