On May 9, three-month copper futures - the London Metal Exchange's and hence the world's benchmark - reached $2,715.50 a tonne. It was the highest price of the year. On the surface, it looked like a sort of triumph - with the LME's turnover up 700% since 1987 and its business far outweighing that of its major rivals, the exchange was surely as good an instrument of price formation as was going to be found in an imperfect world.
On June 13, at a press conference after the annual meeting of the LME board, just hours before Sumitomo announced that Yasuo Hamanaka, its chief copper trader, had been fired after running up estimated losses of $1.8 billion, LME chairman David King was lauding the "unique qualities" of the exchange and its runaway success. The news from Sumitomo was a shock to outsiders, but those on the floor clearly knew what was afoot. With rumours of Hamanaka's sidelining and then dismissal circulating, the futures price plummeted by a quarter from its May 9 peak.
An adjustment was under way, but why had it taken so long? Was the LME's success - it handles 90% of the world's trades in copper - built on the fact that it offered an efficient price-forming mechanism, or did participants just like the light regulatory touch?
The rise of the LME was dramatic. In 1988 New York exchange Comex, which trades gold, silver and copper through open outcry, had double the turnover of the LME. But the LME expanded so rapidly that in 1993 Comex joined forces with rival New York exchange Nymex in an effort to challenge the London market's growing domination of base-metals trading. The LME has established itself as the pre-eminent market for hedging base-metal prices for industry users and for commodity funds. The prices set there are used as an industry benchmark. "There is nothing else to refer to," says David Sobotka, managing director of commodities at Lehman Brothers.
Copper has always been the flagship contract for the LME and volume traded is now greater than the combined volume of the seven other traded metals. Vivian Davies, chief executive of Brandeis, an LME ring-dealing member, attributes expansion during the 1990s to a surge in project finance for infrastructure and an expansion of copper-using industries. Most of the copper that goes to consumers is hedged against delivery either through Comex contracts, or through traded futures and options on the LME.
Traded options have been listed on the LME since 1987. Options are available for each month up to 27 ahead. And futures can be traded on the exchange by brokers dealing for producers, consumers and intermediary smelters and founders for any date up to three months, then every Wednesday for the next nine months and every month out to 27.
Customers directly involved with copper as producers or consumers still make up the bulk of business. William Adams, analyst at Rudolf Woolf, a large LME ring-dealing broker which is now part of Canadian metals group Norunda, says that "90% of our deals, and the LME's contracts in general, are trade-based".
Most producers now use put options to fix a floor for prices. Back in 1993, though, Per Sekse, vice-president of commodity derivatives at what was then Chemical Bank, noted that "most consumers of base metals are consistently not hedged". It's still true that consumers are still less likely to use the exchange than producers. Lehman's Sobotka says: "Sellers are still far more interested in buying hedges than consumers."
Industry use of the LME to hedge shades off imperceptibly into investor involvement as a strategic alternative to equities and fixed-interest. Lehman Brothers and other large investment houses have become involved in commodities, especially base metals, during the 1990s. They offer tailor-made derivatives to help market participants improve their trades by fixing prices for longer or more specific periods than the exchanges offer.
An advantage for clients of these developments is that by working off-exchange they can hide their positions from rivals. Goldman Sachs (through Aron), Deutsche (via Sharps Pixley), UBS, Crédit Lyonnais (by setting up Credit Lyonnais Rouse in 1993) and Barclays became involved, either by buying membership of the LME or by buying metal brokers.
Commodity funds accounted for almost 25% of the market in 1994. These baskets of commodities - generally including copper because on exchanges it is the most liquid base metal - offer investors broader exposure to inflation-free quasi-securities when bonds and equities seem to offer relatively poor returns.
Despite these developments the LME copper market still rests solidly on industry fundamentals. At the June 13 press conference, King announced that 47.2 million lots of copper (each of 25 tonnes) had been traded in 1995, a turnover of more than $2,750 billion. LME chairman Raj Bagri rightly called his exchange "the world's base metals market". LME deals in seven base metals; Comex, by comparison, trades only a copper contract. Nick Moore, analyst at Flemings, calls Comex "a peanut market compared to the LME".
But how well does this rhetoric stand up in the face of recent events, notably the intermittent backwardation that has affected the copper market since last November? By May, the cash price of copper, which is set in the morning ring session at the LME, was $300 higher than the three-month future.
The fundamentals of copper supply and demand, which ultimately move the market, indicated that the spot price should have been lower. The May high could be explained by a strike at Chilean state-owned mining company Codelco. Chile has been the world's largest producer of copper since July last year. Production was stalled, copper became scarcer and the price was bolstered. "The copper surplus was temporarily reduced," says William Adams of Rudolf Woolf.
But overall production this year has remained high and so the mysterious backwardation trend still lacked explanation, let alone resolution. Last November, though, the LME initiated an investigation into backwardation in the market that ended up at Sumitomo's door and eventually led to Hamanaka's dismissal. The very size of Sumitomo's copper business seems to have driven it from a stringent regulatory environment to a relatively relaxed one. Sumitomo US Corp, a subsidiary of Sumitomo Corp, ceased trading on Comex in 1993. On Comex there is a limit to the size of position a client can hold whereas on the LME members are merely required to submit confidential reports of large positions held by their customers to the LME secretariat.
