Garry Jones, chief executive of the London Metal Exchange (LME), likes to talk about the opportunities presented by China's rapid economic growth. China is set to have more middle class people than the European Union by 2020, he points out, people that will bolster its demand for capital and commodities.
The LME now has a sizeable amount of resources aimed at developing its business in China, he says, reflecting the country's huge importance to the base metals market. In November last year, the LME signed up investment bank China Merchants Securities as a clearing member – the last of three Chinese firms to have joined the LME as clearing members, all of which came on board since 2012.
Jones's enthusiasm for China is easy to understand. Having joined the exchange in late 2013, he is the first chief executive to take charge since its £1.4 billion purchase by Hong Kong Exchanges and Clearing (HKEx) in December 2012. In addition to his role at the LME, he also serves as co-head of global markets at HKEx. That gave him a front-row seat for the November 2014 launch of the Shanghai-Hong Kong Stock Connect (SHKSC), a "mutual market access programme" that allows investors in each jurisdiction to trade shares in the other. Replicating the idea for the LME and commodities "will take a lot longer", says Jones, but it is on the agenda.
Nonetheless, developments in more mature markets have also demanded the LME's attention of late. They include the launch of LME Clear, the LME's new clearing house, which has been in the works since December 2011. The launch of LME Clear last September means the exchange no longer has to rely on London-based central counterparty LCH.Clearnet to clear its trades, and is expected to bring other benefits.
Among other things, Jones says the new clearing house will make it easier for the LME to launch new products. That should be helpful, since it is planning to extend its offering in ferrous and precious metals during 2015, as well as moving into clearing for over-the-counter derivatives.
I wanted to play a role in opening up China's capital markets and I also wanted to convert the LME into a world-class exchange
In expanding into precious metals, the LME should be aided by its new role as the independent administrator for London Bullion Market Association platinum and palladium prices, which it took over in December 2014. Like other exchanges, the LME has eagerly pitched to take over the running of precious metals indexes as regulators tighten the rules on benchmarks due to the Libor scandal. But even though the LME was picked to run platinum and palladium pricing, it lost out in silver and gold, which remains something of a sore point for Jones.
While regulation is creating opportunities for the LME in the administration of benchmarks, it is also causing headaches elsewhere. In the interview below, Jones expresses concern at the flurry of new laws engulfing market participants in the EU and US. The European Market Infrastructure Regulation (Emir), which requires derivatives to be reported and cleared, is having the unintended consequence of pushing base metals participants away from clearing, he argues. Position limits for commodity derivatives – envisioned by both the US Dodd-Frank Act and Europe's Mifid II – duplicate the exchange's existing rules, he says. And he worries that many EU regulators simply view trading and speculation as "a bad thing".
Then there's the issue of warehouses. In the past few years, controversy has enveloped the LME due to the long queues faced by buyers of aluminium trying to unload metal traded on the exchange from some of the warehouses that store it. The queues have received scathing criticism from users of aluminium, including Atlanta- and Chicago-based drinks manufacturers Coca-Cola and MillerCoors. The hold-up has been particularly acute in Detroit, where around 30 warehouses are owned by Metro International Trade Services. Until it was sold last December, Metro was a unit of Goldman Sachs, which has been accused of trying to profit from the queues, allegations the bank denies. In November 2014, such claims were repeated in a report by the US Senate Permanent Subcommittee on Investigations (PSI) that questioned the involvement of banks in physical commodities.
In response to the controversy over warehouses, the LME chose to reform its rules back in November 2013. But the planned changes were delayed due to a UK legal challenge by Russian aluminium producer Rusal, which claimed the exchange didn't consult properly on them and demanded a judicial review. An initial court judgement in favour of Rusal was overturned by the UK Court of Appeal in October last year, and the LME finally introduced the new rules on February 1.
Q: The launch of LME Clear in September last year was a big development for the LME. What was the scale of the change, in terms of staff?
A: LME Clear has about 50 staff, so the LME's total headcount is now over 300. A few years ago it was 80, just to put it into perspective. We're bursting out of this building, it's just too small.
Q: You're bursting out of this building, so you're looking for new space?
A: We've just announced our plans to move into a great new building at 10 Finsbury Square. Last year, we made the decision to keep our trading floor – the ring – and to invest more in it, so there were specific logistical issues we needed to consider. But 10 Finsbury Square is a modern, open-plan building and we'll be able to create a dedicated space for the ring there. We hope to move within the next 12 months.
