Exchange Offers Incentives for Financial Users
Gary Jones, chief executive offer of the London Metal Exchange, is spearheading a drive to attract more proprietary traders and hedge funds to LME's metal markets.
THE LONDON METAL Exchange is embarking on arguably its most ambitious program of change ever as it steps up plans to boost participation and enhance liquidity in the world’s largest metals market.
Launched last year but with its most critical aspects about to kick in this fall, the exchange’s Roadmap to Enhanced Participation and Liquidity on the LME includes plans to attract proprietary traders through new incentive programs and expand access to LME Select, its electronic trading platform.
The LME is confident it will generate new volumes and liquidity while retaining the traditional trade and industry business on which it has thrived. Its existing membership, particularly the brokerage community, is less convinced, fearing the changes will lead to reduced trading activity on the core three month contract and make the LME more vulnerable to competition from other exchanges.
The so-called Roadmap will mark a step-change for the 138-year-old exchange, which accounts for some 82% of global non-ferrous metals trade and still retains a vibrant open outcry futures trading floor, one of the last of its kind in the world.
But in recent years the exchange has lost market share in its flagship copper contract to its peers in New York and Shanghai while the number of floor members has fallen, as costs such as exchange and clearing fees have risen and a percentage of volume has moved online.
Third Wednesday
At the heart of the Roadmap is the belief that financial market participants such as hedge funds and proprietary traders would love to trade the exchange’s contracts, but do not find the LME’s dates structure easy to navigate. That is because with a rolling three month prompt date, any LME position left open overnight has to be closed out by trading the liquid three month contract and then making an adjustment to square the dates via a carry trade.
Although complex, this dates structure—under which a forward price for any individual date can be traded through a series of carries—is a key differentiator for the LME compared with other commodity futures exchanges, such as CME Group and Intercontinental Exchange. It’s also what makes the LME a forwards market and not a futures market; traders have the flexibility to settle their contracts daily out to three months, weekly out to six months and then monthly out to a number of years.
Carries are central to the LME’s role as a venue for physical merchants, producers and consumers. The dates structure is tailored to the physical users of the market, which use carries between individual dates to accurately match hedging programs to physical purchases and sales.
But as part of its goal to attract new users, the exchange plans to develop liquidity in the standard monthly settlement date, known as the third Wednesday.
Proprietary trading groups have told the exchange that they would trade a lot more on the LME if they could do so through a monthly outright futures contract, the LME says, in part because they could arbitrage that trade far more easily against contracts at the other base metal venues around the world.
The LME’s goal is for proprietary traders to deepen liquidity, narrow spreads and enable end-users of the market place—in this case, the physical industrial hedgers—to move in and out of positions more easily and smoothly. Around two-thirds of LME open positions currently sit on the third Wednesday settlement dates, which “shows there’s demand for exposure to monthly dates,” said Garry Jones, the LME’s chief executive officer.
Direct Access
The LME also wants to allow proprietary, algorithmic and other traders to access LME Select directly, instead of going through the LME’s top tier Category I and II members.
Earlier this year the LME launched a consultation on changes to its membership rules that will allow Category III and IV members to have direct access to LME Select. Category III members are trade clearing members, who can trade and clear their own business but cannot issue client contracts or trade in the ring. Category IV members are associate broker members, who can issue client contracts but are not clearing members. There are currently two Category III members and four Category IV members. The LME is expecting to get applications for Category III and IV membership from participants in the U.S., Singapore and Hong Kong.
The LME also is removing an existing rule stipulating that no member may undertake any regulated activity (as defined in U.K. regulation) unless the member is authorized, including through exemption, by the U.K.’s Financial Conduct Authority. Under the new approach, non-FCA authorized applicants would have to demonstrate an applicable exclusion or exemption to carry out regulated activities on the LME. In effect these changes mean that Category III and IV members will not need to be authorized by the FCA or their home country regulator in order to trade on LME Select. On the other hand, they will have to demonstrate why they have an exemption or exclusion from regulation and that their activities meet FCA standards or its equivalent.
