COLUMN-LME and its warehousers; a long, unhappy marriage: Home

By Andy Home

LONDON, Oct (KOSDAQ: 039200.KQ - news) 4 (Reuters) - How about this for a neat summary of the heated debate swirling around the London Metal Exchange's (LME) malfunctioning warehousing system?

"Serious concern was expressed about the independence of warehouses, relationships between warehouse companies and members which are potentially open to anti-competitive and market distorting behaviour, long term storage and incentives offered by warehouses which can restrict the availability in practice of LME stocks, perceived excessive charges levied by warehouse companies for taking stocks out and the speed with which stocks can be taken out of warehouses."

This kaleidoscope of concern, however, does not come from the recent U.S. Senate Banking Committee hearings on Wall Street banks' ownership of physical assets such as LME warehouses.

Nor does it come from any of the responses to the LME's latest proposal for tackling the long load-out queues at many of its good-delivery locations.

It comes, in fact, from an LME policy paper dated October 13, 1998.

"Market Aberrations - The Way Forward" resulted from a root-and-branch investigation of the LME by the then top UK regulator The Securities and Investments Board (SIB) in the wake of the 1996 Sumitomo copper scandal.

It is proof that LME warehousing, the critical point at which paper and physical metal markets meet, has always been a source of conflict and discontent.

All that has really changed is the scale of the problem after the wholesale consolidation of the LME warehousing sector under bank and merchant ownership.

FOR BETTER...

Actually, things had been even worse prior to 1998.

That policy paper marked a watershed moment for the LME, ushering in what amounted to a complete overhaul of the exchange's compliance function.

Warehousing was also transformed.

Introduction of the SWORD electronic warrant system was accelerated to provide transparency on who owned what in LME sheds.

Incredibly from today's perspective, warrants had previously been bearer documents and warrant transfer had taken place by motorcycle courier at the end of the London trading day.

The LME stocks reports were changed to show a breakdown of available (open) tonnage and non-available (cancelled) tonnage.

Warehouse operators were required to notify the LME of maximum rental and load-out (FOT) charges for any financial year. These were then published.

"Chinese walls" were introduced for warehouse operators that were owned by trading entities to prevent the misuse of sensitive information.

After intense and often acrimonious debate a new LME warehousing contract with the exchange's warehouse operators became effective at the start of 2000.

The cumulative effect was to drag the LME's warehousing operations out of the dark ages of the 1980s and 1990s.

Older readers may want to pause to remember and younger readers to imagine what LME warehousing was like before these changes.

A compliance department that had virtually no visibility on who owned registered stocks, or in rumoured worst-case scenarios, whether stocks were even where they were supposed to be rather than en route to where they were supposed to be.

Leaks of information about stock movements at a time when the LME stocks reports could still move prices.

Warehouse operators that were actually dealing in LME warrants on their own account, an offence which cost Henry Bath, now owned by JP Morgan Chase (Other OTC: JFTTL - news) , 50,000 pounds in fines in 1999.

Increases in FOT charges that were often arbitrary and could take place without warning at any time.

It took the calamitous events of the Sumitomo Copper Crisis to revolutionise the exchange's delivery function.

...FOR WORSE

Some issues have proved more intractable, though.

LME warehousers' enthusiasm about getting metal into their sheds, most commonly by offering "freight incentives" and discounted rental deals, has always been in sharp contrast to their reluctance to see it go.

The minimum stipulated load-out rate was raised to 1,500 tonnes per day in 2003 after much horse-trading with warehouse operators.

Even back then it was widely treated as a "de facto" maximum load-out rate. Sometimes it was just ignored.

Metro (Other OTC: MTRAF - news) was prohibited from warranting metal in its Long Beach and New Orleans sheds in 2002 after the LME upheld complaints it had "failed to demonstrate it can meet acceptable delivery out rates". Metro ended up paying a 50,000-pound fine.

Steinweg was fined 10,000 pounds in 2003 for the same offence, slowing deliveries of lead from its Singapore sheds, purportedly because the metal was going to a rival warehouse.

