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COLUMN-LME turns the regulatory screw on its warehousers: Andy Home

(Repeats July 2 item. The opinions expressed here are those of the author, a columnist for Reuters.)

By Andy Home

LONDON, July 2 (Reuters) - Whisper it softly, but the end of the load-out queues that have plagued the London Metal Exchange (LME) warehousing system for so long may finally be in sight.

May next year, in fact, if the exchange's latest package of measures is implemented.

The LME has launched a formal consultation on two new queue-killers: a further increase in load-out rates and the capping of rent on metal caught up in queues.

The consultation process may be no more than a legal nicety. The proposals are themselves the result of a discussion paper that generated 45 meetings with and 24 written responses from a broad cross-section of LME users.

Moreover, such is the momentum of the regulatory drive to pull warehousing into the broader market-abuse framework that most warehousers seem to accept that resistance is futile.

Behind the LME stands UK regulator the Financial Conduct Authority (FCA), which has apparently spelt out directly to warehouse operators the new lie of the regulatory land.

Behind the FCA lurks the even bigger stick of U.S. regulator the Commodity Futures Trading Commission (CFTC).

Indeed, with such strong regulatory tail-winds the LME's ambitions to sort out once and for all its warehousing problems now go beyond the queues.

The LME has put down a clear marker on what is arguably the core underlying issue with its whole delivery system, namely the high costs of exchange storage relative to non-exchange storage.

QUEUE-KILLER

The LME's first proposal is to lift the minimum load-out rates across its warehousing network and to lower the threshold at which those rates apply.

The move was well signalled in the March Discussion Paper and is intended to accelerate queue decay.

Although the LME has already introduced its linked load-in-load-out (LILO) formula, forcing warehouse operators with queues to load out more than they load in, the two embedded queues at Detroit and the Dutch port of Vlissingen would still have taken too long to dwindle to the targeted 50 days or less.

Or, as the LME expresses it, "the persistence of queues at certain warehouses (...) has affected the LME's ability to demonstrate and provide its regulators, particularly the Financial Conduct Authority, with assurance that the LME has arrangements in place that will ensure that its warehousing arrangements operate in a way that enables the LME to continue to satisfy its regulatory obligations".

If, or once, the new load-out requirements are introduced, the LME estimates that those two queues will fall below 50 days "between 26 April 2016 and 5 February 2017".

However, it argues that the "'worst case scenario' is reasonably unlikely to occur, and therefore the market could reasonably expect that the embedded queues at Vlissingen and Detroit would have fallen to beneath the queue threshold of 50 days by 1 May 2016".

FUTURE QUEUE-KILLER

Which is when it proposes to introduce its future queue-killer weapon, namely the capping of rents on metal stuck in queues.

In essence, if metal has been queuing for 30 days, the warehouse operator must halve the maximum payable rent. If it's been queuing for longer than 50 days, the warehouse operator will not be able to charge rent at all.

The removal of any financial incentive in "owning" a queue is probably both the most efficient way of killing off the present queues and deterring warehouse operators from trying to build load-out queues in future.

Ideally, the LME would introduce rental caps on logjammed metal tomorrow but believes that if it did, it would be sued by either Metro (Other OTC: MTRAF - news) or Pacorini, the two operators that "own" the queues at Detroit and Vlissingen respectively.

Deferring the introduction of the measure to May next year doesn't eliminate that risk but if the two embedded queues at those locations are already below the 50-day threshold by that date, the likelihood of legal challenge diminishes.

Moreover, if anyone does fancy their luck in the courts, they may have to deal with more than just the LME and the FCA.

As the LME somewhat drily noted, "queue-based rent-capping has significant support from certain quarters, including regulators in the U.S."

That's a reference to a letter from the CFTC to the LME, supposedly private but quickly splashed across the pages of the Wall Street Journal, in which the CFTC opined that rent capping had the greatest potential to reduce the queues in a timely manner.

Lest the LME failed to take the hint, the CFTC has been sitting on its application to allow U.S. traders direct access to its system.

Indeed, the CFTC may go further still. As the LME also noted, "it is possible that some form of requirement for a queue-based rent cap may be written into U.S. legislation in respect of the recognition of Foreign Boards of Trade".

WARNING SHOT

Between them the existing LILO rule, the new faster load-out rule and rent capping down the line would seem to be the killer combination to kill off the queues, or at least reduce them below the targeted 50 days.

But high rents and high load-out charges, defined as the free-on-truck (FOT) charge on the LME, would persist.

It's the massive gulf between LME warehousing charges and storage costs everywhere else that caused the load-out queues in the first place.

Years of aggressive cost increases for LME storage are a long-standing bug-bear for the exchange's users. The LME has at various times mulled introducing caps on costs but always shied away because of the threat of legal action by warehousing operators.

The potential for litigation remains high to the point that the LME doesn't want to risk court action on charge capping (CC) delaying its other proposed measures.

But "the LME believes that the long term benefits for the market would, on balance, outweigh the negative consequences, particularly if CC were implemented at a future date to allow adequate time for market and warehouse company adjustment".

So it has decided to adopt what it calls a "wait and see" approach.

What this actually means is that it reserves the right to cap charges at a future date if "rents, FOT rates and inducements remain at unacceptable levels".

In other words, it has put its warehousers on notice. Unless they collectively start closing the gap between the costs of LME storage and off-exchange storage, the LME will do it for them.

And, as with its queue-killers, the justification would be the regulatory requirement to run an orderly market.

Because that's the real tectonic change that is becoming ever more clear.

Warehousers on the LME or indeed any other commodity exchange can no longer claim they are simply providing ancillary services to trading and are therefore immune from the rules governing trading.

Against a backdrop of heightened scrutiny of all financial benchmarks, the regulatory link between exchange warehousing and price discovery has been made explicit.

It may have happened anyway, but there's little doubt that those persistent queues at Detroit and Vlissingen have been the catalyst for regulators to turn their full firepower on the previously mundane but opaque business of storing stuff.

(Editing by Dale Hudson)

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