Q: Why is the ability to clear your own trades such a valuable thing?
A: It allows you to control more of the trade life cycle. So you have the point of trading – which on the LME can be electronic, the telephone or the ring – you have clearing and you also have to report to a trade repository. If you can control all of that, you can link them all together. Clearly, there are revenue implications. But also, if you're going to launch new products or make changes, you can do them on your own priority schedule. Of course, these things always have long lead times – it's probably six months to a year to do anything, particularly if you need to get regulatory approval. In addition, because we are a new clearing house and we had to get authorisation from the Bank of England and approval from the college of regulators in Europe, it was a good chance to revisit the risk parameters and methodology for margining and the look-back period on the valuation.
We're now clearing all our own markets, and we hope to clear OTC markets as well – part of the LME's business comes through OTC anyway. And we'll be looking at clearing other products as we expand our product range.
Q: When do you plan to start clearing OTC metals?
A: Well it's in the business plan for next year – there are no definite dates. The LME itself is looking at developing more products, first of all in its core markets. We're looking at launching premium contracts in aluminium, where you can trade a regional premium, as well as the underlying global reference price. We're looking to do more business in the ferrous suite, which is really steel, in the first case, followed by scrap and rebar at a later date. We're also looking to do more in the precious metals space, because we've just started providing the reference price for platinum and palladium. We narrowly lost the bid to provide the gold fix, which we weren't very happy about.
So when we say 'clear other markets', we mean adjacent markets to what we're clearing now, plus the OTC element of that, plus completely unrelated markets. We've had approaches from other trading venues to consider clearing for them. They know we've got a system that's very quick, that has a very good risk overview and real-time clearing. So for products that are similar – that have a forward price and are, from a mathematical point of view, not completely stage left – the marginal cost of developing a new product on the current infrastructure is lower. We wouldn't compromise the underlying business, but we are certainly looking towards diversity.
Q: There's been a lot of controversy over the queues in some LME warehouses. Despite a legal challenge from Rusal, you decided to go ahead and implement rules designed to cut those queues from February 1. Can you tell us about that?
A: We don't own warehouses; we regulate and approve them to store LME metal. We have approved about 680 around the world. There are queues at two warehouse locations – one in Detroit and one in Vlissingen in Holland. We trade 14 different markets and aluminium is where the problem is. You might ask why there is a problem in aluminium and not in copper, and that's an interesting question. A lot of it is to do with the structure of the market and what happened after the financial crisis. So in 2008 and 2009, economic growth was stifled and the use of metals and all commodities was also stifled. The normal economic reaction would be for people to cut production, close mines and close smelters. But at the same time, interest rates dropped very low under quantitative easing. So suddenly it became possible, if you owned aluminium, not to stop producing, but to produce it and to put it into a warehouse, because you could fund it at half a per cent, lock in the two-year forward price and get a risk-free rate greater than US Treasuries. A queue forms in a warehouse because of structural reasons – that's one of them. And the premium – or the level of the regional price over the LME price – is partly governed by that queue, but it's also governed by supply and demand in a country, it's governed by transport costs, it's governed by many other costs.
Within the warehouses themselves, the problem of delays developed. So we've tried to change the rules so that warehouses have to load out more material than they load in if a queue gets above a certain length. And then they can't take any more material in until they've taken out a much larger amount – this is the so-called linked load-in/load-out rule. We were all ready to go with that but then Rusal decided to take us to court, saying we'd made the decision the wrong way and did not consult enough with the industry. It's been a long-running legal saga, but we were successful in the courts in the end, and the rule went into effect on February 1.
Q: In November 2014, the US Senate PSI report repeated accusations that some warehouse owners were taking advantage of queues in aluminium to turn a profit. What's your response to that?
A: In the PSI report, specifically, they talked about a number of factors that may have had economic connections with warehouses. But when we regulate and approve warehouses, there are very strict rules about what they can and can't do. If they're part of a bigger group, they can't share warehouse information with other areas of the company that are not connected with the warehouse. They are subject to audits – random audits and regular audits. If we find anything that we feel is breaking the rules or anything close to it we can investigate, and if anybody else brings anything to our attention, we will investigate that as well. All these things are ongoing and obviously I can't comment on any particular point, but of course with the PSI investigation, that group had the power of subpoena, so they could actually get information we couldn't get. They highlighted two or three incidents that happened over there, most of which happened some time ago, but all of which we already knew about, with one exception. So it's not like we were surprised at this.
