May 12, 2017 / 11:12 AM / 3 months ago

LME's hunt for elusive volumes could cause more shrinkage, risk benchmark

Traders and clerks react on the floor of the London Metal Exchange in the City of London February 14, 2012.Luke MacGregor/File Photo

LONDON (Reuters) - The London Metal Exchange (LME) is intent on enticing more investors to halt a slide in trading volumes, but users fear its plans could cause further erosion and even shake the foundations of its benchmark contracts.

The 140-year-old exchange is battling to reverse declines triggered by large increases in trading fees in 2015 and an economic slowdown in China, which accounts for nearly half of global consumption of base metals.

While it remains a dominant force in global markets, rival CME (CME.O) has been encroaching on its territory.

Copper volumes in the first four months of 2017 on the CME Group (CME.O) leapt 21 percent over the same period last year, while the LME posted a drop of more than 7 percent.

This is mainly because many funds prefer the CME's copper contract as it can be bought, sold and settled in one day.

The LME's benchmark three-month contracts - the lifeblood of the market - are used as reference prices in contracts around the world by traders, consumers and producers for buying and selling copper, aluminium, zinc, lead and nickel.

"We use the LME because it has liquidity for all the metals we trade, not just copper," a fund manager focused on natural resources said.

"The structure is not a problem for us, the accounting aspects are. I have to carry all positions to maturity on my balance sheet, it ties up capital."

Growth in the physical market peaked some years ago, so the exchange needs to look elsewhere to boost revenues for parent Hong Kong Exchanges & Clearing Ltd (0388.HK), which paid $2.2 billion (£1.7 billion) for the LME in 2012.

To facilitate a boost in volumes, the LME last month published a discussion paper listing alternatives to the status quo.

New LME Chief Executive Matt Chamberlain favours the option of extrapolating prices for three-month contracts and carry trades to populate the monthly contracts on its electronic system.

The exchange favours a technique called implied pricing to extrapolate synthetic prices for contracts that mature on the third Wednesday of each month from trading activity on other dates.

It hopes the idea can spread liquidity from its rolling three-month contracts to monthly dates that fund investors find easier to trade.

WHERE CARRY IS KEY

A fund wanting to bet on higher prices on the LME buys the three-month contract today and when it sells, perhaps a few days later, has to reconcile the two dates with another transaction known as the carry trade.

These carry trades occur at random dates in the future and are covered separately. If the monthly contracts became the most liquid, only the average exposure would be traded on the LME.

One broker estimated that if his carrys over the next three months totalled 9,000 lots, averaging would leave only about 900 going through the LME. "At $2.70 per lot that's roughly a revenue loss of $22,000 in fees."

Loss of volume on the three-month forwards is also expected by banks and brokers, which already offer funds monthly prices calculated using three-month contracts and carry trades.

A metals trading source at a bank said the "downside" was loss of volume on the three-month contracts. "Moving to the monthlies is a risky proposition because you become interchangeable with the CME."

The head of a metals brokerage said: "It risks the benchmark status of the three-months, a unique selling point."

But, the bank source said, the LME was under pressure to boost volumes, which last year tumbled 7.7 percent.

"An alternative would be to create liquidity points for the third Wednesday of the front month, the second month and the third month, which would help keep the date structure and the carry trades," metals industry veteran Jeremy Goldwyn said.

"The nuclear option of going solely to monthly dates would mean the carries market disappears and shreds volumes."

An LME spokeswoman said the exchange was aware of a "broad spectrum of views in the market on the subject of monthly electronic liquidity".

"The exchange ... looks forward to receiving feedback from all segments of the market on this topic and formulating a clear strategy that takes account of the views of its user base."

Editing by Veronica Brown and Dale Hudson

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