Metals exchanges temper volatility with visibility: more reforms to come?

The commodities price "supervolatility" sparked by the Russia-Ukraine war may be prolonged – reminiscent of that seen during the oil price shock, China's awakening as a consumer nation, and the global financial crisis.

Metals may bear the brunt.

Slow recovery from the GFC, and COVID-19, eroded investment in new mine production, trimming supplies even while population pressure and the decarbonization drive boost demand. The low-carbon world is high-metal. Prices have jumped: aluminum and zinc are up 21% year to date, copper 7% and nickel 57%, while lithium prices have more than doubled amid tight supplies.

It is in this environment that metals exchanges are most needed to provide a reliable market framework. Exchanges attract more players at times of volatility, when spot markets risk becoming dysfunctional.

The UK's Financial Conduct Authority and Bank of England's current probe into London Metal Exchange nickel trades and the LME's commissioning of an independent review – following speculation that led to a recent trading suspension – indicate more regulation or reform may come.

The pressure is on

Governments – already stockpiling metals for use in electric vehicles and wind power – need to act to regulate markets and ward off shortages, global trader Trafigura's CEO Jeremy Weir told the Financial Times Commodities Global Summit in Lausanne late March. Germany is moving towards gas rationing. Could critical metals be next?

Inventories remain low following a 2021 global market deficit in metals including copper, aluminum, nickel and zinc, according to the World Bureau of Metals Statistics. Russia produces 17% of the world's nickel, and this is now subject to geopolitical restrictions, igniting speculation.

And in early March the market caught fire. A client of a London Metal Exchange member – and named as founder of the world's biggest stainless steelmaker and major ferronickel producer Tsingshan – established a short position equivalent to two and a half times the LME's available 70,000 mt nickel stocks. This propelled prices up 250% in three days, forcing a market suspension and resulting in trades cancellations estimated by market sources at $3.9 billion.

Electric vehicle battery makers started to shun nickel in favor of cobalt, while stainless steel users reinforced a trend to choose chromium-bearing ferritic rather than nickel-bearing austenitic grades. Platinum prices rose as automakers looked to replace Russian palladium (found together with nickel) with South African platinum, reported broker SP Angel. Nickel reached the threshold of being considered a precious metal, priced at more than $1 an ounce.

"Exchanges need to get smarter about initial margin requirements and get nimble on intraday variation margins," said UK-based Mark Thompson, director of Met Trading. "They need to ensure sufficient margin is in place to protect all participants and ensure these are paid within 24 hours, suspending contracts if they're not. A level of prudence is required when circuit breaker price moves are introduced and on potentially closing overnight sessions: in volatile markets the biggest moves will occur outside normal trading hours."

Related content: Stuttering LME nickel trade throws confusion over physical market

New controls

Price visibility and regulation are key. Following last month's hypervolatility – which resulted in over a week's suspension of electronic nickel trades, accounting for around 40% of total nickel trades – LME, a wholesale exchange, for the first time ever introduced price bands on outright contracts. Initially on nickel, these were extended to its other base metals physical trades, which can now rise or fall a maximum of 15% from the previous day's close.

A controlled correction of nickel resulted, and "orderly" trading resumed. The pricing bands don't in themselves reduce volumes and have been gladly received "as they've put stabilizers on the market", LME said.

LME has lowered its accountability levels for nickel: over-the-counter data must now be reported on trades of more than 3,000 lots (of 6 mt each), compared to previous accountability levels of 6,000 lots, boosting visibility. The exchange admitted in an April 4 note that its "lack of direct visibility… of sizable positions in the OTC market" contributed to the March 8 disorderly trading and recognized that "not all participants agreed with the course of action undertaken" to handle the situation. One market player, roiled about the canceled trades, said business risks being lost to the Shanghai Futures Exchange (SHFE) and COMEX (CMEGroup).

Still, the new regulations will now be in place for an open-ended period and the LME reserves its right to introduce further interim measures as appropriate to ensure market stability pending the outcome of the independent review.

It believes it should prioritize implementing OTC trade reporting for all LME metals, with an appropriate first step being to extend the provision of OTC daily position reporting (now implemented for nickel) to other metals.

"The LME is committed to ensuring that the actions of all participants (including the LME itself) are fully reviewed, and appropriate actions taken to both restore confidence and support the long-term health and efficiency of the market," said CEO Matthew Chamberlain.

Retail exchanges

Retail-focused exchanges have typically already had price bands or limits in place on metals futures trading. SHFE has exercised these since their its metals contracts launched, to "safeguard" market participants, with tighter variations than those introduced recently on the LME. SHFE allows a plus or minus 3% movement in the case of steel hot-rolled coil and rebar, copper, aluminum, gold and silver; plus or minus 4% for nickel, zinc, lead, tin and stainless steel, and plus or minus 5% for steel wire rod. However, its website notes it can adjust the price limits in accordance with market risks if it sees a so-called "one-side market".

US-based CME Group, also considered a retail exchange, operates both price limits and Dynamic Circuit Breakers, or DCBs, to restrict markets "moving too far or too fast in a specific period of time." DCBs are designed to transition impacted contracts into a two-minute pre-open state upon being triggered. The upper and lower limit for DCBs is a 10% move within one hour for CME's COMEX and NYMEX metals markets. CME's clearing house continuously adjusts margins based on market volatility, while a market regulation team manages all participants' position limits. CME Group offers futures trading in coal, alumina, aluminum, iron ore, ferrous scrap, copper, zinc, gold, platinum, palladium, lead, lithium, cobalt and others.

SGX – price bands only on rubber

Singapore Exchange (SGX) in late March reported "phenomenal" trade volumes, with the underlying commodities of its derivative contracts including iron ore and coking coal experiencing considerable price volatility following Russia's invasion of Ukraine.

SGX has a range of tools to ensure an orderly market, and these will be enforced when necessary, according to director Will Chin, head of commodities. Limits may vary according to the percentage of physical market availability that a trade represents, in multiples of typical cargoes, and taking into account market players' behavior patterns.

SGX's steelmaking raw materials and steel rebar contracts cash settle on prices that reference physical market trading, reducing the risk of delivery squeezes, it says.

Market sources, however, note that iron ore and steel products may be warehoused or stored for shorter periods than non-ferrous metals due to the potential risk of rust. Iron ore and coking coal's wide variety of grades and specifications also mean, increasingly, that these are produced or shipped for specific customers' steelmaking installations, making them less of a standardized commodity than non-ferrous metals.

"Price discovery has to be rooted on a fundamental principle of willing-buyer, willing-seller basis, and the exchange is not the arbiter of what constitutes a reasonable price move. Price limits may not be an adequate parameter determining orderly trading, and are ineffective for contracts primarily traded over-the-counter and cleared on exchange," said Chin.

SGX operates price bands only on its rubber contract, which is almost 100% screen-traded, considered to facilitate trading. Iron ore, SGX's metals mainstay, with volumes creeping up year on year, is traded mainly OTC, with around 30% on-screen, while its coking coal contracts are 100% OTC.

Even before the Russia-Ukraine war put its volatility stamp on markets, iron ore was already on a roller coaster on fundamental supply-demand issues tempered by COVID-19: from a low of $78/mt in November 2019 it soared to $233/mt in May 2021 before falling back. S&P Global Commodity Insights' Platts assessed the 62% Fe Iron Ore Index at $154.65/dry mt CFR North China on April 8.

With additional reporting by Analyst Lucy Tang