Early on 4^th April 2022 the UK Financial Conduct Authority (“FCA”), supervisor of the London Metal Exchange (“LME”), and the Bank of England (“BoE”), supervisor of LME Clear Ltd (“LMC”), published a joint statement declaring that they will perform a review into “the LME’s approach to managing the suspension and resumption of the nickel market”. In addition, the LME and LMC announced they were commissioning their own independent review of events on the same day (LME Notice 22/099, LME Clear Notice 22-022, hereinafter “Ref 22/099-022”).

Recap

First, a quick recap. Several LME member firms were reportedly on the brink of insolvency because of “significant upward price movements” (Ref 22/099-022) in the nickel market that occurred between 7^th – 8^th March 2022. Nickel experienced a 250% surge at one stage. The LME responded by: (i) suspending trading in all nickel contracts from 08.15 UK time on 8^th March, and (ii) cancelling all nickel trades that were entered into after midnight UK time on 8^th March. Trading in nickel resumed on 16^th March 2022 after the LME took soundings from various stakeholders on how to best ensure market stability. This resulted in the implementation of interim 15% “limit up, limit down” controls on the prices of physically settled metals contracts. The effectiveness of the new measures was tested immediately. Technical issues meant that “a very small number of trades” (Ref 22/099-022) escaped the newly implemented controls. These trades would also be cancelled. In addition, LMC raised default fund contributions.

Backlash

The LME is facing a backlash from a wide range of market participants over its handling of the disorderly nickel market. Quoted in the Financial Times on 4^th April 2022, outgoing LME CEO Matthew Chamberlain said the impending section 166 review “represents a huge challenge for the LME and I’m very conscious there’s a lot of anger and it has damaged the reputation of the LME”. For its part, the LME contends that many members were previously opposed to the introduction of:

• price limits; and
• the provision of data on OTC positions as proposed in the LME’s Discussion Paper on Market Structure (January 2021, hereinafter “DPMS”), perceived to be “operationally challenging and potential overreach” (Discussion Paper on Market Structure: Feedback and Outcomes, LME, 8^th June 2021) because “OTC positions” in this context refers physical transactions (as opposed to OTC derivatives transactions) that many market participants argued sit outside the LME’s jurisdiction.

On the contrary, critics of the LME assert the nickel crisis has its roots in:

• a conflict of interest: China’s Tsingshan Holding Group Co. was widely reported to be the “Big Short” in the nickel market during the material period, leading some to allege that the Hong Kong Exchange (“HKeX”) owned LME exhibited favouritism to the Chinese entity’s interests at the expense of other market participants (Financial Times, 19^th March 2022). The LME strongly denies this;
• a lack of competence and knowledge in some of the LME’s key functions (Financial Times, 19^th March 2022); and
• technical weaknesses, particularly considering the error in LME Select that allowed some trades to escape the new interim price controls (Financial Times, 16^th March 2022).

Lessons from history

So what can the market expect from the impending reviews? A trip in the time machine may offer some insight.

Founded in 1877, the LME has survived some major controversies since Margaret Thatcher’s Big Bang paved the way for the introduction of the Financial Services Act 1986, ushering in the modern regulatory era. Two controversies stand out.

The first was the collapse of the International Tin Council in the mid-1980s, also known as the “tin crisis”. This would lead the newly formed Securities and Investment Board (“SIB”) to impose central clearing on the LME’s membership that had previously settled trades bi-laterally.

The second was the discovery, in 1996, of fraudulent copper trading by Sumitomo trader Yasuo Hamanaka that would lead to a reported USD$2.6bn of losses. This prompted the SIB to review the quality of governance and systems and controls at the LME.

In both cases, proposals for reform were met with fierce resistance from metals “insiders” who resented interference from “outsiders” who were perceived to be uninformed. After the introduction of central clearing, then LME CEO Michael Brown declared: “The metal exchange as we know it ceased to exist on October 24” (Financial Times, 27^th March 1986). Lord Bagri, Chairman of the LME during the post Hamanaka SIB review cautioned: “There is a fine line to be drawn between need and greed and between legitimate surveillance and over-regulation. Over-regulation would drive the OTC market to more exotic regions like Caribbean beaches or snow-capped mountains” (Financial Times, 9^th October 1996).

