LME London Metal Exchange — what is it and how does it make money? Secrets Revealed.
LME London Metal Exchange — what is it and how does it make money? Secrets Revealed.
A Somewhat Longish Introduction
Those of you who had the misfortune of frequenting online B2B platforms and who had dealt with wannabe sellers of copper or aluminum, especially from the former Soviet Union, but also from South America and even the People’s Republic of China, frequently hear bizarre statements running along these lines: Our price is the same as the one on the exchange (they mean the London Metal Exchange) or we offer a discount off the listed exchange price. Sometimes they don’t even reference London Metal Exchange, and say our prices are just like “on the exchange” or we “offer a discount off the exchange price”
Let’s clarify some matters.
Their principal misunderstanding is that the London Metal Exchange is a newspaper-like index of prices. I may later tell you a hilarious though alas a typical story of how middle-level Soviet industrial nomenklatura tried to steal, and no doubt eventually succeeded in stealing, assets of a state-owned company, robbed and dispossessed workers while, in front of outsiders, manipulating with imaginary foreign indexes. The story was sad though typical.
Misunderstandings about the London Metal Exchange are a trait of these sellers-wannabes.
It is however not the case with bonafide exporters of copper or aluminum because the latter know well what they are doing. Also if you encounter a would-be exporter who is not fluent in English, then just keep going. Not because English is a better language than Farsi or Greek but because the international metal trade is conducted in English, even though all educated folks can converse in French.
In my experience, major Russian mining companies have well-trained staff and often employ native speakers for their English-language correspondence. If a seller-wannabe doesn’t even know production figures for copper, either regional and global and has no idea how much copper was exported through what port, then you shouldn’t be wasting your time with the creature either.
Lack of basic skills and knowledge is a red flag of a grotesque size. It’s a stay-away sign. If a man (and I yet have to encounter a woman in this crowd) is clueless about basic trade terms or knows them only in translation, then there is no point in talking with him further. Believe me, there’ll be no miracle down the road.
What is LME? In a few words. And why it is useful to those who don’t trade on the floor of the London Metal Exchange.
LME is the London Metal Exchange. The company was founded in 1877 as The London Metal Market and Exchange Company. Though most laymen think of LME as of an English or rather a solidly British institution, it’s neither. LME is Chinese. It’s owned by the Hong Kong Exchanges and Clearing 香港交易及結算所有限公司).
The London Metal Exchange is a tool of speculation. To put it differently, it has no productive capacity and no purpose except as to buy “cheap” and sell “dear”. Its transactional space is known as the ring. That harks back to the much earlier days of the 1600s when “trading” was done by anyone who wanted to trade had done so in physical rings drawn in chalk on the tavern floors.
By the way, because of the coronavirus epidemic the London Metal Exchange’s own Ring has been closed and quite possibly it will remain closed for good.
However, all these slightly disparaging things said, the LME provides one exceptionally important service that is absolutely free. It publishes prices of metals traded on the Exchange.
Prices fluctuate daily or rather on the days when the exchange is open.
Below you’ll find a summary of how London Metal Exchange prices can be linked to physical metal contracts. You can download a very detailed article on the subject directly from the London Metal Exchange.
What is LME price?
LME price is the price recorded on the LME on a certain date.
LME price already pressuposes discount
It is difficult to explain to some wannabe sellers (to the degree that in some instances we have almost given up on the ungrateful task) but any price offered with the LME price even as guidance must offer an additional discount. Else nobody would buy it. Because? Because you cannot just buy and sell through the London Metal Exchange. You need to be qualified to do so and you need to pay up some serious money up front to do so.
The London Metal Exchange (or LME) publishes a fee schedule. It is an extremely complex document. The Fee schedule consists of whopping 24 pages of text.
To cut a long story short, it would cost you anything from 2% to 15% to sell anything on the LME, possibly more with some lots and the price a real seller offers must offer a discount off LME which will be higher than the cost of the purchase through the exchange because why anyone would bother.
Let’s take copper. You’d melted an improbably huge quantity of door knobs and handles and you’ve got 100 tons of copper. You’d need to pay 65 000 pounds (GBP) to get your copper “brand” registered on the exchange, you must pay either a broker or become a member of your own (that would range from niggardly 5000 pounds to 95 000 for “some privileges), you must pay access facilitation fee of 10 000 and transactional fees).
