London 24/02/2015 - The LME could lose what makes its unique in its pursuit of higher volumes via its attempts to boost liquidity around its 'Third Wednesday' date, some users have warned.
Although the exchange has played down fears it risks alienating much of its existing user base by promoting futures-style trading, this disagreement is not merely over technical measures but is an existential debate over who the exchange is for and how it should operate.
Last month the exchange relaxed its order-to-trade ratio policy on 'Third Wednesdays' to make it more attractive to would-be users who are deterred by the LME's unique system of prompt dates - the dates on which a forward contract will be settled, going daily out to three months, weekly out to six months and monthly beyond six months.
Some LME users have complained that a rolling three-month contract is not suitable to hold for more than one day because that prompt date is no longer liquid on the following day, the exchange said. Around two-thirds of the open contracts on the LME are set to expire on the same monthly date.
The LME is also looking at developing software to enable implied liquidity - or 'chaining' - on LMESelect, automatically joining outright orders and carries to create a broader set of outright bids and offers.
It believes market participants would be willing to post bids and offers on such carries in an implied liquidity environment where they are more likely to be executed as part of a chained bid. Still, given the costs involved this move will only be considered in a future release of LMEselect.
But exchange users who are acclimatised to the strong and unique prompt date structure fear that any attempt to promote outright monthly contracts would not provide fresh liquidity but would merely shift it away from three-month business.
"The market wants it, apparently," a Cat One member said. "But… the LME is so intrinsically attached to the spread market and that's what generates business and revenues. With Third Wednesday contracts, the LME will lose revenues and won't gain any fresh liquidity."
"The risk to the prompt date structure and the spread liquidity is tremendous," an industry veteran added.
There are also concerns that any emphasis of futures-style trading would render ring trading obsolete, leading to the closure of the open-outcry ring - the last of its kind in Europe.
"It is a paranoid time - as a ring trader [this] feeds that paranoia," a floor trader said. "It is a risky game - if it does cannibalise the prompt date, then you can't go back."
Still, recent efforts by the exchange underscore its support for open-outcry trading. The LME last year committed to investing one million pounds into ring-based technology, fitting new wall boards on the trading floor to help ring and LMEselect pricing, as well as facilitating business conducted on the floor. It has also promised to retain the ring and these changes when it relocates to larger premises by the first quarter of 2016.
And its proposed changes are a matter of enhancement rather than replacement, it believes. It does not see any inherent conflict between users of daily and monthly prompt dates.
LME head of business development Matt Chamberlain told delegates at a copper conference last week that the contracts are "not an attempt to attack the three-month date", adding that he expects three-month business to remain liquid into the future.
"The LME values the unique structure of its market and is committed to enhance it following guidance from its membership and user base," an exchange representative told FastMarkets.
"By enhancing liquidity on LMEselect for 'third Wednesdays' - where 65 percent of LME open interest already sits - we believe we can meet demand for a more traditional futures-style trading, offering the option to place bids and offers on outright monthly dates, without altering the unique structure of our market," the representative added.
While there is understandable nervousness about any change, it can be for the better particularly if it means more business, one LME trader said.
"It was the same when the exchange went from sterling to the dollar. When this happened the LME said it would increase participation but traders were concerned it would take money away but participation jumped and this far outweighed the loss of currency arbitrages," an LME trader said.
While some users of the exchange some may find a change in the trading landscape of this magnitude to be detrimental to their business models, others - particular algorithmic traders - have said they would be keen to use monthly dated contracts if they were available.
"Funds are saying that if the LME made it more accessible they would like that - they normally get in and out of a position quickly and do not like an unknown factor such as fluctuating backwardations," the LME trader said. "But it is all very well saying that over cocktails - the proof will be if this converts into actual usage."
While the exchange is not so naïve to think that everyone who said they would use the contracts would do so, it still believes there is a synergy between the two styles of contracts, Chamberlain said.
The introduction of monthly contracts would put it in direct competition with other exchanges that, from January 2017, would also be able to list LME contracts - for a fee - under the terms of MIFID II.
"If the LME were to do monthly contracts, the last stand unique selling point to stop cloned markets would be the benchmark prices and, under MIFID II, they must become public property by 2017," a second source added.
Still, the exchange is working with industry groups and legislators to ensure that the specific nature of its business is fully understood and it supports regulation that promotes efficiency, systemic stability and better management of risk for all users, it said.
"While it is too early to comment on the impact of proposed MIFID II legislation on any specific venue, the LME and LME Clear are well-positioned to take advantage of competitive opportunities, including those prompted by regulatory change," it said.
(Additional reporting by Perrine Faye, editing by Mark Shaw)