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LONDON, Nov 4 (Reuters) - The London Metal Exchange's proposals to cut queues to get metal out of the warehouses could increase price volatility and reduce transparency as more metal moves off the exchange, Goldman Sachs said in a research note.
The LME, the world's largest metals marketplace, has come under regulatory and legal scrutiny over its metal storage practices, with complaints about months-long queues to withdraw physical metal from its warehouses.
Clients of the warehouses say the system inflates the cost, or premium, to secure metal. This is particularly so for aluminium, which is used in packaging and transport, even though the market is in global oversupply.
In July, the LME proposed new rules to overhaul the delivery system from next April that would force warehouses to release more stocks once the wait-time breaches 100 days.
The exchange, acquired by Hong Kong Exchanges and Clearing last year, said last month it had made a decision on its proposal, and would reveal details at a later date.
Goldman, which owns metals warehousing firm Metro but has Chinese Walls between its research, banking divisions and warehousing operations, said premium volatility had indeed increased the cost of using the LME as a hedge against physical prices.
"Clearly, should these costs increase, the demand for the LME as a hedging tool against physical price risk may decline," Goldman said.
"But going too far in the other direction in managing this basis (premium) risk may also impact the economic role of the exchange market - reducing transparency, liquidity and impacting the ability of the LME to create a buyer of first resort and seller of last restort."
To support the mechanism of physical delivery of its futures contracts the LME approves and licenses a network of around 700 warehouses across 36 locations around the world.
"Increasing the load-out rate potentially lowers transparency and increased LME rents and delivery-out charges as warehouses attempt to recoup the costs of investing in additional capacity to load out," Goldman Sachs said.
And limiting the load-in rate reduces the LME's ability to create a market of last resort in times of surplus, it said.
"We find that 'managing' the queue by the LME could have significant direct costs in the proper functioning of the exchange which can increase price volatility and indirect social costs by reducing transparency as more metal moves off exchange," it said.
LME warehouses hold 5.4 million tonnes of aluminium, but it is concentrated in only two locations: Detroit, where Goldman's Metro dominates, and Vlissingen in the Netherlands, Glencore-Xstrata's Pacorini stronghold.
Metal buyers' complaints have resulted in U.S.-based lawsuits by consumers, distributors and others alleging aluminium price-fixing and anti-competitive behaviour by investment banks, large trading houses and the LME.
Goldman, a defendant in some of the lawsuits, has dismissed the lawsuits against them as without merit.