The nickel market at the London Metal Exchange went nuts last week. A Chinese trader is a big short and the market went against their position.
In response to the extreme volatility, the exchange shut down trading.
This is sort of okay. Markets stop occasionally. In our own US stock market, there are circuit breakers that have been installed and adjusted since the crash of 1987. They are transparent. Everyone knows where they are.
When I traded commodities, I knew where the market’s daily limit was. Occasionally, it would open at one of the limits. It wouldn’t trade. Eventually, the price would hit where the market would assume risk trading it and it would loosen up and trade.
The LME took a very unconventional, to say the least, step. It canceled $4B notional value in trades. This is not a small amount of trading when you look at the contract specifications of LME’s Nickel contract.
I have been in hot markets when trades were canceled. When we had the old pits, I was a Pit Committee Vice-Chair. When the market was rocking and totally volatile and unpredictable, we would order the pit reporters to put the market on what’s called “Fast Market”. That tells the rest of the world the tape they are seeing is unreliable. It also allowed order fillers more leeway on filling orders.
Very very occasionally, we would cancel trades that happened. You’d have a large resting order in the pit, and a small order would get filled above or below that price. It was a mistake made, and it compromised the integrity of the marketplace.
That was a 100% human market.
The hedge fund AQR run by Cliff Asness has been especially vocal about the canceled trades. I think Asness has a legitimate beef. Cynics will say Asness is screaming because he is out a large sum of money but I think they are incorrect. You can read his Twitter feed but I think his pinned tweet sums it up pretty well.
Commodities are not like stocks. You can’t trade around a price. For example, if I have a resting order to sell 10,000 shares of IBM at a price on the NYSE, it might trade above that price on the many dark pools that the SEC allows. This can’t happen in commodities because there are no dark pools. One contract, one price. Even at competing exchanges on the same commodity, the arbitragers keep the price in line. Back in the old days when the LIFFE and CME competed on the Eurodollar contract, arbs would “Buy London, Sell Chicago” and vice versa every single day.
In computerized markets, exchanges might cancel some trades because of a technical glitch. You can see when it happens. It ticks you off if you had an order filled. But, it happens so rarely these days you understand and again, it’s totally transparent to the market and not arbitrary. Exchange rulebooks have plain language surrounding when something like this might happen.
The rules of the road are clear.
The LME is a human market and has introduced some computerization to make it more hybrid. It’s one of the last ones.
Here is what was in the Financial Times. But the exchange also cancelled all 5,000 nickel trades that had been executed on Tuesday, worth nearly $4bn. Mark Thompson, vice-chair of Tungsten West and a longstanding trader on the LME, estimated the exchange had wiped out $1.3bn of profit and loss on the deals. It was “in the interests of the market as a whole”, the LME said.
An exchange should never put itself in the position of deciding what the price of the underlying instrument trading on its exchange should be. An exchange is only in the business of providing an orderly and structured marketplace so market participants can determine that price in a transparent manner.
Exchanges also secure the pay and collect function, make sure that trades are cleared properly, and make sure accounts, money and markets are secure. Matching trades is the easiest part of being an “exchange”. The rest of it is the hard part.
In the past, when exchanges were run as mutual organizations they had the imprimatur that they were “members clubs”. In some cases, that reputation was deserved depending on the exchange. We were very sensitive to that at CME when we demutualized and became a for-profit publicly traded exchange.
On the trading floor in most of our pits, not all, our ethos was always take care of the outside customer. The pits that did that had successful contracts and thrived. If you screwed the customer over, they left.
In this case, it was positions held outside the purview of the exchange. The positions held in over-the-counter derivative contracts were blowing up his total position. One question I have is did the LME clearinghouse have enough money deposited from the trader for the LME positions? Or, did they have a sweetheart arrangement?
Years ago when he was House Financial Services Chairman, Democratic Congressman Barney Frank visited CME. He was really upset about the price of oil. It was high and going higher. He advocated for new rules around trading like more severe position limits in the crude oil market. When we explained that this idea would actually drive trading underground and potentially destabilize the oil market he backed off. People that don’t understand why markets exist often have a lot of bad ideas regarding them.
