LME reform controversy highlights divisions between members

* LME discussion paper due in late April/early May

* Expected to include option of monthly futures for base metals

* Reformers look to gold contracts as model

* Falling volumes raise pressure to change

By Peter Hobson and Pratima Desai

LONDON, April 11 (Reuters) - The London Metal Exchange (LME) is considering reforming its complex structure of trading to lure funds and reverse falling volumes, laying bare a schism between those wanting change and core traditional members who do not.

By early next month, the 140-year-old British institution that sets global benchmark prices for industrial metals such as copper and aluminium will publish a discussion paper that is expected to include the offer of a simpler alternative to its intricate three-month date structure, sources say.

A hike in trading fees two years ago drove many LME regulars to the over-the-counter markets, precipitating a 7.7 percent fall in trading volumes last year and 4.3 percent the year before and forcing the exchange to consider its future.

Dwindling volumes have undermined profits at parent Hong Kong Exchanges & Clearing Ltd (HKEx (HKSE: 0388-OL.HK - news) ), which paid $2.2 billion for the LME in 2012 and is still trying to recoup on its investment.

"Growth has to come from speculators," a source at a London-based brokerage said. "They are going to have to come out with something new, they can't just keep tinkering around the edges."

That something new, metal industry sources say, could be modelled on the exchange's new precious metal contracts due to go live in June.

Its mix of daily and monthly gold and silver contracts aims to allow industrial users to hedge specific dates. But its standardised monthly future would also appeal to funds, allowing them to settle a trade as soon as it is closed, much like futures on other exchanges such as the CME.

"There are people who want futures and there are people who want to leave things as they are," the head of a commodities brokerage said. "A lot of our clients are real hedgers so the date structure has a value for us, but some of our clients are financial and they would prefer futures."

The LME will seek feedback on the discussion paper before implementing any changes.

"We are committed to broad engagement with our stakeholders, to understand their perspectives, and to map out a development path for the LME which evolves together with the needs of our users," the LME said.

"We will only make changes where and when we believe these to be in the best interests of the whole market."

'BREAD AND BUTTER'

Traditional members fret that adding more industrial metals contracts will erode liquidity for the three-month forward contracts that are traded in the open-outcry ring, risking the exchange's position as global benchmark setter.

"They need to understand we, and the three-month contracts, are their bread and butter, we are their core audience, they can't have everything," one brokerage head said.

"Taking liquidity away from the three-months could impact their use as global benchmarks, without which the LME becomes like any other exchange."

Liquidity on the LME is concentrated in the rolling three-month forward contracts, based on the time it took to ship copper from Chile (Stuttgart: 704599.SG - news) to London in the 19th century, which allow industrial users to lock in prices on a specific day.

But it is costly and complex for financial investors.

For example, a fund wanting to bet on higher prices can buy the three-month contract today and when it sells, perhaps a few days later, it must reconcile the two dates with a separate spread transaction.

That requires three transactions and three lots of fees. Matching the dates has to be done through a broker, and the forward contract requires investors to wait until its expiration date to settle their accounts. Speaking at a briefing this year, HKEx chief executive Charles Li said: "It's really about making our system easier, making our trading platform more friendly, (so) completely new people can find it easier."

The LME has already tried to make trading easier for funds by trying to boost liquidity on Select, its electronic trading system, for monthly forward contracts, which settle on the third Wednesday of each month, with incentives such as discounts for new participants.

The monthly forwards are only two transactions, both of which could be done on Select. But liquidity is lacking, sources say.

"With (Other OTC: WWTH - news) the third Wednesday contract, your money is not unlocked until settlement," a U.S.-based investor said. "They need to go one step further – offer futures. On COMEX, when I want to buy copper, a few clicks and it's in my account, if I want to sell tomorrow a few more clicks and it's done."

(Editing by Susan Thomas)