The London Metal Exchange (LME) is today pleased to announce the outcomes of its Discussion Paper on Market Structure, which will enhance the LME’s electronic offering and provide greater transparency, while also preserving optionality for the Exchange’s diverse global customer base.
This structural evolution reflects the LME’s strategic principles - serving the physical market, ensuring fairness, increasing user choice and maximising trading efficiency - enabling the LME to modernise its service offering, adapt to new market dynamics and continue its growth trajectory, for the benefit of the market as a whole.
The LME received a record 192 responses to the Discussion Paper, reflecting the importance and complexity of the issues addressed. Most notably, there was strong support for the LME's stated aims of promoting transparency, fairness and the digitisation of its market more broadly, while respecting key principles such as the Exchange's commitment to its physical stakeholders and user choice. As expected, there was a very broad range of views and opinions in response to the details of the key topics in the Discussion Paper.
Matthew Chamberlain, LME CEO, said: “We are pleased to be advancing plans today which we believe will allow us to evolve our market as a unified community. The divergent views in response to the Discussion Paper were particularly apparent between traditional participants and some smaller physical clients on the one hand, and our larger merchant trader and financial participants on the other. However, respondents were constructive in proposing approaches to reconcile these differences, respecting the differing needs of the LME community, and preserving the unique and mutually beneficial blend of physical and financial market liquidity, which makes our market so special. We would like to thank the market for their valued and considered contribution to this important discussion.”
Gay Huey Evans OBE, LME Chairman, commented: “The Discussion Paper aired a very constructive debate around some complex issues and the Board of the LME very much welcomed the considered input from members and the broader global metals community. It is the responsibility of the Board to explore such complexities, looking at the full and diverse spectrum of customer needs, so that we can meaningfully move forward knowing that we are doing the right thing for the benefit of the market and metals community as a whole. The Board believes that the pathway laid out fully respects the interests of the physical participants who sit at the heart of our ecosystem and achieves the right balance between fairness, choice, efficiency, and progression.”
The Ring and reference prices
There was a wide range of views expressed on the topic of Ring pricing and trading, which the LME has taken into account in its support of Ring trading for the determination of Official Prices, while also permanently moving Closing Price discovery and trading to its electronic platform.
The electronic discovery of Official Prices has worked well during the pandemic period - due in large part to the support of Category 1 members. However, smaller physical participants, who are particularly focused on the lunchtime Official Prices, have expressed a preference for prices to be discovered in the Ring, and Category 1 members generally agree that they can best provide liquidity for such pricing in the Ring. Subject to consultation, the LME will resume discovery of the lunchtime Official Prices in the Ring, which will reopen for trading from 6 September. This date has been chosen to provide certainty and allow forward planning, on the basis that the LME’s existing vaccine criteria is expected to have been met, with adequate time allowed to ensure vaccine efficacy, even though recommended workplace social distancing could remain in force. If confirmed, this pricing approach would be subject to continued support from LME Category 1 members.
At the same time, market feedback also confirmed that financial participants and many of the larger physical users, who are more focused on Closing Prices and who use these primarily in marking their portfolios to market, have a strong preference for electronic pricing due to its capacity for enhanced participation and transparency. The LME’s position, therefore, is that its Closing Prices should be determined electronically - as has successfully been the case since the temporary closure of the Ring in March 2020.
Since trading on the Ring was suspended in March 2020, the LME’s electronic Closing Price process has seen increased participation and enhanced transparency. While the pricing methodology is inherently complex due to the number of dates that require pricing, the democratisation of the process itself has, in the LME’s view, ensured a fairer and more representative marketplace. A permanent electronic shift in Closing Prices will allow for the evolution of a more deterministic electronic pricing methodology, which will further enhance the process. To support this transition, the LME has today published a draft methodology and intends to form a Closing Price Working Group, comprising a broad range of market users, to ensure that the methodology continues to evolve to best reflect customer needs. The implementation of any methodology enhancements will be subject to a separate consultation, intended to be issued in the second half of 2021.
