Chinese tycoon Xiang Guangda was certain the price of nickel was going to fall. The owner of steel producer Tsingshan Holding Group, who is nicknamed Big Shot, had amassed a large short position on the London Metal Exchange (LME). He had taken out futures contracts that would profit if the price of nickel fell. In early March, as Russia – the world’s third largest nickel producer – waged war in Ukraine, the price of nickel shot higher, leaving Xiang scrambling to post more collateral to meet the margin calls that would cover his short position.
By the end of March 7, the price of nickel had risen to just under $50,000. The next morning however, before anyone had even gathered at the LME’s circular trading pit in the heart of the City of London, the price had surged again, this time to more than $100,000 a ton – a roughly 250% jump in the space of 24 hours. Shortly after, the LME decided to pull the plug. It suspended trading – the first time it had done so since the tin crisis in 1985.
Yet the LME then went one step further, not only suspending trading but canceling all trades that had taken place that day – some $3.9bn of them, according to Bloomberg.
Xiang was effectively given a reprieve, while investors who had taken the other side of the trade and had correctly bet on nickel prices rising saw some substantial profits vanish as quickly as they had arrived. The LME reset prices to the previous day’s close.
The fallout was swift. Traders took to Twitter to vent their frustration. Founding principal of AQR Capital Management, Clifford Asness, tweeted that it was an excuse for the LME’s outright favoring of some clients over others, calling them “slime balls”.
The debate rumbles on
“There is a question mark over whether the LME took its eye off the ball,” says Andrew Mitchell, Head of Nickel Research at consultancy firm Wood Mackenzie. “There were certainly pointers the day before, if not two days before, that things were not right. So it was primed to go and one feels that a little bit of an investigation or thinking about what was going on before trading opened the next day would have been a more sensible option.” Some market watchers believe the LME was trapped in a no-win situation – if it hadn’t canceled the trades, the aftermath could potentially have been much worse.
“Probably, from the LME’s perspective, the cancellation – which it knew would result in a firestorm – was better than the alternative, which quite plausibly could have been the failure of the exchange,” says Craig Pirrong, a professor at the University of Houston’s Bauer College of Business and an expert in commodity markets economics.
With prices soaring upwards of $100,000 a ton, traders caught on the wrong side of the price moves would have struggled to pay their margin calls or afford to close out their trades, and the exchange’s clearing house wouldn’t have the funds to cover prices at those levels.
“The losses have to be allocated somehow and so if the contracts hadn’t been canceled as they were, they would have been torn up some other way. And there would have been collateral damage as well.”Craig Pirrong, professor, University of Houston
“The clearing house would go bust and there are questions about how that would be resolved,” explains Pirrong. “The losses have to be allocated somehow and so if the contracts hadn’t been canceled as they were, they would have been torn up some other way. And there would have been collateral damage as well – likely some brokerage firms would have become insolvent, so it would have been a mess, and that clearing up would only be starting now. It would be a tortuous process.”
The LME’s decision to cancel the trades is also not entirely without precedent, with most exchanges reserving the right to scrub trades they deem to be uneconomic, says Jeffrey Harris, a professor at the American University’s Kogod School of Business and former chief economist at the US Commodity Futures Trading Commission.
“In most of the futures pits, when we used to do things verbally and yelled things across the floor, there was always a whole set of call out trades where people didn’t agree on terms and those would get canceled,” says Harris. “And then there’s also a lot of ‘fat finger’ errors in electronic trading, where somebody might miss out a decimal point. So exchanges usually reserve some right to be able to cancel those, but that doesn’t mean it’s not without controversy.”
Did the LME miss a trick?
What the LME was missing, however, were some common safety measures that could have prevented nickel prices from boiling over and the market unraveling.
“Most exchanges have a daily price limit to make sure that these sorts of price spikes don’t happen,” says Harris. “That’s common in most commodity markets, particularly where there can be extreme events, such as crop failures and other weather-related impacts. So it’s a little bit unusual not to have price limits in place.”
The LME also lacked a joined-up view of positioning and how traders and brokers were potentially exposed to any sudden price shocks.
“This whole episode was an example of extreme concentration risk – concentration risk that, to some extent, was masked from the LME,” says Pirrong. “Tsingshan apparently was doing its over-the-counter trading through multiple LME members. So, even though the LME would have seen the futures positions that, say, JPMorgan held to hedge its exposure to its counterparty, it wouldn’t have necessarily known that all of those futures positions it was seeing were essentially offset by OTC positions facing the same entities.”
Part of the problem is that market participants pushed back on having to give up information that might reveal their trading strategies.
“The LME had wanted it but it had never been able to or had the will to impose it,” says Pirrong. “Now the catastrophe has allowed them to put those measures in place, but it’s sort of shutting the barn door after the horse has bolted.”
“As long as the procedures are followed by the exchange and there has been an independent assessment of whether or not a trade was viable and whether or not prices were reasonable at the time, it’s hard to see how they might be held liable.”Jeffrey Harris, professor, Kogod School of Business
Some traders have responded by filing lawsuits against the LME. US hedge fund Elliott Management is suing the LME for more than $456m, while trading firm Jane Street is suing for just over $15m. But some experts think these legal punches might be difficult to land.
“As long as the procedures are followed by the exchange and there has been an independent assessment of whether or not a trade was viable and whether or not prices were reasonable at the time, it’s hard to see how they might be held liable,” admits Harris. “That’s not to say it wouldn’t be possible if there was evidence that somebody had called the exchange and said ‘I’ve lost a ton of money, can you cancel this’ and they acted on that – that would be a different story.”
While the LME’s reputation has taken a battering from the debacle, in part because of the perception it had bailed out Tsingshan and its banks at the expense of other market participants, it remains the only viable venue where traders can hedge nickel prices.
“The exchange effectively provides a market of last resort for metals, but there is no alternative. If you want to bet on nickel, you don’t have a choice of where to go,” says Mitchell.
Potential conflicts of interest
“It’s going to take a long time to restore confidence,” says Pirrong. “Historically, the LME has had more than its fair share of controversies. It had the tin crisis in the 1980s. Then the acquisition by Hong Kong Exchanges in 2012 caused it a reputational hit.”
The episode has also reignited debate about the ownership of exchanges and potential conflicts of interest that arise.
“Once you have a commodity exchange that’s a commercial enterprise, rather than being mutually owned, then there will always be a question about whose side is the exchange on,” explains Harris. “That feeds back into its reputation. If an exchange is not acting independently, then it runs the risk of running into liabilities or its reputation being permanently hit.”