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COLUMN-Faced with falling volumes, what price liquidity for the LME? Andy Home

(Repeats column published on May 17 with no changes to text)

* The opinions expressed here are those of the author, a columnist for Reuters

* http://tmsnrt.rs/1V7pJ7w

By Andy Home

LONDON, May 17 (Reuters) - Why are trading volumes falling on the London Metal Exchange (LME)?

The dominant global arena for trading industrial metals saw activity decline by 4.3 percent last year, the first annual contraction since 2009.

The slide has accelerated over the first four months of this year, volumes tumbling by another 9.2 percent. If that trend continues, 2016 will mark the sharpest fall in activity since 2001.

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These figures were not explicitly mentioned by any of the LME speakers at Monday's "Update Forum", a regular town hall meet with exchange members and the press.

But they loomed large in the background as officials stressed the continued dominance of the LME as the premier price discovery venue for industrial metals and laid out plans to enhance liquidity through a series of incentive schemes.

The concern, though, is whether the search for volume growth will itself alienate the very industrial user base that has made the LME so successful over the years.

Graphic on LME volumes 2000-2016: http://tmsnrt.rs/1V7pJ7w

DIFFERENT MARKETS

"I'm getting really fed up reading in the press about market share," said Garry Jones, chief executive officer of the LME, in his opening remarks.

As well he might, given the explosion in trading activity on the Shanghai Futures Exchange (ShFE) this year. Volume on the ShFE nickel contract, for example, now regularly exceeds that of the LME nickel contract, even though the Shanghai product has only been trading for just over a year.

But, as Jones pointed out, the two markets "are linked but they are not the same".

Specifically, there is no equivalent on the LME of the day-trading retail crowd that has been stampeding through the commodities space in China this year.

Indeed, so disruptive has been the crowd's cumulative activity that the Chinese authorities have spent the last couple of weeks trying to disperse them by raising margin and trading fees.

Proof, if it were needed, that volumes are not the only metric of a successful commodity exchange.

Indeed, Chinese exchanges' repeated salvoes against speculative froth are unlikely to do anything to boost their appeal to industrial players looking for a reliable reference price.

CME Group (Kuala Lumpur: 7018.KL - news) 's increasingly bold forays into the metals trading space, on the other hand, may prove a different sort of challenge.

Because while Jones also highlighted the amount of purely speculative activity on the CME's copper contract, new products such as those for aluminium premiums take more direct aim at the LME's core constituency.

The LME can take some comfort from the fact that the very nature of these contracts implies continued use of its own aluminium contract as "basis" price.

Not so, however, the new aluminium alloy contract announced on Monday, with possibly barbed timing in terms of the LME's Update Forum.

It (Other OTC: ITGL - news) 's hard to see automated trading programmes being drawn into an instrument targeted at such a specific part of the U.S (Other OTC: UBGXF - news) . manufacturing base.

PRICING UNCERTAINTY OR MORE?

So, if the LME isn't losing market share to either ShFE or CME, how come volumes are falling?

The LME's answer yesterday was "pricing uncertainty", the current low but choppy price patterns which have served to reduce hedging flows.

There is an obvious comparison with the two previous stand-out years of lower trading volumes on the LME, namely 2009 and 2001, both of which were also characterised by price falls and murky outlooks.

But there is a nagging suspicion there might be more fundamental issues at work here than simple market fundamentals.

As one LME broker, Kingdom Futures, wrote recently in the context of falling volumes, "This will once again bring up the argument that algorithmic trading is driving the markets as traditional trade clients are finding higher transaction costs, tightening of credit facilities, risk aversion (...) driving them away from the markets or seeking alternatives to the LME to manage risk."

Don't expect any LME official to draw such a direct link between trading fee increases and falling volumes.

But such fears, whether justified or not, cut to the heart of the LME's drive to boost liquidity.

Because the emphasis is on attracting proprietary financial traders, who prefer to ply their trade on markets more vanilla than the LME with its arcane prompt date system and bewildering array of spreads.

Hence, the incentive programmes are targeted at boosting liquidity on the third-Wednesday monthly prompt dates and the spreads between those dates and the rolling, traditional three-month date.

The staggered rebate schemes, which the LME has just opened up to all member clients, are only applicable to trading on the LME's electronic Select system.

Trades conducted on the LME floor (the ring) and over the phone are not included.

The LME remains publicly committed to floor trading. And it has just spent a good deal of time and money building a new one in its new Finsbury Square offices.

But there remains a built-in tension between remoulding the LME trading system to make it more attractive to financial players and preserving the unique market features preferred by industrial users of the market.

THE FUTURE IS STEEL?

The LME's two new steel contracts might offer one possible way of squaring the circle of liquidity and industrial pricing relevance.

The exchange hasn't had much past success in diversifying its offering beyond the core six base metal contracts, or eight, if you count the two aluminium alloy contracts.

The molybdenum and cobalt contracts tick over but volumes are low, and in the case of cobalt, have shrunk sharply by 65 percent so far this year.

Physically-deliverable steel billet is still there but hasn't actually traded since June of last year.

However, the steel scrap and steel rebar contracts are both showing encouraging signs of life with volumes of 2,647 lots and 662 lots respectively so far this year.

The LME announced the first voice-brokered trade of the scrap contract last year, a significant leap from electronic-only trading.

"We feel," said Paul MacGregor, LME managing director and head of sales, "that we're getting to a point where we can see a rapid build-up in liquidity."

Mind you, it's worth noting that the new contracts will not allay traditionalists' fears about the changing nature of the exchange since both are classic, vanilla cash-settled monthly futures contracts.

They do offer a potentially powerful offset against the current decline in base metals trading.

But if that current core trend continues, Garry Jones is probably going to continue being fed up reading about the LME's share of the global metals trading business. (Editing by David Clarke)