Trading on the London Metal Exchange was extremely testing on Tuesday, 8^th March 2022. A price spike in nickel led to the LME suspending trading in the metal at 8.15am until further notice (LME Rule Notice 22/055). The LME is hoping to resume trading in nickel at 9am on Friday, provided that large (100 lots+) long and short positions can be netted off prior to re-opening.

Billed as an “epic squeeze” (Bloomberg News, 2022) evocative of the 1985 tin crisis (Burton, Farchy and Chang, 2022), the nickel spike poses perhaps the first serious challenge to the regulatory settlement instituted in the aftermath of the 2007-2008 financial crisis. In the context of derivatives trading this was principally comprised of the clearing and trading reforms contained in the European Markets Infrastructure Regulation (“EMIR”) and second Markets in Financial Instruments Directive and Regulation (“MiFID II”, “MiFIR”) respectively. To comply with this package of regulations, market participants faced a barrage of cost, complexity, and paperwork. Many will now be wondering whether it was all worth it.

In particular, the effectiveness of the position limit regime introduced by MiFID II is likely to be called into question. The current spot month (next ‘Third Wednesday’) single limit for LME Nickel is set at 25,150 lots. The other month limit is currently set at 80,200 lots (Financial Conduct Authority, 2022). According to the Financial Times (Hume and Lockett, 2022), the size of the (combined) short position that triggered the current crisis is at least 100,000 tonnes (just shy of 17,000 lots based on a 6 lot contract size). The current limit appears woefully inadequate. Moreover, some commentators have asserted that the short position holder produces nickel that is not LME grade (Hamilton in Hume and Lockett, 2022). If true, one is likely to query whether ‘hedges’ against the commercial risks associated with non-LME grade metal should objectively qualify as risk-reducing for the purposes of applicable regulations, including applying for position limit exemptions. Furthermore, given the wealth of information in the possession of regulators and venues since the implementation of MiFID II position reporting, the quality of the ‘softer’ position management efforts is also likely to be scrutinised once the fog clears.

The UK Government is poised to make significant changes to the position limit regime in the aftermath of the recent Wholesale Markets Review. It is possible that the events occurring at the LME will inform future legislation. However, any changes to the 2007-2008 regulatory settlement will come too late to play a role in mitigating the current risks resulting from the crisis in Ukraine. Nevertheless, some elements of the post financial crisis regulatory package could help buy side commodity market participants plan for further uncertainty.

Considerations applicable to trading in exchange traded derivatives (“ETDs”)

If you are involved in trading in exchange traded derivatives (“ETDs”) as a direct client of a clearing member:

• ensure you are clear regarding the treatment of your positions and collateral in the event of a clearing member’s default. EMIR requires that clearing members publicly disclose the levels of protection and costs associated with different levels of segregation that they provide. This information is usually published on a clearing member’s website in a prominent place and is likely to be called “Clearing Member Disclosure Document” or something similar; and
• (re)familiarise yourself with the default and porting (i.e. position movement in event of a clearing member’s default) processes of the relevant clearing house. For:
  • LME Clear, see here
  • ICE Clear Europe, see here
  • European Commodity Clearing, see here
  • LCH SA, see here

If you are involved in trading in exchange traded derivatives (“ETDs”) as an indirect client of a clearing member, i.e. you are a client of a financial institution that is itself a direct client of a clearing member:

• are you clear where the clearing level positions that relate to your trading are held (by (a) clearing member; and (b) type of clearing account (net or gross omnibus segregated account)?
• have you received an indirect client clearing agreement from your financial institution?
• have you reviewed the Clearing Member Disclosure Document issued by the Clearing Member? It is recommended that you review this for reasons set out above (in relation to direct clients).