High load-out charges have also been the subject of frequent and vociferous criticism, culminating in the International Wrought Copper Council formally complaining to the European Commission in 2006.

The LME the same year commissioned Europe Economics, the same consultancy used more recently to look at the aluminium queues, to undertake a comprehensive study on FOT charges.

It was well understood even then that high out-charges could be used to pay "freight incentives" for attracting metal in, leading to "disproportionate amounts of warranted metal accumulating in certain locations, thereby distorting the market." ("A review of the possible consequences of a change in contract terms from in-warehouse to FOT basis with respect to all metals traded on the LME". Europe Economics, Feb. 20, 2007)

When Goldman Sachs bought Metro in 2010 and started building up the original aluminium queue in Detroit, the bank didn't have to reinvent the wheel. It simply dusted down a well-thumbed warehouser manual for revenue maximisation.

True, the game was raised several levels, but then there was a lot more aluminium around after the Global Financial Crisis. And a lot more money to finance that metal thanks to quantitative easing.

NO SILVER BULLETS

So why, if all the core problems of the LME's warehousing function were well understood over a decade ago, have they not been fixed?

The simplest part of the answer is because the LME hasn't, and never has had, the legal power to dictate to its warehouse operators anything that pertains to their commercial business.

Any attempt to set maximum rental charges, cap FOT charges or restrain the use of "freight incentives" would fall foul of competition law.

All would be silver bullets for resolving the underlying fault-lines between LME users and LME warehousers, precisely the same fault-lines which have once again been opened up by the aluminium queues.

So too would be prohibiting ownership of warehouse operators by market players, whether they be Wall Street banks or physical market power houses such as Glencore-Xstrata and Trafigura.

But precedent, as lawyers are all to happy to point out, is a powerful thing.

And the trading-warehousing conflict of interest is hard-wired into the LME's history.

It didn't start when Goldman Sachs (NYSE: GS-PB - news) bought Metro. It didn't even start when Metallgesellschaft bought Henry Bath in 1986.

It started in 1877, when Henry Bath became a founding member of the LME. Bath was a merchant, shipping copper ore from Chile, a producer, with a smelter in Swansea, and a forward metal dealer out of its office in London. ("Henry Bath and Son, a company and family history", Michael Jackson, updated 2010).

And it was also a warehouser. Indeed, it both established the first LME warehouse and issued the first ever LME copper warrant in 1883.

It was, in other words, the 19th century equivalent of Glencore, controlling the supply chain from mine to market, including a significant part of the LME storage function.

NO CONSENSUS

Deprived of such silver bullets, the LME has had to look at either more structural solutions, such as shifting the entire basis of its contracts from in-warehouse to FOT, or, as is now the case, trying to micro manage the system.

The 2007 study into switching to a free-on-truck (FOT) basis reveals two other major historical hindrances to resolving the eternal LME warehousing conundrum.

The first has been a consistent lack of consensus about what to do. Not just between warehousers and everyone else but between brokers, traders, producers, manufacturers and warehousers. Often between LME board members.

"The views expressed by one person were often at odds with those advanced by another, and sometimes the arguments offered were not consistent in themselves."

"In some cases the interrelationship between markets was poorly understood, and there was a wide array of views on the ways in which any change in the LME price, everything else being equal, would affect the premium."

"There were also significant differences on matters of fact."

The palpable frustration of the report's authors still resonates six years on.

And any of those comments could equally apply now, witness the very differing views of the LME warehousing problem expressed by aluminium producers and by consumers.

BETTER THE DEVIL YOU KNOW?

Even more fundamentally, there has always been the fear of unintended consequences, which in the case of the 2007 FOT study resulted in a no-change recommendation.

As Phillip Crowson, who chaired the LME committee examining the issue, wrote at the time: "The consequences, which are often unpredictable, of such changes may be far more damaging than the original concern, and may not adequately solve it."

The very importance of the LME's warehousing function in linking paper and physical markets means the more dramatic a change in the warehousing rules, the more dramatic the potential impact.

