London 14/04/2016 - The LME might struggle to get approval for and then implement a proposed change to a system where the free on truck (FOT) contract change is met by the seller rather than the buyer, market participants said.
The exchange last week proposed for discussion a series of measures aimed at ending ever-increasing warehouse rent and FOT rates, which it deemed out of line with the economic cost. Initial charge increases submitted this year averaged 10 percent for rent and 12 percent for FOT.
Of the measures, the inclusion of FOT Conversion (FOTC) - almost a decade after it was first proposed and rejected - has raised a few eyebrows.
FOTC is the conversion of the LME contract from an "in warehouse" contract (buyer pays FOT) to an "FOT-paid" contract (seller pays FOT). This rules out an "exit charge" whereby those purchasing the metal are subjected to high FOT rates that they had not been able to negotiate.
This is not the first time such a proposal had been explored. In 2007 the LME - then a membership-owned entity - ran an independent review into its feasibility but dismissed it as "not in the best interest of the exchange or the wider metals industry".
"This would achieve nothing for consumers and would not improve the overall efficiency of the LME system," the review said at the time.
Its revival has therefore drawn the most comment from exchange users.
"It makes no sense - the LME had a good look before and it was deemed that the overall outcome not worth the disruption to the market," a market participant said. "This is one move that could really put the cat among the pigeons."
Approving FOTC this time around carries the risk of alienating warehousers - there is a risk they would no longer see the LME as their main model and would shift more markedly to off-exchange business where the costs of compliance are lower and potential margins higher.
"Big warehouses will just not bother attracting metal - why bother when you can have it cheaper?" another market participant said.
But the context has changed since the 2007 review - ever-increasing FOT rates may mean a different outcome this time, the exchange said.
"We constantly update our view - the world changes," LME head of business development Matt Chamberlain told FastMarkets. "We can't always be bound by what we have said in the past... the factual matrix evolves and the legal side does too."
"On balance, the community will decide if the negatives outweigh the positives. The FOT is much higher now and the value of the greater FOT may outweigh the disadvantage," he said.
But there may be many hurdles to the implementation FOTC, the largest of which would be the logistical challenge of introducing the mechanism.
The simplest method would be a future introduction - the LME sets a start date beyond the maturity of the longest-dated contract. But the aluminium and copper contracts can have maturities up to 123 months forward, meaning it would be some time before it could be rolled out.
Another possibility is a "big bang" introduction - the LME selects a date beyond which all LME contracts would be settled on a FOT-paid basis. But, again, there are hurdles.
Because open interest would already exist beyond this date, it would be necessary to adjust all positions already open on the market with a "universal rate". Deriving this rate would be complicated and contentious.
"No matter what rate they come-up with, someone will be aggrieved," a source said.
But the LME may simply have included FOTC in its discussion paper to ensure it covered all bases in case of legal action and does not expect it to be approved this time either.
In 2014, Rusal challenged the LME's implementation of load-in/load-out rates (LILO), calling the rule change "unfair" and "unlawful" because the exchange failed to examine other options.
The Russian aluminium producer won its first court case - the LME consultation should have included a robust discussion on the possibility of banning or capping of warehouse rents, the court ruled - although this was later overturned on appeal.
Fresh legal action is possible either to delay or halt the implementation of the proposed rule changes, market participants have warned - something the LME has also acknowledged.
"If a solution proposed by the LME has a serious adverse economic impact on a particular participant in the market, it is possible that such participant might try to challenge the LME, regardless of the strength of the LME's legal position," Chamberlain said.
"The objective of such a challenge may be to obstruct and delay changes or alternatively to ultimately prevent such changes. Litigation is undesirable from the perspective of the market because it creates uncertainty," he added.
(Editing by Mark Shaw)