COLUMN-Things can only get better in HKEx and LME's marriage?: Andy Home

(Repeats Friday column without change)

By Andy Home

LONDON, Oct 17 (Reuters) - "In short, this is not a takeover; it is a marriage". That's how Charles Li, chief executive of Hong Kong Exchanges and Clearing (HKEx (HKSE: 0388-OL.HK - news) ), described the 1.38 billion sterling ($2.2 billion) purchase of the London Metal Exchange (LME) back in 2012.

He was speaking at the LME's annual black-tie dinner at the Grosvenor House in London, conceding that it was the first time he himself, once an oil worker, had ever worn a black-tie.

The dinner forms the centre-piece of "LME Week", described by Li as "a pilgrimage of like-minded people (...) where the financial meets the physical; where the best minds meet with the largest hands; where the money meets the rock."

Two years on and Li will next week once again sit at the high table at Grosvenor House along with the new management team installed after the purchase.

He, and the massed ranks of the LME brokerage community seated around him, may well be minded of the witticism penned by Canadian playwright Raymond Hull. "All marriages are happy. It's the living together afterward that causes all the trouble."

It's fair to say this marriage has not got off to the best of starts.

HKEx has found itself embroiled in the toxic legacy of the LME's dysfunctional warehousing system, spending much money and time fighting off a flurry of lawsuits and multiple regulatory pressures.

The mood among the LME's brokers is sombre as they face up to the reality of a new fee structure, which, according to Martin Pratt, chief operating office of Triland Metals, will "undoubtedly force metal market participants to carefully review their business models and trading relationships."

It may, in other words, not be the most exuberant of LME Weeks as the largesse of the past gives way to a new-found austerity among the week's many parties.

The exchange's swoop on the platinum and palladium price "fixes", however, could be a sign that things may be about to get better for both partners in this east-west marriage.

THE PAIN OF BEING COMMERCIAL

In truth, the LME "Street" knew from the very start that its previous low fee structure, predicated on the old member-ownership model, would have to change.

Indeed, it's benefited from a two-year stand-still on fees that will end at the start of next year. It's just unfortunate that the new fees are coming on top of the extra costs of being in the financial brokerage business caused by post-financial-crisis EMIR, or the European Market Infrastructure Regulation to give it its full name.

Hence the predictable wailing and gnashing of collective teeth and the nit-picking over the LME's claim that average trade-weighted transaction costs will rise by 34 percent.

The LME's fee structure is as labyrinthine as the market's date structure, inextricably so. It's true that some components of the transaction costs will increase by far more, 97 percent in the case of non-ring exchange trades.

But the real issue with the new commercialisation strategy, as HKEx calls it, is the legacy of the totally non-commercial ways of the past, such as brokers not charging customers for short-dated trades such as "tom-next".

That will have to change and some of the public statements made since the new fees were announced late September may be more calculated at preparing clients for those changes than having a swipe at the exchange's management.

THE PAIN OF PHYSICAL DELIVERY

HKEx itself may have more justified grounds for grievance with its new partner.

It probably underestimated just how toxic was the debate about the aluminium load-out queues at some LME warehouses. It almost certainly didn't expect to spend quite as much time in law-courts, both in the U.S. and the UK, as it has done over the last couple of years.

From a public relations perspective, it's been an ordeal by fire and the spate of global headlines containing the words "LME", "warehousing" and "manipulation" has pushed any idea of extending the LME's warehousing network into mainland China firmly off the agenda.

From a commercial perspective, the LME now also has a major new challenge to its franchise in the global aluminium market in the form of a rival contract from the CME Group (Kuala Lumpur: 7018.KL - news) .

Adding insult to injury was the legal attack by Russian aluminium producer on the LME's proposed solution to the queue problem.

That action has now been seen off, albeit after 10 months of lawerly debate. That clears the way for the LME not only to introduce its new load-out rules but a potentially more far-reaching overhaul of its physical delivery function.

Skirmishing in the U.S. courts continues, although here too the LME and HKEx will feel they are gradually turning the class-action tide.

COMMON GROUND

Both newly-weds do, however, have some common ground, even if it is in itself equally worrying for both.

******************************************************* Graphic on LME annual volume growth: http://link.reuters.com/tut23w Graphic on LME volumes by contract: http://link.reuters.com/het23 *******************************************************

The growth in LME trading volumes has slowed sharply this year to just 3.7 percent over January-September from 7.1 percent last year. Indeed, it looks set to be the third straight year of slower growth since the boom times of 2011.

That translates into less revenue growth for everyone; brokers, LME and HKEx.

This reflects market realities such as the lacklustre range-bound trading that has characterised the copper market for much of the year. It's worth noting that CME copper volumes, for example, have also fallen this year and by a harder 19 percent than the 8 percent contraction in the LME's flagship contract.

But breaking the LME volume figures down by contract reveals a problematic trend. Three of the four worst performers have been the LME's most recently-launched contracts.

Steel billet has fallen into complete disuse, while volumes in the two minor metal contracts, cobalt and molybdenum, have dropped by 11 percent and 36 percent respectively and not exactly from a high base in the first place.

The LME portfolio of industrial metal contracts needs a refresh. And it's not hard to see from where it might come.

Copper volumes on the Shanghai Futures Exchange have also succumbed to the global trend this year but the year-to-date contraction has been just 1 percent. Aluminium volumes have quadrupled, zinc volumes have tripled and lead volumes over the July-September period were the highest in that contract's history.

Iron ore trading is booming on both the Singapore Exchange and on the Dalian Exchange, both of which have benefited from pricing volatility in China's largest metallic import market by volume.

The time appears right for HKEx to deliver on its promise to use the LME's metals franchise as a way of leveraging its existing position as gateway through China's Great Currency Wall.

It is preparing to do so via the relaunch of yuan-denominated "mini" contracts derived from the LME's copper, aluminium and zinc contracts.

MORE TO COME

The LME, or as Li likes to call it, the western wing of the HKEx house, is also mulling new contracts.

And the most positive achievement over the last couple of years is getting to a place where it will be much easier to do so than in the past.

On his recent blog, Li talked up the technical achievements of the exchange, including the in-sourcing of information technology and the launch of LME Clear, its own clearing mechanism.

Not exactly the stuff to get the blood racing, but it does mean the exchange, to quote Li "is master of its own destiny".

When LME clearing was still done via LCH.Clearnet, new products had to join a development queue as long as that to get aluminium out of an exchange warehouse in Detroit.

That will now change.

The proof comes in the form of the LME's successful move to take over the benchmark pricing of both platinum and palladium from Dec. 1.

It will do so using a custom-built electronic system, LMEBullion, which seems set to move from drawing-board to reality at a speed previously unheard of in terms of LME projects.

Other products will follow, first and foremost physical premium contracts, although there is a certain irony in the LME offering a product to fill a pricing gap arguably created by its own warehousing problems.

It will be what comes then that really determines how this marriage fares.

The bottom line is that both sides need more volume growth and more new products to deliver it.

(Editing by William Hardy)