Under the new rules, Category III and IV members will be able to trade without being sponsored by a broker, but they will still need to clear with a clearing member, and they will not have access to the floor – this is still the preserve of Category I ring-dealing members. In addition, the LME upgraded its LME Select system in April, adding new pre-trade risk management tools. As a result, clearing members can now monitor all orders flowing into the platform and set risk limits for clients as well as their own traders. Recognizing the importance of speed to the types of firms that it wants to attract, the exchange designed the risk management system so that all orders pass through the limit checks, ensuring that the risk controls do not add latency to the trading process.
Trading Incentives
To help generate more on-screen liquidity in the third Wednesday prompts, the LME recently launched two new one-year incentive programs for trading in its three main markets—aluminium, copper and zinc. Both programs apply to outright three month and third Wednesday futures contracts, and only if they are traded on, LME Select.
The first program provides proprietary trading groups already active on the LME with fee rebates to those trading above a certain volume threshold each month. The second program is for brand new market participants and is targeted at individual proprietary traders, with the goal that they graduate to become liquidity providers and move onto the fee schedule scheme.
The exchange opted to use rebate schemes— which apply for trade on LME Select across aluminium, copper and zinc on an aggregate basis across firms—after discussions with proprietary trading firms revealed a desire to be active on the LME but a deterrent based on exchange fees, as well as the rolling three month contract.
Proprietary trading groups have told the exchange that they would trade a lot more on the LME if they could do so through a monthly outright futures contract.
A crucial test for the Roadmap will be seen when the LME launches market-making programs in November. These will not be just for prop traders; they will be open to existing members as well as physical participants. If selected after a competitive formal tender process, they will be contractually obliged to provide a two-way market for the third Wednesday prompts in return for a fee waiver.
Some companies have already started making two-way prices for third Wednesday contracts on LME Select. John Shay, a senior vice president at Virtu Financial, confirmed that the New York-based proprietary trading firm is making markets on the exchange’s electronic platform.
“As the exchange rolls out liquidity provision and market making opportunities, Virtu will look to allocate more resources to LME,” Shay said. “Overall we believe this is a positive move that will greatly benefit the LME market.”
The exchange has taken other steps to help tighten spreads and deepen liquidity on LME Select. This includes increasing tick sizes to match those of the open outcry platform, which has added orders at depth on the screen, and launching LMEstage, a system for testing automated trading strategies.
The exchange also lifted a 50-1 order-to-trade ratio restriction for third Wednesday contracts out to six months on aluminium, copper and zinc. In effect, this means that LME Select participants can submit as many third Wednesday order entries as they like, which allows market makers to update their quotes more frequently and removes a key barrier for automated trading. LME data shows that on average there are now more than 80,000 quotes made on a daily basis on the third Wednesday date in total for aluminium, copper and zinc for the six forward months.
“By lifting our order-to-trade ratio and offering displayed electronic pricing on the dates where most of our users want exposure, we have already seen a great many more orders placed on these monthly dates. This will benefit the whole market, bringing more liquidity, tighter spreads, better monthly price transparency and improved order-book price-point depth,” LME’s Jones said
"Optimum liquidity is a core service that any exchange must offer, and as the LME evolves we must continue to strengthen the essential relationship that already exists between the physical and the financial users of our market."
Garry Jones
London Metal Exchange
Wary of Change
The LME now faces the challenge of bringing its traditional member community on board and addressing fears that the LME is becoming a U.S.-style futures exchange.
In a public speech at the LME annual dinner in London last October, Apurv Bagri, the chief executive officer of Metdist, a ring-dealing member of the LME, warned that the exchange needed to protect its unique structure, which includes individual prompt dates, multiple trading methodologies, non-cash clearing, the dual capacity role of members and deep links with the trade and industry.
“If, over time, the LME is reshaped into a lookalike American-style exchange, then the very barriers that have prevented competition will dissipate, and lead to the erosion of our dominant position,” said Bagri, whose father is former LME Chairman Lord Bagri. “If we give up or dilute our historic links to the physical trading community, then our uniqueness will disappear and the ability to create value will be dissipated.”
