LONDON (Reuters) - The London Metal Exchange (LME) is returning once again to the vexatious issue of its warehousing function.
It has been five years since the exchange initiated a multi-pronged reform process to deal with the problem of long load-out queues in its physical delivery network.
The last structurally embedded queue at the Dutch port of Vlissingen disappeared in July 2017. There are still occasional flash queues, such as the 121-day waiting time for aluminium at Malaysia’s Port Klang, but accelerated load-out requirements prevent them from becoming embedded.
The question now facing the LME and its users is whether the exchange’s reforms have been too successful.
By facilitating faster load-out of metal, have the reforms also served to inhibit inflow? Are LME stocks now too low relative to the amount of metal sitting in off-market storage?
This conundrum lies at the heart of the LME’s “Discussion Paper on LME Warehouse Reform” released last month.
It includes some nuts-and-bolts suggestions from the exchange’s own warehousing committee, but equally significant may be the LME executive’s own thoughts on the transparency of its daily stocks reports.
Total LME-registered stocks have fallen steadily from more than 7 million tonnes in 2013 to 1.7 million tonnes at the end of March.
Part of this decline may be explained by market fundamentals, such as the current broader squeeze on metal availability in the zinc market. But the LME also recognizes that its rules may have a material impact on the attractiveness of LME warehousing compared with alternatives such as off-warrant storage), the exchange notes.
Low inventories for on-exchange metal are a cause for concern for warehouse operators, consumers and traders - a rare consensus, albeit for differing reasons, in a historically fractious debate.
The LME’s own warehousing committee has come up with some proposals.
The one that has grabbed the headlines is a recommendation to relax the rule that warehouse operators can’t charge rent for metal in a queue after 50 days. The proposal is that the cut-off period be extended to 80 days.
Warehouse operators have assured the LME that the “structural queue” revenue model is no longer part of their business and that 80-day queues would not become a new “business target”, according to the LME.
Others may be wary of taking them at their word and the LME notes with a degree of understatement that “there are likely to be differing opinions in the market regarding this”.
Perhaps more interesting is the warehouse operators’ apparent acknowledgement that some of their own practices may need to change.
LME warehouse operators have always offered incentives to attract more metal. Incentives, indeed, are probably the key determinant of how much metal is stored with which LME operator.
One type of incentive, the so-called “evergreen rent deal”, has become ever more popular and ever more controversial.
Rather than receiving a cash incentive, someone delivering metal onto LME warrant gets a share of the rent collected by the subsequent owner or owners of that metal.
For the new owner, the only way of breaking that lock-in under the current rules is to physically move the metal out of the rent-share warehouse.
The LME’s warehousing committee has suggested that an “evergreen” deal could be terminated by simply cancelling the metal and then rewarranting it. That does, however, normally come at a cost for the owner of the metal.
The LME itself adds a suggestion that such a deal could be terminated even more simply by, for example, the new owner submitting a written request to the warehouse operator.
Underpinning such questions of queues and incentives is the still-yawning gap between the cost of storing metal in an exchange-registered warehouse and in off-market storage.
A shadow LME warehousing function has evolved to bridge this gap, with LME operators offering relatively cheap off-warrant storage in or near LME-registered sheds with a “standby” commitment to warrant whenever required.
Even some LME warehouse operators now think headline rental rates may have to be reduced. Unsurprisingly, however, the LME notes that there is “a broad spectrum of opinions” on what still remains the thorniest of LME physical delivery issues.
The LME executive has thrown a couple of its own extra suggestions into the mix, the most interesting of which address the transparency, or lack of it, in the exchange’s daily stock reports.
When a large amount of metal shows up as an “arrival” in the LME report, such as the 31,000 tonnes of copper that hit the system on April 3, it hasn’t “arrived” at all but has rather been building in the shadow LME storage system.
Only the owner knows when the stock will be warranted and therefore only the owner is in a position to take advantage of any impact on price.
Other exchanges don’t work this way. COMEX warehouses, for example, report both on-warrant stocks and “eligible” stocks, meaning metal stored in exchange sheds but not on warrant.
This eliminates the surprise effect of large amounts of metal mysteriously showing up in a single day and the LME is interested in what its users think about moving to a similar system.
There are similar concerns about how the “out” side of the stocks reports work - specifically the way the LME currently breaks down registered tonnage between on-warrant “live” stocks and “cancelled” stocks.
The latter implies that the metal has been cancelled in preparation for physical load-out, but this is not always the case and such metal can often be bulk re-warranted, confusing any price signal.
The stocks reports in their current format, in other words, can be actively gamed by traders shifting metal between reporting categories.
One solution, the LME notes, might be to finesse the way it reports its stocks to split out metal that has been both cancelled and scheduled for physical load-out. Metal that has been cancelled without any load-out schedule would be aggregated with “live” stocks.
The result would be that cancelled metal would no longer be reported to the market, which the LME says would curtail the potential for abusive behaviour on the basis of such distinctions.
The broader market would certainly welcome such enhanced transparency, but how long would it be before the ever-inventive trading community comes up with a new ruse to game the system?
Answers to that and all other questions in the Discussion Paper can be sent to the LME by the end of May.
— The opinions expressed here are those of the author, a columnist for Reuters —
Editing by David Goodman