Unfortunately, in the US there is a great groundswell of concern from companies such as Coca-Cola or MillerCoors. It's our impression that they go to their senators to complain and then the senators feel compelled to do something. And, it seems to us that the CFTC may feel under quite a bit of pressure to respond to complaints as well... But for those companies to try and sell to senators that we've got this mass of metal in warehouses that they can't get is totally untrue.
Q: I'm not suggesting the LME is guilty of any wrongdoing. But presumably, as an exchange, you want to make sure you have a properly functioning market?
A: We've announced that we want to launch our new premium contracts – what does that mean? It means, if you buy a North America premium contract for aluminium, you will get delivery in a warehouse with no queue. That's in the contract. Warehouses have agreed to have certain stock that will never be in a queue. Of course, it is a different price, but you can buy it and you can sell it. So if you think the premium's going to narrow you can do that trade and if you think the premium's going to widen you can do that trade too. And in fact, there is no queue in most of the warehouses. There are a lot of US warehouses – for example, in New Orleans or on the west coast – where there is no queue at all.
Q: When are you launching those contracts?
A: They're coming in 2015. It requires rulebook changes, regulatory approval and then obviously we've got to clear them. But we're very keen to get this done. We started by thinking about a contract for the [US] Midwest and maybe one for the north of Europe, to capture the Vlissingen issue. But we've had a lot of interest from Asia and we're going to be launching an east Asia premium contract and a South-east Asia contract as well, because there's been strong demand in those areas.
Q: Are you concerned about the impact of financial regulation on the commodities market and LME participants?
A: Yes I am, because there isn't one size that fits all. It's not a stock market. It's not easy to understand, but you have many exchanges with different products that they've created that are separate. For example, there's been a lot of talk about the imposition of position limits for commodities. The LME already has a position limit regime, which we call lending guidance. That means people who develop a dominant position in a particular metal have to lend an amount of it back to the market at penal rates to ameliorate the effect of their holding. Lending guidance is designed to prevent market squeezes, and it works. So when we talk to US regulators about position limits and the structure there, we try to explain in great detail how our system works.
Also, you feel sometimes that European regulators view trading as a bad thing, and speculation as a bad thing. My personal view is that you must have trading, and you must have speculation to create liquidity pools that people can hedge in. Otherwise, the markets will just seize up. There has to be a return for that.
There's been a lot of talk about Mifid II and the changes from Mifid. Again, they're not written for us – they're not written for a commodities exchange and they're not written for a specialist in the metals business. But there again, you sometimes struggle to see things in the regulation that are definitely going to benefit the market.
I want to also make this point: there have been some really unintended consequences of Emir. The whole broad thrust of Emir, plus the move towards segregated accounts and everything else, in many cases is having the unintended consequence of pulling people out of clearing. Because in the metals business, the members can all act both for their own account and on behalf of clients. Now of course with the segregation of accounts and different types of accounts... in many cases, the cost of clearing has gone up. And some people say 'you know what, I'd rather take X, Y or Z bank's credit and do an OTC trade rather than put it through clearing'. And the intermediaries quite often are taking more business OTC, because there's no mandatory clearing of OTC metals at the moment.
Q: That's going to change once the Emir clearing obligation for commodities takes hold, though, isn't it?
A: Yes. And against that backdrop, the underlying volumes of the LME are up. We had a 3.5% increase in volumes in 2014, which is amazing really, given the downtrend in general prices of commodities and the low volumes across most other exchanges in this area. So I'm very pleased to be in that position.
Q: Let's talk about the SHKSC. What's the significance of that programme for the LME?
A: We've been working on this for a long time. As you know, I'm chief executive of the LME but I'm also co-head of global markets for HKEx, so I'm there quite often. I won't claim credit for that particular deal, but I'm obviously working on it with the team and looking to extend it to into other areas. Essentially, the Chinese markets have always been closed, and over the last few years, you've seen some reforms that have allowed foreign investors to trade in China under [qualified foreign institutional investor] schemes, but you've got to put the money in renminbi and you've got to put it into a non-convertible currency onshore.