The LME and its owner Hong Kong Exchanges and Clearing have since said they value the uniqueness of the market and have no plans to change into an American-style futures exchange. But fears persist that the Roadmap proposals may shift trading from the prompt dates system and push it online to the third Wednesday dates.
With commissions for executing three month trades already slim and being eroded by the use of front-end routing systems to LME Select, brokers rely on a thriving carry business for revenues. Push liquidity to the third Wednesday and away from the prompt date system, and those carry revenues are directly hit, they argue.
Critics of the Roadmap argue that if sophisticated market participants like proprietary traders wanted to trade copper they would already be using the LME. They also say that direct access will reduce the role of the LME’s brokerage members, trimming their margins further and lowering the level of regulatory oversight.
Fred Demler, global head of metals at INTL FCStone, said that allowing Category III and IV members to access LME Select directly may well disadvantage Category I and II members.
Demler said that the strict licensing and training requirements placed on FCA-authorized persons, along with audits, capital requirements and controls, are essential for an efficient and fair market and therefore the LME’s move appears to run counter to the prevailing focus of the regulatory authorities to increase oversight and controls.
“The changes will permit a level of regulatory oversight and control that may differ from FCA requirements, could create more volatility and market inefficiencies, impact operational and compliance controls and change regulatory capital, that currently burdens Category I and II members,” he warned.
Some LME members also argue that the promotion of the third Wednesday will drain liquidity away from the carries, which are central to the market’s role as a venue for physical merchants, producers and consumers.
But the exchange does not agree that the proposals will reduce trading activity on the core three month contracts, or that this may impact the open outcry trading floor; it sees the monthly outright prices running in parallel to the current date-structured forward contracts. The LME also thinks any loss in fee income will be outweighed by increased volumes, and believes fears about less liquidity at the front end of the curve are unwarranted. As for the direct access rules, the exchange argues that its approach will bring the LME into line with most other exchanges in the U.K.
The LME’s Jones said the exchange is at a very early stage in the evolution of third Wednesday trading, but has seen no reduction in liquidity in the prompt date structure as a result of the changes.
“The LME is rooted in the physical market—it is what gives the LME its competitive edge—and we are committed to preserving and protecting those features that make us unique, such as our warehousing network and date structure,” Jones said.
“Optimum liquidity is a core service that any exchange must offer, and as the LME evolves we must continue to strengthen the essential relationship that already exists between the physical and the financial users of our market,” he added. “It is not about replacing one with the other, it is about enhancing their interdependence to benefit the whole market.”
East Meets West
A critical component of the LME’s strategy is centered on China, where it is working with its owner HKEx to leverage the accelerating pace of China’s internationalization and meet Chinese needs to hedge international commodity price risks.
Chinese membership has increased since HKEx took over the LME. GF Financial Group became a Category I member and Bank of China and China Merchant Securities became Category II members. In addition, Industrial and Commercial Bank of China upped its stake in Standard Bank, a Category II member.
But Chinese market participants say that while many of the Roadmap strategies are positive, the LME must continue to broaden its product range, remain a cost-effective trading and clearing venue, and leverage its newly established clearinghouse, LME Clear.
“We understand that the HKEx needs to make its £1.388 billion ($2.8 billion) investment in the LME work, but this needs to come from the development of new participants in the existing contracts rather than making the existing contracts more expensive. Therefore many of the initiatives in terms of the development of these new participants are welcome,” said Andy Gooch, chief executive officer of GF Financial Markets (UK), a subsidiary of China’s GF Financial Group.
“In addition they need to consider new contracts both on the futures side and the OTC clearing side which can enhance the product range and put LMEClear in a position to benefit as the regulatory environment moves more towards cleared OTC products,” he added.
These services must be provided on a cost-effective basis, Gooch continued, to ensure the LME remains the hedging and trading medium of choice for customers in both their existing customer base and the new ones.
This will ultimately be the true test for the exchange.