The FCA and BoE announced that the section 166 review will focus on the quality of the LME’s and LMC’s governance, market supervision and risk management. The scope of the present review is eerily like the inquests conducted post tin and Hamanaka. Extrapolating from this and other developments since Hamanaka, there is a strong possibility that updated versions of previous proposals will be reintroduced. The proposals may go beyond matters directly related to the nickel incident, and could include (in no particular order):

The closure of the LME Ring

• Previously proposed: DPMS and threatened prior to this.

Strengthening of position limits

• Previously implemented: second Markets in Financial Instruments Directive and Regulation (“MiFID/R II”) package, but the nickel crisis has called their effectiveness into question.

An end to dual capacity

• Previously proposed: Never, although heavily scrutinised in Securities and Futures Authority v Brandeis (Brokers) Limited (2001) and the (reportedly settled) civil case of Red Kite Management Ltd v Barclays Bank Plc (2017-2020).

Reform of the inter-office market, possible introduction of ICE Futures style block trade mechanism

• Previously proposed: SIB review, DPMS, some reforms implemented as a part of efforts to meet pre-trade transparency requirements in the MiFID II package.

An overhaul of the LME’s compliance and operational functions

• Previously proposed: Tin crisis, SIB review.

An extension of the LME’s jurisdiction to enable it to take disciplinary action against end clients

• Previously proposed: Never, although the more informal “client of concern” concept was recently introduced. During the fallout from the Hamanaka affair, the LME stressed that it did not have the power to discipline end clients.

Enhanced OTC and physical reporting and information sharing

• Previously proposed: SIB review, DPMS.

Reduction of the membership’s “voice”

• Previously proposed: never formally, although weakened since HKeX acquisition. Some observers such as the Financial Times’s Helen Thomas (4^th April 2022) are now calling for this.

The appointment of additional independent directors to the LME board

• Previously proposed: SIB. The FCA and BoE have already stated this is a priority.

The sale of the LME

• Occurred after post Hamanaka demutualisation. Some argue a resale is now necessary to restore confidence (Financial Times, 19^th March 2022).

Summary

History is not a crystal ball. However, there is a strong possibility that the conclusion of the FCA and BoE’s section 166 review will be recorded as the final “showdown” in the political battle between “insider” and “outsider” interests at the LME.

If you would like help with planning for the operational impact of potential regulatory change, A.C.Culley & Co. can assist. Please contact us today at enquiries@acculley.com for a free one-hour consultation.

Originally published by Thomson Reuters © Thomson Reuters

References

4th April 2022. Szalay, E., Stafford, P. and Hume, N. UK regulators to launch review into LME’s nickel trading chaos. The Financial Times.

4th April 2022. Thomas, H. The City’s nickel crisis is an embarrassing failure. The Financial Times.

4th April 2022. Nickel market interim trading measures and establishment of an independent nickel market trading review. London Metal Exchange Notice Reference 22/099.

4th April 2022. Joint statement from UK financial regulation authorities on London Metal Exchange and LME Clear. Financial Conduct Authority. Available at: https://www.fca.org.uk/news/statements/uk-financial-regulation-authorities-london-metal-exchange-lme-clear (last accessed 19th April 2022).

19th March 2022. Stafford, P. Traders in uproar over the LME. The Financial Times.

8th June 2021. Discussion Paper on Market Structure: Feedback and Outcomes. The London Metal Exchange.

January 2021. LME Discussion Paper on Market Structure. The London Metal Exchange.

18th April 2019. Barclays and Red Kite settle copper market dispute. Reuters. Available at: https://www.reuters.com/article/uk-barclays-bnk-plc-metals-idUKKCN1RU1JZ (last accessed 19th April 2022).

21st December 2001. Kay, W. FSA expels Brandeis over copper scandal. Independent.

1998. Crabbe, P. Metals Trading Handbook: A market companion for users of the London Metal Exchange. 

9th October 1996. Gooding, K. LME calls for more power after Sumitomo scandal. The Financial Times.

27th March 1986. Wagstyl, S. The LME accepts the inevitable. The Financial Times.