I don’t think it is improper for an exchange to understand its total risk. If the LME had a conversation with outside brokers to understand the risk it is not a terrible thing but there is a large risk that the information might unintentionally, or intentionally, get transferred to the rest of the market. That’s wrong.
One thing I have observed over the course of my life is you see the true character of people when the chips are down. When everything is totally going against them you see if they will scam to try and get even, or if they will stay honorable. The LME looked at this event and decided not to choose the honorable path. Choosing it would have potentially put them out of business.
My friend Professor Craig Pirrong talks about it all here. He is an expert on clearinghouses. Craig writes,
First, told ya. Seriously, in my role as Clearing Cassandra during the Frankendodd era, I said (a) clearing was not a panacea that would prevent defaults, and (b) the clearing mechanism was least reliable precisely during periods of major market stress, and that the rigid margining mechanism is what would threaten its ability to operate. That’s exactly what happened here.
Second, clearing is supposed to operate under a “loser pays/no credit” model. That’s really something of a misconception, because even though the clearinghouse does not extend credit, intermediaries (brokers/FCMs) routinely do to allow their clients to meet margin calls. But here we evidently have a situation in which the brokers (or Tsingshan’s banks) were unwilling or unable to do so, which led to the failure of the loser to pay.
Third, by closing the market, the LME is effectively extending credit (“you can pay me later”), and giving Tsingshan (and perhaps other shorts) some time to stump up some additional loans. Apparently JPM and the Chinese Construction Bank have agreed in principle to do so, but a deal has been hung up over what collateral Tsingshan will provide. So the market remains closed.
Advocates that want to tear clearinghouses away from the grasp of exchanges will say this wouldn’t have happened if exchanges didn’t own their own clearing. I don’t think that is the case.
In the commodity business, exchanges typically own their own clearing. It’s a strategic asset and encourages innovation. I believe it also contributes to a better, more transparent, and competitive marketplace. The SEC side of the business is rife with special deals and special people.
That’s what is so disconcerting about the actions of LME with regard to this one trader. No one is bigger than the market. No one is special. I don’t care how much money you have, or who you are, or where you live. In the eyes of the market, we are all the same. If you lose, pay up. I don’t care if you are ruined.
It is up to exchanges to make sure the exchange itself doesn’t get ruined.
When I was on CME’s board and we were going down the path of demutualization, one of the most intense and lengthy discussions we had was over how to fund our clearinghouse. Prior to demutualization, funding was “good to the last drop”. That meant every exchange clearing firm pledged all of its capital, and every member-owner of the exchange was also on the hook if something adverse like the Nickel episode at LME happened. I know people who would NOT buy a seat and used “good to the last drop” as an excuse. They leased a seat instead and paid higher fees.
At CME, we took out an insurance policy with reinsurers to get rid of the “good to the last drop” risk. I don’t know what CME does today, nor do I know the size of that policy but I suspect that they still do it that way as do other public exchanges.
I think Craig is right. I don’t ever trust any financial information coming out of China. I suspect the Chinese Communist Party is involved here in the background too. You don’t rise to the top in China without being beholden or a part of the CCP. Lots of things in China are a rigged game. It reminds me of the ending scene of the movie “Chinatown” where Jack Nickleson stares blankly into space.
This will be settled in a court of law. Fortunately, the rule of law in the UK is reliable.
https://www.chicagocontrarian.com/blog/chicago-mayor-featured-premier-u-c-event
Very cogent. Remember trading in Oct. Of 87? Wildly wide markets....the Euros opened 500+ ticks higher. No trades canceled, all accounts settled. No weenies, no crying in the pits. We made sure we knew the pricing and bot and sld accordingly. You better have ice water in your veins and look the Devil in the eye if you're trading commodities... I'm sure for you, like me it was like nothing else on earth when the big trades paid out. Better than ANYTHING. Miss those endorphins.