Another attractive feature of the LME compared with Comex is that transactions can be carried out as a customer of intermediaries known as introducing metal brokers who have access to ring-dealing LME members. Most of Hamanaka's transactions were carried out in this way. Since Sumitomo was not an LME member and did not deal directly with any such member, the company's trades did not come under the jurisdiction of any UK regulatory authority. As the LME's King points out: "Since Sumitomo is not a member of our exchange we have no jurisdiction over their internal affairs."
The LME's King asserts: "We are talking about not the failure of the UK regulatory system nor the LME's controls but about the failure in the running of one major organization [Sumitomo] over a period of 10 years."
The LME's present market structure resulted from the 1985 tin crisis and the liberalization effected by the 1986 Financial Services Act. In 1985 the International Tin Council (ITC), which sought to maintain consistent prices for tin consumers and producers, "effectively defaulted", as one metal trader puts it. This resulted from the failure of the Sixth International Tin Agreement to gain universal acceptance. Thus the ITC became, in effect, a rival of the users of the LME's free market. By propping up the price artificially by buying physical stockpiles of tin, the ITC's buffer stock manager tried - like Hamanaka - to corner the market, but failed when he could no longer raise the amount required to maintain the physical price. The failure of the ITC to honour any of its outstanding contracts led to a tin market collapse. Tin contracts were not traded again on the LME for four years.
Major reforms followed the 1985 tin crisis. At the time the exchange operated as a principal-to-principal market. Clearing was performed by the members themselves as counterparties to the trades - not by a clearing house. After the tin crisis the market became a credit-cleared market making use of the London Clearing House. One broker says the LME "changed fundamentally" as a result. A new form of associate membership was created. These clearing members, though not allowed to deal in the ring, bring extra capital and liquidity to the exchange.
But the post-tin crisis attempts to create a "free, open and transparent market" were not entirely effective. The LME, King admits, occupies a "unique" regulatory position. In an interview conducted before the Sumitomo affair blew up, he said: "On the regulatory front we have a problem fitting into the regulatory environment in the UK, the European Union, the US, in fact everywhere. It is not that we are less stringently regulated, just different." Since the LME deals purely in derivatives, not in physical metals, it is an investment exchange, and accordingly regulated by the UK's Securities & Investments Board. Its members are therefore themselves regulated by the Securities & Futures Authority. As a consequence of the collapse of Baring Brothers, the LME is also party to an international agreement to share data and information with 49 other exchanges and 14 regulators.
In the same interview King went on to say: "If someone breaks our rules we are clear in our philosophy: we hang them high and we hang them publicly." The rules are not insubstantial, but they are rarely applied. The board can require members to outline daily confidential reports of their clients' positions. They can also impose limits on the holding of warehouse physical stock. When Sumitomo was questioned about its Long Beach stock, it claimed it was required for immediate orders.
The LME board can also in theory impose limits on backwardation. In May King announced that the cash and three-month prices should remain within 1% of each other. These powers are infrequently used. King states that his remit is to maintain "an orderly market" but he is against excessive regulation since he believes this would interfere in the natural price formation and hedging requirements of industrial users.
However, as recently as May 1995 Mary Schapiro, who chairs the US Commodity Futures Trading Commission, questioned the LME's ability to police itself. Comex imposes on-the-spot fines on miscreant members. The LME did impose a fine of £100,000 on Credit Lyonnais Rouse (CLR) - only after CLR admitted impropriety - for its part in the 1993 artificial backwardation and squeeze on the physical copper price - which, like the recent episode, was linked by market rumour to Hamanaka. But there have been earlier instances of individuals and institutions that could not be disciplined because, like Sumitomo, they were not LME members. Codelco rogue trader Juan Pablo Davila, who lost millions in 1994, could not be cautioned. Nor could Chinese investment bank Citic, which defaulted on broker payments.
Then there is the class of introducing brokers. Because they are not themselves LME members but act for customers, positions of their clients are difficult to disentangle.
The LME's transparency is also diminished because of the way dealing is carried out. There are only 17 ring dealing members (with capacity for 24). These 17, along with associate broker clearing members and associate broker members, are the only ones authorized to issue client contracts, though these can be passed on to introducing brokers acting for clients. Thus Sumitomo could spread its deals around the ring. Much LME-cleared business is conducted 24 hours a day, office-to-office by phone. The ring operates using open outcry twice daily. In the first session, starting at 11.45, two periods of five minutes for each metal are conducted followed by a 25-minute kerb session when contracts on all seven LME metals can be traded. This process is repeated at 15.15. Ring dealing mainly consists of inter-broker balancing of clients' trades accumulated during the day. Most important, the morning session sets what amounts to an official price, published worldwide for industry users.
Comex, by contrast, is principally an open outcry market, operating from 8.10 to 14.00. But between 16.00 and 08.00 electronic bid and offer prices can be posted. The exchange also imposes limits on large positions. In the LME's King's view "this artificial barrier is the reason why they are unsuccessful."