Consider the uncertainty right now about the implications of the LME's latest proposal to link load-in and load-out rates, a far less dramatic step than changing the terms of delivery reference.

In its July 2 consultation paper, the LME conceded that "this policy could itself unintentionally create an artificial supply and demand dynamic in LME markets."

Many other commodity exchanges allow for physical delivery but the LME's combination of prompt date and warrant system is unique. There is no existing template, against which rule changes can be measured for likely impact.

Get it wrong and the consequences could be disastrous, both for the LME and for the industries it is supposed to serve.

It's not as if the LME hasn't repeatedly looked at alternatives over the 15 intervening years since that "Market Aberrations" document.

It's looked at just about everything, even running its own warehousing operations. ("LME Warehousing Policy - The Way Forward", May 2000)

But time and again, fear of getting it wrong has caused it to stay with the "devil it knows".

ADVERSARIAL RELATIONSHIP

The latest proposed rule change, the third in three years, is yet another example of applying a band-aid to what is fundamentally a dysfunctional relationship between the exchange and its warehouse operators.

So how might the LME try to fix this long, unhappy marriage?

The best answer was probably provided six years ago by Phillip Crowson, who spent many years leading various consultations into LME warehousing back in the early 2000s.

It comes in two main parts.

"Warehouse companies are an integral component of the LME system, but there appears to be far too much of an adversarial relationship rather than constructive cooperation. This has to change."

The LME has repeatedly disciplined and fined its warehouse operators. It has even been to the British High Court with one (Albatros in 2000).

It initially barred them from its warehousing committee and then only let them in as "observers", requiring they leave the room before any votes were taken.

Even now, when there are six warehouse representatives on the warehousing committee, the recent decisions to change load-out rates were taken by an executive committee for fear that the warehousing committee was too conflicted.

Warehousers have responded in kind, resisting any moves that might impact on "their" business, even if "their" business affects everyone else in the market.

And any time the LME has changed its rules, the collective response has been an aggressive hike in already high storage fees, serving only to widen one of the core fault-lines in the relationship.

Given the importance of the delivery function to the operations of the LME, something, to quote Crowson, "has to change".

WHERE IS THE WAREHOUSING TSAR?

Crowson's second recommendation was that "the LME should continue careful monitoring and analysis in order to optimise warehouse numbers and locations as market circumstances change. The criteria for determining warehouse locations and registering warehouse companies should also be periodically reviewed."

There was a burst of enthusiasm along these lines in the early 2000s but the impetus seems to have long since faded.

Why is New Orleans still a good-delivery location for zinc, given the build-up of the world's surplus in a port far removed from any zinc consumption hub?

Why has Pacorini, Glencore's warehouser, been allowed to open 54 registered storage units in Vlissingen, giving it a dominant logistics presence in the Dutch port? Does the market really need this sort of warehousing capacity in a location so close to other good-delivery locations?

The LME seems to have forgotten that it still has the ultimate say on how many registered units are allowed where.

The answer to both of Crowson's recommendations would be for the LME to change its whole governance of warehousing.

Much criticism has been levelled at outgoing LME chief executive Martin Abbott for not doing more about the multiplying load-out queues. Some of that criticism is justified.

But why was it the chief executive who was taking primary responsibility in the first place? Where was the LME's warehousing tsar?

A board member focused only on warehousing and one with the executive authority to pull warehousers into line if necessary.

Someone who could take a strategic view of warehouse registration rather than see it as a box-ticking exercise.

Phillip Crowson came close to fulfilling such a role by default in the early 2000s but since then it has been a hole in the LME's regulatory structure.

The exchange may be legally constrained in what it can do with its recalcitrant warehousers but it is also guilty of forgetting just how important its warehousing function is, both to its own efficient functioning and to the efficient functioning of the physical markets.

If the LME wants to get serious about its warehousing problems, it should get serious about the business of LME warehousing and treat seriously those who are in the business of LME warehousing.

An LME warehouse tsar would be an important first step to righting this unhappy marriage.

Who knows? With a better relationship, the two sides might even agree to look again at some of those silver bullets. (Editing by James Jukwey)