In fact, if you were to do it on your own, and provided you have the exprertise and knowldge (and most of those Internet sellers don’t), you would easily end up paying 100 000 pounds (or over 100 000 euros) to sell your first lot of 100 mt of copper. Or, at the current prices, you’d sell it with a 10 or over 10% commission going over to the London Metal Exchange through assorted charges and fees.
Obviously, companies which do not sell through the Londo Metal Exchange and which do not have own brokers at the LME must offer a discount, which depending on their credibility cannot be that small.
On the other hand, too high a discount is a certain sign that the copper (or other metal that’s being offered up for sale) is non-genuine, and that you are again being lured into a time-wasting experience.
The end of the main part with History and References to follow
An article in the Daily Mail on the London Metal Exchange Ring
History of the London Metal Exchange
The London Metal Market and Exchange Company was founded in 1877, but the market originates from the 16th century, namely from the year 1571 when the Royal Exchange was established in London. Before the exchange was created, traders sold and bought merchandise or consignments of valuable in London coffee houses using a makeshift ring drawn in chalk on the floor. Or that’s pretty much what Wikipedia says.
Alas, Wikipedia lies. Wikipedia is a source of disinformation and lies in ordinary matters and of rabid propaganda in things remotely political or in things affecting the transatlantic Fourth Reich’s operations and goals as well as the dealings of the Deep State. But even in things utterly mundane like historical dates, it is a mess. For example, it says that before 1571 London traders met in coffee houses and coffee shops while the first coffee house in London opened in the year 1652, a temporal impossibility.
The Exchange was opened from 1877 until 1939, when it was closed down by the authorities trying to curb speculation. It remained closed through the years of World War II and was only allowed to reopen in 1953.
Intially only copper was traded on the exchange but zinc and lead were added in 1920, and a number of other metals such as aluminium 60 years later.
The LME was owned by its members until 2012, when it was sold to Hong Kong Exchanges and Clearing for £1.4 billion.
The LME or the London Metal Exchange offers futures and options contracts for aluminium, aluminium alloy, NASAAC (North American Special Aluminium Alloy), cobalt, copper, lead, molybdenum, nickel, steel billet, steel rebar, steel scrap, tin and zinc.
HOW ARE LME REFERENCE PRICES USED IN PHYSICAL METALS CONTRACTS?
LME INSIGHT: FEBRUARY 2018
Copied (Fair Use)
Referring to a widely accepted reference price in physical contracts is a very common practice in commodity markets – especially in base metals. Contracts between producers and consumers typically reference a globally accepted price, such as those discovered on the London Metal Exchange (LME), but also negotiate relevant discounts and premiums basis the material that is being bought or sold.
Conversely, steel markets have historically used a fixed price in their contracts, inclusive of all costs, fees, premiums and so on, or have directly accessed the spot market, leaving them exposed to fluctuations in market conditions. The practice of pricing material based on a reputable reference price, separate from premium costs, has evolved because of the advantages it presents for the companies – transparency, efficiency and optionality.
Key benefits of linking physical contracts to a reference price
In a global economy of fragmented and complex value chains it is increasingly difficult for producers and consumers to consistently “beat the market”. By agreeing to trade at the market price, as reported by the LME or by a relevant price reporting agency (PRA), companies can benefit from a greater level of transparency that these price-discovery organisations and mechanisms offer.
As a result, companies can better focus their efforts on negotiating the value of premiums or discounts between the underlying metal and their specific product. These premiums or discounts can be based on a number of factors including, among some of the most frequently cited: geographical location, grade of material, impurities and delivery terms.
By providing a robust and regulated trading venue for price discovery, the LME allows companies that refer to its prices the efficiency of knowing where the market is at any point in time.
This removes the need for businesses to invest huge resources in gathering the information they would need to continuously and autonomously discover the market price for their metal. PRA’s fulfil a similar role by providing indices that can be used as price references. Using an accepted price allows companies to efficiently refer to the market price for the underlying metal as defined in the specifications of the LME’s contracts or of the PRA’s indices.
