COLUMN-LME warehousing barrage still missing the silver bullet: Andy Home

(Repeats Nov. 11 item. The opinions expressed here are those of the author, a columnist for Reuters)

By Andy Home

LONDON, Nov 11 (Reuters) - The London Metal Exchange (LME) has finally unveiled a barrage of proposed measures aimed at repairing its dysfunctional warehousing system.

It's been a long time coming. Which is not a little ironic since lengthy waiting times to get metal out of LME warehouses lie at the heart of the exchange's problems with its delivery function.

The delay was caused by a legal challenge launched by Russian aluminium giant Rusal. Although a British Court of Appeals ruling went in the LME's favour, Rusal is fighting on with an attempt to take its case to the Supreme Court.

It's an increasingly quixotic legal crusade, given the dissipation of any original fears the LME's reform package would cause aluminium prices to collapse.

But while the threat of more court action lingers, the LME can't publicly address what is arguably the core problem in the relationship with "its" warehousers, namely its inability to determine how much LME storage costs.

A reassessment of whether rents can be capped for metal stuck in load-out queues is excluded from the latest consultation documents because it is the main point of contention in the Rusal court saga.

And that means a broader reassessment of whether the LME has the legal right to get involved in setting rental rates and load-out charges is also on hold.

It's a glaring omission from the consultation process, which will run until February next year.

Faced with what amounts to an overhaul of the LME warehousing business, some operators may well be tempted to do what they have done in the past, which is ram through another above-inflation hike in storage fees.

That would only increase the premium of LME over non-exchange storage, the existing fault line that explains why so much metal is queuing to leave the LME system in the first place.

PREMIUMS AND QUEUES

The LME's double consultation, one specifically on changes to the agreement covering its relationship with warehouse operators and a broader one on the exchange's whole delivery function, derives from the aluminium load-out queues at Detroit and the Dutch port of Vlissingen.

The queues, which still extend for years, have played a part -- just how much is widely disputed -- in the disconnect between LME basis price and physical premium for aluminium. This divergence has punched a hole in the entire industry's ability to hedge its price exposure as well as challenging the exchange's role in providing a meaningful reference price.

The LME's primary policy response to queues is a requirement that log-jammed operators load out more metal than they take in. This will come into effect in February, 10 months later than planned because of Rusal's rearguard court action.

The missed timetable has been made more palatable by the fact that both warehouse operators, Metro (Other OTC: MTRAF - news) in Detroit and Pacorini in Vlissingen, have preemptively changed their operating behaviour to comply with the rule.

In the latest consultation, the LME proposes mitigating further the potential for aluminium queues to affect other metals.

It is looking at a separate 500-tonne per day load-out requirement for aluminium alloy, which, particularly in the United States, has experienced even greater price distortion than that in the primary aluminium sector.

Nickel and tin will each be given a separate load-out requirement rather than being combined at a 60-tonne per day rate. Given that there are already separate load-out requirements for steel, cobalt and molybdenum, the LME is moving further down the road to a system of metal-specific delivery rules.

As for aluminium, the idea is to launch physical premium contracts to allow users to approximate a hedge of the new "all-in" price, comprising LME basis and premium.

These contracts, planned for the second quarter of next year, will also be physically delivered with warehouse operators opting in to a commitment to load out within two working days.

This will entail a split between LME premium and LME standard aluminium warrants, instilling an extra level of complexity into exchange storage and delivery.

And it's clear that the LME is mindful of the need to get ahead of the curve of those who might be minded to game the new system. In the event of a "flash queue" affecting a premium warrant location, the operator will have to initiate a separate premium load-out queue of 1,000 tonnes per day or 3 percent of total premium holdings, whichever is greater.

The LME's assessment is that even in a worst-case scenario, a premium load-out queue would not be more than 34 days, "broadly in line with the average sourcing horizon for consumers requiring access to metal on the LME cash market".

REGULATION

Beyond the immediate headlines of premium contracts and queues, however, lie a mass of proposed changes to the way LME warehousing functions.

Some of them amount to no more than a clarification of previously hazy concepts, such as what constitutes an area of net consumption, one of the main criteria for the LME approving a new delivery point.

Some of them are a belated injection of common sense, such as not approving warehouse operators if they exert potentially anti-competitive control over infrastructure in any good delivery point.

And some look like a response to some of the bad ways of the not-so-distant past, such as requiring a bill of lading for load-out and one that doesn't name as recipient the same or a related warehousing company.

But the real regulatory creep by the LME comes in the small print, particularly that in its Warehousing Agreement template.

In particular, all references to "Applicable Law" will be replaced with "Relevant Law and Regulation".

"This would clarify both the compliance obligations of warehouses and how the LME may take action when required to do so by law and regulation, including where a warehouse may have breached the (UK regulator) FCA's market abuse regime," the LME says.

Clause 9:3 of the Warehousing Agreement, titled "Proper Functioning of the Market", sets out new beefed-up powers of regulation, investigation and intelligence-gathering by the LME.

LME warehouse operators, for example, will have to supply information, initially quarterly, on all charges and inducements "to ensure that they are not distortive and do not constrain the liquidity and elasticity of stocks under warrant".

"Inducements", long a bug-bear of critics of the LME system, would be defined to include "without limitation, any fee, commission, discount, rebate, provision of transport services, or any other monetary or non-monetary benefit given to attract the load-in of metal or deter the load-out of metal".

The bottom line of this and other similar changes to Clause 9:3 is that warehouse operators "must not prevent the orderly functioning of the LME market".

The LME, in other words, is proposing to draw a straight line linking warehouse operators with the market-abuse rules set by the Financial Conduct Authority (FCA).

SILVER BULLET

And, many readers will no doubt feel, about time too.

Warehouse operators will, however, probably beg to differ. Even if they do agree, it will likely come at a price.

The LME expressly concedes in its consultation document that operators will probably respond to the new requirements on load-out and premium contracts by raising their rental charges.

The LME will make those charges more transparent with a proposal that warehouse operators publish on their websites all relevant charges, not just the maximum rental and free-on-truck rates they currently supply to the LME.

But it cannot cap those charges. And as long as it can't, the disconnect between LME and non-LME storage, the core driver of the aluminium load-out queues, will continue.

It's clear from the consultation documents that the LME, and implicitly the FCA, are going to drag the exchange's delivery function into the regulatory light.

But the central dichotomy in the LME's relationship with "its" warehousers for the storage of "its" metal remains.

The silver bullet is still missing. Indeed, until Rusal runs out of legal appeals, we don't even know whether the LME has one in its arsenal. (Editing by Dale Hudson)