A further level of complexity is added because of the extent of over-the-counter (OTC) and off-exchange business. Brandeis's Davies claims this constitutes "at least a third of our business". Lehman's Sobotka concurs. "A lot of our deals are done upstairs," he says. Much of this business consists of traded average-price options (Tapos) or Asian options. Unlike LME traded options these enable contract holders to take delivery at the average price over the life of the option rather than the position at the end of the contract period. From January 1997 such contracts will be listed on the LME.
Davies believes the LME's transparency would benefit from some specific reforms. At the moment clients are allowed to carry over "historical prices" of contracts when they are renewed. Davies considers it inevitable that the exchange will switch to a system whereby contracts are completely cash-cleared each day, as applies at Comex. King reviewed the use of carry-over on contracts last November and agreed to "continue it as long as it has a role to perform". If it was banned, he said, "we would lose control as the practice would be performed off-exchange. However we have agreed to enhance regulation by only allowing it to take place if authorized at board level or equivalent between broker and client." Davies believes that there should be clarification of the LME's regulatory position on large-position reporting and the way it fits into the international regulatory framework (as a commodities exchange it does not currently qualify for the EU's Investment Services Directive). He also considers that the LME board might benefit from drawing some of its members from outside the exchange's own ranks.
The slippery slope of over-regulation Andrew Large, chairman of the uk's Securities & Investments Board, has announced a six-month inquiry into London metals dealing. He reflects on how regulation weathered the copper crisis, 15 months after Barings.
Had Barings taught you some useful lessons?
Yes. Partly it was because of the thought-processes that had gone on over the last year that we did have the machinery in place. The announcement by Sumitomo of the size of its losses came in the middle of the night in London. That didn't give us long to ensure an orderly opening of the market the following morning. Thanks to that machinery, we were able to find all the parties that needed to be found so that they could work out, to the best of their ability, who was going to have what exposure. Then the London Clearing House had to decide what to do about margins; the Securities & Futures Authority had to decide whether it had any parties in the over-the-counter market which might run short of capital? The CFTC (Commodity Futures Trading Commission) had to consider whether there were any American parties which could have difficulties. There also had to be alerts to the exchanges in the US. I'm not saying all these things wouldn't have happened a year ago but I genuinely believe if we'd been faced with what happened that night a year ago - or before Barings had happened - rather than being a tough night it would have been a nightmare. So much thought had gone into it in the meantime, that we were able to approach things in a professional way, rather than everybody having to invent what to do standing on their feet.
Do you think the copper market is a can of worms? Does it now have to be sorted out because it's so untransparent?
The price formation of the world's copper takes place on the London Metal Exchange. I think I'm right in saying that between 85% and 90% of on-exchange dealing in copper takes place on the LME and that is the price formation mechanism. Who does that price formation benefit? Answer: those who use it, and those who use other over-the-counter means of settling trades - the main producers , the main consumers and the intermediaries. How is it then, if it's a can of worms, that 90% of the trades are done there and it's being used for price formation? If what you said is true those people who have an interest would find another means of price formation - and they haven't. The LME offers a service which is valued by those who use its market. Clearly, an event of this sort raises questions. Questions of transparency in a general sense have been raised. It's significant that the LME came to us and asked us to look at their market. But we're also having to look at the way copper is traded over-the-counter. It's too early to say what we might find. We're going to be speaking with big producers and big users of copper, and recyclers as well. We'll also talk to intermediaries. The picture we want to build up is, what are the essentials that users are looking for in that price formation; are they being met; could they be met better?
There are two other things we're concerned about with copper. When a shock of this sort occurs, there are bound to be rumours about potentially very big and unexpected positions, and their capacity to cause instability in the market. The regulators have got to consider carefully whether there is any way of encouraging the market to go forward in an orderly manner. You can get panics in any markets, and this is just the sort of stuff that could give rise to panics - where people find themselves with unexpected changes of environment.
The third thing is enforcement. We don't know what went on yet. Our overriding concern is: has there been any abuse of the market, whether in terms of breaking the rules or the law, that has taken place in the UK. If so, was it regulatory; was it criminal? If any marketplace is thought to harbour abuse that isn't detected and dealt with, it can affect confidence, and that can harm investors. We're looking to see whether abuses have occurred, and if they have that we've done all we can do as far as those who behaved improperly are concerned. The clearer we can be about what's happened, the sooner people will feel more comfortable.
What about the thought that Sumitomo's involvement in the copper market was so huge, that it was causing a distortion?
Of course, the losses were huge. But the problem is, there needs to be some mechanism for doing things. Sumitomo is not subject to our direct remit in the UK. It's in a third country. It's an end user. Maybe you can make dealing more transparent on exchanges. But what about the OTC deals? Wouldn't the parties merely find other ways to trade? Some might say that this means there is a need to regulate a bit more here or there. On this basis, the world's legislators could end up saying, "The game's got to stop, we'll put a big regulatory structure in place everywhere." Then, any company here which bought and sold anything - I mean goods like copper, not just financial asset - would all of a sudden have some linkage with financial services regulators in case they were doing it in futures. We would all need to think long and hard before taking any such step.
David Shirreff |