Last but not least, companies that refer to globally accepted prices, like the LME’s, retain the optionality to be able to hedge their exposure to the price of the underlying metal without any basis risk on that exposure. By being able to trade in standardised and liquid markets, companies that refer to LME prices are then empowered to be flexible in their decisions.
They can lock-in or float prices, based on their risk appetite, their future projections and the shape of the forward curve. However, producers and consumers will still have exposure to premiums and discounts because these are so specific to the material in question. For example, the cost of a premium will factor in details such as the port a shipment is coming from, or going to. Given that standardisation breeds liquidity in a market, it would be almost impossible to find a market where premiums and discounts could be traded.
Using LME reference prices in physical copper contracts
The LME Official Price for copper is established daily from the bid and offer prices discovered at the close of the second morning Ring (at 12:30-12:35 London time in the LME’s open outcry trading floor). The LME Official Settlement Price, also discovered in the Ring, is the cash seller’s price for copper and is used extensively in physical copper contracts throughout the world.
This means it represents the price of any approved LME brand of copper available for delivery in any location in the LME’s global warehouse network in two working days’ time. Once the price is set, the LME records, distributes and publishes the price to vendors around the world, who will in turn disseminate the data to industry users across the value chain.
For copper, the LME Official Settlement price will be used throughout the industry pipeline in physical contracts in a number of ways. For example:
The Production Stage – extraction of copper from its host rock (ore)
Copper is typically extracted by crushing ore rock into powders, which normally contain between 0.5 and 2.0 percent copper.
Consequently, copper producers will use a metal contract with a price formula referencing the Official Settlement Price (the cash seller price) for copper, which allows for the price differential between the ore and the LME grade of underlying metal – in this case Grade A copper cathode.
The End Product Stage – copper semi-fabrication to final use
Material is priced at a discount to the LME Official Price for copper until the added value of fabrication becomes more significant and the metal object progresses along the supply chain, away from the LME copper grade material, to that of a finished product e.g. copper wire.
At this point, it is priced at a premium. The metal content in a contract is always priced, but, if the metal value decreases as a percentage of total value, so does the direct exposure to the LME price.
Accordingly, copper fabricators will, similarly to the copper producers above, use a percentage of the LME Official Price for copper in their contracts dependent on what proportion of the value of the products is attributable to the underlying copper metal.
The role of third party pricing in the steel industry
Historically, the carbon steel industry has been quite restrained in its use of reference prices in physical contracts, preferring instead to rely on long-term fixed contracts where possible, or on the active spot market as an indication of where the market value is for a specific deal. However, the lack of a globally accepted reference price has made steel price risk very difficult to manage and created a lot of uncertainty for companies along the value chain. This has now changed. Since the launch of the LME Steel Scrap and LME Steel Rebar futures, it is now possible to risk manage the price of steel.
The LME’s ferrous contracts are cash-settled futures that refer to underlying indices published by Platts TSI – a PRA. Companies can now reference the LME monthly price in their contracts, or use the corresponding monthly average of the daily prices published by Platts TSI, and then trade and hedge the same underlying price on the LME. This removes the basis risk between the price reference and the hedge, while leaving the company exposed only to the premiums or discounts negotiated for an individual contract.
Over decades, if not centuries, the base metals industry has developed sophisticated practices for the market pricing of metals at all stages along the value chain, from mineral ores to finished products. With the recent arrival of liquid steel futures, and related risk-management opportunities, the steel industry has now found the missing incentive that was keeping it from developing similar contractual practices.
Now the carbon steel industry can also start benefitting from the increased transparency, efficiency and optionality that have been available to the base metals markets for decades.
To trade contracts in copper, tin, or any other metal listed on the LME, one has to trade through an LME member. Purchasers of contracts, which are then left to reach maturity, will receive a warrant for a specific LME approved warehouse to take delivery of the metal if required.
The LME issues, each day, detailed figures on how many tonnes of each metal is in its warehouses, which helps producers and consumers make correct business decisions.
The LME’s Ring is a magnificent anachronism. But for how much longer?