Considerations applicable to trading in over-the-counter (“OTC”) derivatives

If you are involved in trading any over-the-counter (“OTC”) commodity derivatives with a financial counterparty:

• consider whether all your trades have been confirmed;
• consider whether it would be prudent to engage in a portfolio reconciliation exercise, e.g. by examining one-way data received from your counterparty. Pursuant to EMIR, a non-financial counterparty under the clearing thresholds (an “NFC-”) is required to reconcile its portfolios:
• at least once per quarter when 100+ OTC derivative contracts are outstanding with a counterparty; or
• at least once a year when fewer than 100 OTC derivative contracts are outstanding.

Financial counterparties and non-financial counterparties above the clearing thresholds (“NFC+”) must perform more frequent reconciliations. Please refer to the onshored portfolio reconciliation regulations for more information.

Market participants will want to have a clear view of their current exposures, regardless of the mandated reconciliation frequencies outlined above. Accordingly, it may be prudent to approach your counterparty to propose the performance of a reconciliation. Some counterparties will use software to assist in this process. All market participants will obviously be extremely busy at this time. Still, there is value in carefully scrutinising one-way data for any discrepancies.

If you detect any discrepancies engage with your counterparty as soon as possible to try and resolve these. If, after such engagement, you are unable to resolve a discrepancy satisfactorily, then consider raising a dispute pursuant to the process outlined in your agreement with your counterparty (look for clauses entitled “OTC dispute resolution” or something similar) or relevant protocol, if you (and your counterparty) adhered to this e.g. the ISDA 2020 UK EMIR Portfolio Reconciliation, Dispute Resolution and Disclosure Protocol or similar. As the title suggests, the ISDA Protocols also contain details on the portfolio reconciliation methodology that the parties have agreed.

Summary

The fallout from the 1985 tin crisis would have significant implications for trading at the LME. Most notably, the Securities and Investments Board insisted that contracts traded on the LME become subject to central clearing. Since the tin crisis the LME has negotiated the ramifications of the Hamanaka scandal and the collapse of MF Global.  Safely navigating the risks posed by current pressures affecting the commodity markets will require maximum engagement from all stakeholders.

A.C.Culley & Co. has extensive experience of trading floor operations. Contact us today if you would like help with strengthening your systems and controls.

References

Contract specifications: LME Nickel, London Metal Exchange. Available at: https://www.lme.com/en/metals/non-ferrous/lme-nickel/contract-specifications (last accessed 9th March 2022).

2022. Chinese nickel giant secures bank lifelines after epic squeeze. Available at: https://www.bloomberg.com/news/articles/2022-03-09/chinese-nickel-giant-secures-bank-lifelines-after-epic-squeeze#:~:text=The%20Chinese%20nickel%20company%20at,people%20familiar%20with%20the%20matter (last accessed 9th March 2022, subscription required).
2023. Hume, N. and Lockett, H. Chinese metals tycoon faces steep losses on nickel price surge. Financial Times, available at: https://www.ft.com/content/0269cdda-ef67-43c8-b820-a919c919b5fa (last accessed 9th March 2022, subscription required).
2024. Burton, Farchy and Chang. LME halts nickel trading after unprecedented 250% spike. Bloomberg, available at: https://www.bloomberg.com/news/articles/2022-03-08/lme-suspends-nickel-trading-after-unprecedented-price-spike (last accessed 9th March 2022).
2025. Member Notice 22 055: Trading suspension update: criteria for resumption of trading and application of price bands. London Metal Exchange, available at: https://www.lme.com/api/sitecore/MemberNoticesSearchApi/Download?id=fbdadbfd-bc73-4637-b817-0675b8280308 (last accessed 9^th March 2022).
2026. Wholesale Markets Review: Consultation Response. HM Treasure, available at: https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1057897/Wholesale_Markets_Review_Consultation_Response.pdf (last accessed 9th March 2022).
2027. Position limits for commodity derivative contracts. Financial Conduct Authority, available at: https://www.fca.org.uk/markets/regulation-markets-financial-instruments/commodity-derivatives/position-limits (last accessed 9th March 2022).