London 06/04/2016 - The LME is right to look at enforcing some "needed" restraint on ever-rising warehouse rents and free-on-truck (FOT) rates but should be wary of a heavy-handed approach, sources in the warehousing sector told FastMarkets today.
The LME will carry out a comprehensive review of its physical delivery network, it said this morning. It is laying out possible reforms in a discussion paper sent out to market participants, focussed on capping charges set annually by warehouse companies for the costs of storing and delivering metal.
Fresh discussions over warehousing and charges follow the annual submission of rent and FOT rate rises that were much higher than expected - a consequence, warehousers argued, of the increased costs of dealing with a more stringent regulatory regime.
And just two companies Metro and Istim lowered their rates after the LME offered a one-off window to make reductions before rents came into effect on April 1. Metro and Istim had submitted the highest levels of all LME-registered warehouse firms.
This year's rises are symptomatic of a structural fault in the exchange's warehouse system and physical delivery network, the exchange said in its paper today.
Rather than competing over having lower rates, warehouse operators are inherently incentivised to charge higher fees due to them being directly linked to the incentive system, which dominates the storage space and involves metal holders being paid flat fees by warehouse companies to deposit metal in their warehouses, it argued.
"The higher the rents and FOTs, the higher the financial incentives the warehouse operator can offer the metal owner. It is a self-reinforcing system," the LME said, stressing that incentives distort LME exchange pricing and are detrimental to metal end-users wishing to take delivery of stocks bought on the exchange.
This in turn is something the Financial Conduct Authority - the LME's regulator - frowns upon.
"An unduly high logistical cost burden will naturally weaken the LME's ability to fulfil this role [as a "market of last resort" for those buying and selling metal] and subject those using the market for this purpose to a greater frictional cost of usage than would be rational in a well-functioning economic system," it added.
Taking action to stem this race to the top is necessary, most market sources agreed.
"It's needed damage to avoid bigger damage," one warehouse operator told FastMarkets. "It's not that we like it but it's better than facing an inflation war between warehouse companies."
It is not unusual for warehouse rents to rise annually but this year's surge is emblematic of a changing approach from some companies, sources said.
"They saw that increasing the FOTs and rents creates a competitive advantage in which they can destock others [by attracting metal through incentives] and not be destocked themselves," the first warehouse source said.
SOFT APPROACH
The LME outlined several suggestions on how it could exercise greater control over the warehousing and physical delivery aspect of its global business, a key characteristic of the exchange that sets it apart from competitors such as CME.
These include a fixed annual adjustment to rates corresponding with inflation, a freeze on the current rates for corresponding year(s), a transitional rate reduction and an immediate rate reduction - all of which would act as a cap on future fee rises.
Capping annual rate increases using such methods is common for other commodities and on exchanges such as Liffe and may be the best option to restrain the market, sources said.
"In soft commodities, certainly in coffee, there was quite a lot of fighting between warehouse keepers [who were] destocking and re-stocking but it has gone down since they introduced the same level of FOTs - now everyone is allowed to use the maximum rate published for each location," a second warehousing source said.
WAREHOUSE COMPANIES COULD SUE
But the exchange must tread carefully, any attempt by to force warehouses directly to lower their rents would "100 percent" lead to lawsuits, warehousing company sources said. Indeed, several large companies have previously threatened to do so.
"Warehouse operators are likely to sue. [Asking them in February to revise their proposed rate increases] impacted carries as people would have adjusted the book in time for April end - now the goal posts have moved," a trading source said.
"They also need warehouses - if all the metal leaves the LME, then issues with backwardation become a bigger deal. There is no shortage on the aluminium market but there is a shortage of LME-registered metal in LME sheds. [This is] dangerous," he added.
Feedback to the LME's paper has a deadline of May 18; it remains to be seen if the major changes proposed by the exchange will be taken on board fully or challenged by some warehouse operators and leave the LME with another legal battle - similar to that it had with Rusal - on its hands.
(Additional reporting by Kathleen Retourne, editing by Mark Shaw)