Although the Ring is now set to reopen after lockdown, technological advances mean its doors will eventually shut forever
By John Butler
Monday June 14, 2021 11:23 am
This article is not about JRR Tolkien’s famous trilogy of fantasy literature. But it is about a very real ‘Ring’ that, in a practical sense, has ‘bound’ the global industrial metals market together for more than a century.
The global Covid-19 pandemic and government policy responses thereto have catalysed social change on a wide variety of fronts. Even one of the most venerable and famously conservative commodities market institutions — the London Metal Exchange — is now embracing modernisation.
In early 2020, when lockdowns were introduced in the UK, turning the City of London into a virtual ghost town overnight, the LME closed the Ring. For those not familiar with LME convention, the Ring is a large room in the LME’s headquarters on Finsbury Square in the heart of the City.
In the Ring sits a select group of representatives of the LME’s principal, ‘Category 1’ members. They wield signs and communicate in a language that would befuddle anyone not well-versed in the jargon of industrial metals trading.
Today, the Ring remains closed, even though much of the City has now reopened for business. It is set to reopen on 6 September but for how long? As the LME explained in a recent discussion paper on market reform: “The LME feels it is now time to consider the case for a permanent move to an electronic pricing structure and closure of the Ring. This could give all participants certainty over the future of pricing and allow all stakeholders to make business decisions with confidence.”
Long before Covid-19 arrived and in line with other commodities exchanges, LME trading had already been migrating more and more to electronic form. The Ring, however, still held an important place, where the most important market makers were able to discover prices in real-time, potentially giving them an important informational advantage.
Informational advantages are part and parcel of market-making. No one can or will make a market in any commodity unless they are somehow compensated for doing so. Normally, this takes the form of a ‘bid-offer’ spread in the market. But insiders typically have the opportunity to ‘warehouse’ risk if desired — that is, to hold proprietary positions in excess of the essential inventory that is required to provide enough liquidity to be able to function as a market-maker at all.
It is normally a matter of semantics, sometimes of regulation or law, whether or not market-making power is merely used to make a reasonable profit or abused to make an unreasonable one. Traditionally, global commodities and foreign-exchange trading has been essentially ‘caveat emptor’, with participants accepting that insiders have a small, unquantifiable advantage and that using them as counterparties in exchange for the liquidity they provide is simply a cost of doing business.
However, the growth of electronic trading systems and platforms has largely disintermediated the global commodities and foreign-exchange trade. The LME’s Ring is the most magnificent anachronism that remains. But for how much longer? Does the LME see the writing on the wall?
It almost certainly does. A growing number of market participants prefer the ease, convenience and, most important, transparency of electronic trading and pricing. But, of course, in addition, they also want the liquidity that only specialist market-makers can provide.
Market-makers don’t cede market power voluntarily, so game theory requires them to see benefit in accepting a migration to more transparent, electronic trading. As is true in any industry, the desire is for profit.
And profit is always a function not only of margin, but of volume. If the LME’s Category 1 market-makers are confident that, by embracing a full migration to electronic trading, they can boost volumes sufficiently to compensate for a shrinking bid-ask spread and relative loss of insider information, they will almost certainly acquiesce.
After all, they are the last remaining holdouts in a world that has, in nearly all cases, already moved in this direction years ago.
Thus there is another ring that provides a useful analogy here: yin and yang. The fact is, you can’t have an efficient, liquid market without specialist market‑makers.
And you can’t have market-makers who can’t make a profit. Technology may democratise access to information to a great degree, something to be welcomed. But if it democratises it too much, it can actually harm rather than benefit participants. If one or more specialist market-makers, facing such narrow bid-offer spreads and lack of any useful information advantage, choose to exit, the entire market potentially suffers.
My guess is that the LME finds a way forward, that the Ring is eventually closed again (permanently), and that a new generation of traders, with extensive, expert knowledge of their respective metals markets, adapt to new technologies with little if any disruption.
There is always room for skilled market-making and liquidity provision in any market, especially one in which the underlying commodities are as fungible and widely useful as the major industrial metals.
John Butler, a former MD at Deutsche Bank and Lehman Brothers, is a consultant for Macro Hive and the author of The Golden Revolution, Revisited.