Enhancing liquidity
Respondents were supportive of the overarching proposal to enhance electronic liquidity for the benefit of the market as a whole. There were, however, concerns from all user groups around possible unintended consequences, including the potential impact on market liquidity of the simultaneous introduction of electronic pricing alongside the proposed liquidity enhancement initiatives. Therefore, the LME intends to introduce a set of solutions to enhance electronic liquidity, taking on board input from respondents, from 2022 onwards.
Many respondents agreed with the LME’s view that some less liquid instruments would continue to be best supported by the inter-office market. As such, the LME intends to identify a set of liquid contracts it believes can support electronic liquidity, with any new measures - such as fee changes, a liquidity provider programme, promotion of an enhanced transparency cross trade and block rules - applying only to this set of contracts. Taking feedback into account, the LME will also investigate the potential application of such measures on the market as a whole, including OTC activity, to ensure liquidity is optimised. Additionally, the LME will endeavour to ensure that any measures remain structurally supportive of certain types of “back-to-back” or “inter-dealer” brokerage models that may be more fee sensitive.
In respect of enhancing the transparency of the inter-office market, the LME will seek to ensure that all price-forming trades are booked and published to the market more quickly on core market data feeds, making appropriate data more clearly identifiable.
Margin methodology
As with the Ring, there was a wide breadth of views expressed on the topic of variation margin methodology. The current contingent variation margin (CVM) system can be helpful for smaller physical users as it facilitates the provision of credit from members to their clients. As such, smaller physical clients and Category 1 members broadly supported the maintenance of CVM, while larger physical clients, financial clients and Category 2 members generally supported a transition to the market-standard realised variation margin (RVM) model. A number of members also expressed a preference to introduce a value-at-risk (VaR) initial margin model before any decision regarding variation margin is taken.
Given the clear advantages of the two variation margin models for different stakeholders, the LME, while committing to retain CVM in the medium term, will embark on a feasibility study that considers the development of an approach that may recreate the cash flows of a CVM model for RVM contracts, which could support the traditional brokerage community in the provision of credit to their smaller physical clients.
A market-wide move to RVM will not be proposed until the feasibility of the new approach has been assessed and proven using the LME’s ferrous contracts, which are already margined using RVM. Importantly, any change to RVM will not happen until after the successful introduction of VaR. The LME plans to introduce VaR, which is expected to provide margin efficiencies for physical and financial clients alike, following the delivery of its new trading platform.
Adrian Farnham, LME Clear CEO, said: “The move to VaR will bring benefits to the market as a whole by providing substantial margin efficiencies. Additionally, a flexible approach to the handling of variation margin could provide an innovative solution that would enable our customers to choose the margining application that best suits their business. Should such an approach prove feasible, a move to RVM would then simply involve LME Clear paying profits on a daily basis, and could allow smaller physical clients to continue to receive the financing benefits of CVM for contracts margined on an RVM basis.”
Market conduct
In respect of the physical market, there was general consensus among respondents to the Discussion Paper that the LME should not attempt to extend its regulatory scope into pure physical transactions by way of introducing reporting obligations. Clearly, this limits the LME's ability to proactively monitor for physical market anomalies affecting trading activity; however, the LME agrees that its focus for the time being should be on ensuring that it uses its recently strengthened investigatory powers to undertake any required retrospective action where necessary.
Respondents were generally supportive of the LME taking a greater physical market role in respect of the off-warrant stock report (OWSR). As such, the LME intends to enhance the OWSR, and limit the warranting of metal not previously disclosed on the OWSR. Additionally, the LME plans to publish near real-time OWSR data, and move disclosure responsibilities from warehouses to metal owners with support from members. The Exchange believes that these enhancements, which will be implemented from 2022, will result in more comprehensive and accurate OWSR data, and will provide greater transparency on physical stocks to all market participants.
The LME’s consultation on the pricing venue proposals will run until 9 July 2021, with results expected to be issued on or around 9 August 2021. The LME intends to launch a second consultation in the second half of 2021 on the Closing Price methodology enhancements.