London 08/04/2016 - The London Metal Exchange's Matt Chamberlain is confident it can reach an agreement over warehouse reform but acknowledged there could be legal ramifications if the exchange were to force warehouses to cut FOT rates.
Chamberlain, who is head of business development at the LME, told reporters in a teleconference on Thursday of the need to reform free on truck (FOT) rates billed by warehouses for the cost of loading out LME warranted material when purchased on the exchange.
"Many market participants come to us and say these are out of line with what we believe is the economic cost of providing this service… it is absolutely right that is something we look at," Chamberlain said.
Initial charge increases submitted this year averaged 10 percent for rent and 12 percent for FOT, which the market "was extremely unhappy about", Chamberlain said.
When the LME, with the agreement of its warehouse committee, reopened the rent window to allow for reductions, rent increases were dropped to an average of 7 percent and FOTs to 9 percent, which was "still quite high" Chamberlain added.
The LME has outlined several proposal to tackle high FOTs and rents charged by warehouse companies.
"[Warehousers] are following game theory where they will want to have the highest charges because if they don’t they may be out-competed on incentives and not get any metal," Chamberlain said.
While rent is a concern, the LME's priority is working down FOT charges, he added.
In its discussion document released on Wednesday, the exchange outlined five ways in which FOT rates could be kept in check.
FIXED-TERM WAREHOUSE AGREEMENTS
The first, fixed-term warehouse agreements would involve changing the LME's warehouse agreement from an "in perpetuity" model to a "fixed term" one, with annual or biennial reviews allowing the exchange to review how certain warehouses were operating with the use of LME metal.
The raises that operators proposed for rents and FOTs would be a key parameter in their agreement renewal.
CHARGE CAPS
Second, and perhaps most controversially, the exchange is considering introducing a charge-capping system, implementing a rule limiting warehousing charges for rent and FOT or perhaps just FOTs.
Chamberlain described this option as aimed regulation in its "purest form".
"We will publish a list of rents and FOTs or probably just the FOTs because that's the real issue. High rents are a concern but they are mainly a just concern," he said.
The aim of the cap would be to bring FOT rates for LME exchange warrants down to the levels that are agreed and negotiated between metal holders and warehouses for 'off-warrant' material traded physically in over-the-counter (OTC) markets.
The exchange's issue with FOT on its metal warrants is that, while OTC traded premiums can be negotiated based on incoterms, those buying through LME contracts have no choice in the material they are allocated through the LME clearing system and potentially face punitive costs to receive that metal, based on factors out of their control.
Moreover, it is in the interest of sellers to accept high FOTs because they receive better incentives as a direct consequence, the exchange noted in its discussion paper.
Rent capping could be introduced in a variety of ways: freezing rates at present levels; allowing rents and FOTs to increase yearly but only at levels reflecting inflation adjustment; and setting a 'transitional floor' whereby FOT rates would drop towards those agreed by non-LME metal holders and warehouses, for example.
The most drastic option proposed for discussion would be to force warehouses to drop to those levels immediately, which the exchange refers to as "Worst-Case Bilateral Warehousing Charges".
The last two would require further quantification on what those levels would be, as well as introducing further debate on who would set them.
They would also affect multiple deals relating to rent and incentives reached by warehouses and metal holders, and could affect trades, metal flows and LME forward spreads, especially for aluminium.
It would also require the LME to draw on new information it expects to obtain from warehouse operators from April concerning the FOTs that are offered to non-LME clients.
And if FOT and rent were to be frozen, it is up for debate whether the LME and the market would base the rates on this year's rates, which the LME deem unsatisfactory, or 2016-2017 annual levels, which are an unknown quantity.
LME GUIDANCE
The LME might also bring about change with a softer tone, using guidance rather than a forced hand. The two ideas put forward along these lines are charge threshold guidance and charge-based incentive guidance.
For the former, the LME would publish what it deems to be acceptable levels of FOTs or "shadow caps". For the latter, the LME would monitor the incentives offered for LME material by warehouses, utilising its powers to have companies report their incentives to them.
"It may well be that a voluntary regime works here because the warehouses want to be part of [the LME system]," Chamberlain said.
FOT CONVERSION
Finally, the LME proposes moving the goalposts with respect to FOTs, namely converting the LME contracts to "FOT paid" from their current "in-warehouse" basis.
Instead of the buyer paying for FOT, that responsibility would pass to the seller, making the seller "much more likely to negotiate a deal that is fair" and bring charges down, the exchange said.
"This re-engineers the LME contract that removes this upward pressure and in many ways that is the most elegant solution," Chamberlain said.
LME BRACED FOR LAWSUITS
The exchange is open to other ideas or combinations of various proposals and awaits the response to its discussion paper.
"We are genuinely open to the views of the market as we go through this process towards where the market feels is the best balance between the economic market interest of all the market actors," Chamberlain said.
But with potential reforms flying in the face of business, the LME is already bracing itself for lawsuits if it decides to impose cuts to rates on warehouse operators.
"We fully recognise that the more aggressive we are then the greater potential for legal action," Chamberlain said.
The discussion period is to last for six weeks from April 6 to May 18, after which an internal discussion will take place for a further six weeks.
On July 16 the results of the discussion will be announced and a possible consultation launched for another six weeks before a second internal discussion takes place.
The results of any potential consultation will be announced on September 16 and if any changes have been agreed upon they will be implemented in mid-December.
This accounts for the initial submission of rent and FOT from warehouses, which takes place from November 1 to December 1, the deadline for 2017-2018 rent submission.
(Editing by Mark Shaw)