What SHKSC means is that for the first time, we've effectively built a connection between the Hong Kong and Shanghai exchanges. If I'm a western investor trying to buy Chinese stock, I can now enter my order in Hong Kong and my margin, my payment and everything is made in renminbi to a clearing house in Hong Kong. And if I'm a Chinese investor and I want to invest in Hong Kong, I can buy and sell my stocks in renminbi using my Chinese clearing account. What happens every day is that the two clearing accounts net with each other, so the counterparty to the western investor is the clearing house in Hong Kong and vice versa.
We started with the Shanghai Stock Exchange because it's the biggest in China, and we've got something like 85% of the market cap of the exchange available through this process; all the blue chips. We're extending it bit by bit. We could well link with other venues. Clearly, Shenzhen may be the next step, there are ongoing discussions but nothing's been finalised. We're looking at equity derivatives – so, it would be fantastic to trade the domestic Chinese stock indexes from Hong Kong and overseas indexes through Hong Kong. We're talking about exchange-traded funds, which is another massive market. And importantly for the LME, we're talking about commodities, but this will take a lot longer.
Q: Is the SHKSC a model that could be used for metals?
A: Yes, in theory, it could. It's not where we're starting, because the Chinese authorities don't want us to launch everything at once. Just after linking Shanghai in cash equities, commodities are not going to be number two. But it's on the radar and lots of intelligent discussions are going on. It's one of the main reasons I took the job here, because I wanted to play a role in opening up China's capital markets and I also wanted to convert the LME into a world-class exchange.
Q: The LME pitched to become the administrator of gold, silver and platinum and palladium prices last year. You won platinum and palladium – are you pleased with that?
A: Yes and we built a completely new system called LMEbullion to deal with that. It's been very successful. One of our aims is to increase participation in price formation for platinum and palladium. Four contributors were involved in the old process, and we've already seen a new participant coming on board with the new system. We're hoping to get that number up to a lot more very quickly. We've already got quite a lot of expressions of interest, which would be a really good benchmark of success. We were second on silver, there wasn't much in it. But I think we tightened up our offering a lot in platinum and palladium. And of course, a lot of the players in that market are also our clients in base metals.
In gold, we were very disappointed, because we built a new system and felt that our governance and experience in being a price reference for base metals was positive. We were also pleased with the internal and external audits on our Iosco [International Organization of Securities Commissions] compliance, which was important because gold is a designated benchmark administration product under the new rules, like Libor. We felt that our own price formation would stand up to scrutiny, because there are real prices happening in real time – there are people risking capital to trade and anybody can put an order in. So it checked all the boxes with Iosco. But to be frank with you, there was a lot of confusion around who the electorate was and how it was going to work, and what it meant to be a benchmark administrator. The process kept changing, which was very disappointing. In the end, we were told that it was very close and there was very little in it, but the detail of how it was chosen remains a mystery.
Q: So you don't know what swung it towards Ice, the Atlanta-based exchange?
A: No... the fact that Ice is already a benchmark administrator shouldn't mean anything, because you have to reapply for gold anyway. And the regulator said that as long as you're a regulated body and you meet certain criteria and you have experience in producing benchmarks, then you don't need to be a benchmark administrator on day one. So we shall see. It doesn't mean that we're not interested in clearing gold, silver, platinum or palladium next year, and indeed maybe trading it.
Q: Why are exchanges falling over themselves to become benchmark administrators for various products?
A: We feel that the formation of the base metals reference price – we've got a reference price, it's not technically a benchmark - is important, because so much of the OTC market prices off it. If you're the reference price for the world's base metal markets, it gives you immense credibility in that business. And you can then start clearing and doing everything else as well. So it's very important.
In precious metals, it wasn't so much that we were pushing to do it... We didn't push our way in, saying 'me, me, me, I want to do this'. But when banks announced they wanted to look at a third party doing it, it was an obvious adjunct to our business to do so.
Q: So it's not a wild moneymaking opportunity?
A: No. In our platinum and palladium deal, it's public knowledge that we're not charging for the submission of prices in the reference price periods. We are selling market data and we share that with the market. We're not looking to make lots of money out of this – we want to make some money out of it – but mostly to develop some credibility in precious metals. That allows us to launch some other products in due course and, particularly, to clear those instruments. That's really what it is. We're not looking to change the structure of the market completely, because that's the domain of the precious metals banks. We're certainly not going to fight that.
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