The London Metal Exchange (LME) has been helping metal producers and consumers manage their price risk since 1877. The physical metals market is in our DNA and most of our base metals futures contracts offer the option of physical settlement via our licensed global warehouse network. Many of the features that make LME contracts unique evolved from and for the physical metals industry, including our daily prompt date structure, large lot sizes and the ability to actually deliver physical material.
Since 2015, the LME has launched a number of new cash-settled futures contracts focused on meeting the risk management needs of the steel, aluminium, electric vehicle and battery materials industries. Our cash-settled futures are structured differently from our physically settled contracts, yet share the same goal of providing the metals community with effective tools to manage price risk and the financial community with opportunities to trade metals markets.
While cash-settled futures are commonplace in many commodities markets, they differ from our physically settled futures in a number of ways. In this LME Insight, Kate Davey and Alberto Xodo explore cash-settled futures, how they differ from physically settled contracts and how they can be used.
LME futures contracts - key differences
|Physically settled futures||Cash-settled futures|
|Final settlement on maturity date||Settled by delivery or receipt of physical metal using LME warrants.
The Official Settlement Price is used to price physically settled LME futures contracts. It is discovered in the Ring, and is the last cash offer price from the second Ring session.
| Settled by the transfer of cash on the maturity date of the trade. The difference between the final settlement price and the fixed trade price is the amount due at contract maturity. The final settlement price is a monthly average of the spot prices published by the relevant Price Reporting Agency (PRA).
|Closing price discovery||The Closing Price is used to assess end of day valuations and calculate margins. It is determined by the LME using the relevant published price methodology.|
|Prompt dates||Daily out to three months forward, weekly out to six months and monthly out to a maximum of 123 months – depending on the metal.||Monthly – out to 15 months|
|Clearable currencies||USD, JPY, GBP, EUR||USD|
|Trading venues||Ring, LMEselect, Inter-office (telephone)||LMEselect, Inter-office (telephone)|
|Margining||Discounted Contingent Variation Margin (DCVM)||Realised Variation Margin (RVM)|
Why cash settlement?
Cash-settled futures provide the industry with the advantages of having risk management tools available even when physical settlement is not suitable or cost efficient. In the case of a low-value-per-tonne commodity like steel scrap for example, the cost of storing, insuring and financing the physical material could quickly grow to be a significant share of the total value. Under these challenging conditions, relying on physical settlement could undermine the effectiveness of the instrument as a hedging and price discovery tool. Cash-settled futures can also benefit traders and the investor community by operating more similarly to other futures markets.
How does settlement work?
Physically settled LME contracts require the exchange of physical metal using LME warrants, unless the position is closed out prior to the maturity date. If the position is taken to maturity, long position holders (ie the buyer of the contract) receive randomly allocated LME warrants (physical metal) in exchange for payment of the notional value determined by the contract price. Short position holders (ie the seller of the contract) are required to deliver physical metal of their choice and will receive payment of the notional value determined by the contract price. With cash-settled futures, there is no transfer of LME warrants or physical metal. Cash-settled futures require the transfer of an amount of cash determined by the difference between the original fixed price of the contract and the floating final settlement price (determined by the published reference price from the PRA). When the final settlement price is higher than the original contract fixed price, the long position holder (buyer) receives cash from the short position holder (seller). If the settlement price is lower, the long position holder (buyer) transfers the difference to the short position holder (seller). These transactions happen via LME Clear, the central counterparty (CCP) clearing house for the LME, which we’ll discuss in further detail below.
Physical settlementFig. 1 Physical settlement
Fig 2. Cash settlement
LME Clear is the clearing house for the LME, providing a financial guarantee to every traded contract and acting as ‘the seller to every buyer and the buyer to every seller’.
In order to provide this financial guarantee, buyers and sellers need to post margin. Whenever a new position is opened, both the buyer and the seller have to deposit a pre-defined amount of money for each lot in the position, referred to as initial margin. This deposit, which is held by the LME Clear until the position is closed out or it reaches maturity, allows the clearing house to manage default risk.
Price changes in the underlying contract create profits or losses when marked against the original trade price (in the case of physically settled contracts), or the previous night’s settlement price (in the case of cash-settled futures) of a given transaction. This price change is referred to as the variation margin. The LME operates two margin methodologies for variation margin – Discounted Contingent Variation Margin (DCVM) and Realised Variation Margin (RVM).
LME cash-settled futures utilise RVM. Under RVM, both profits and losses are exchanged between LME Clear and members daily.
LME physically settled futures, on the other hand, utilise DCVM, where losses are realised daily between LME Clear and members, but profits are only realised at the end of the contract. This is why LME physically settled futures are often referred to as “forwards” rather than futures.
Price Reporting Agencies (PRAs)
PRAs are an essential element of cash-settled futures because they provide futures contracts with one of their key ingredients – the spot price (more on this below). Selecting the most relevant PRA for any given contract, therefore, is key to its success.
Prior to each cash-settled contract launch, the LME carefully analyses PRAs to ensure that they can provide the requisite underlying reference price for each contract on the basis of several criteria, including market acceptance of their price and compliance with IOSCO standards for price discovery.
The LME works with a number of different PRAs to ensure that each contract is underpinned by the most relevant and accurate spot market price.
In addition to the current market price (ie the price at which you can buy or sell a specific instrument at any given moment), there are three types of reference prices to be aware of when trading cash-settled futures.
- Underlying spot market price from PRA – PRAs receive information and data on transactions in the spot market and use them to assess a spot market price. Spot prices are a useful data input for traders in futures markets because they provide an indication of where the spot physical market is trading today, as well as market trends. Spot prices are also vital as they are used in determining the Final Settlement Price of the LME’s futures contract (see below).
- Closing Price (also known as daily settlement price) – Discovered by the LME for each future prompt date on the basis of transactions, bids and offers, and other elements of the LME’s published pricing methodology. The Closing Price is used as an evening evaluation of positions as well as to determine the variation margin requirements and the value of open positions. On the last business day of the month, the closing price for the front month future is the same as the final settlement price.
- Final Settlement Price – A simple monthly average of the spot prices published by the PRA, used for final settlement of open positions at maturity. On the last business day of the month, this is published as the Closing Price for the front month future.
The forward curve
Forward curves are discovered for all futures contracts – physical and cash-settled – and show the prices being quoted for prompt dates beyond spot. A forward curve is in “contango” if the nearby prices are lower than the forward prices and is therefore sloped upwards. It is in “backwardation” if the nearby prices are higher than the forward prices and is sloped downwards.
The front month (the nearest expiration date to the current date) of a cash-settled futures contract is unique in the forward curve because it trades at prices that reflect two components:
- Historical known data: the prices that have already been published for the current month
- Expectations on future data points: the prices for the remaining part of the current month that are still unknown
The relative weight of the two components changes over time as more historical data points become known. For example, at the beginning of the month, market participants can only refer to their expectations of future data points, while at the end of the month, most of the data points that input into the monthly average (ie those that have already been published for that month) are known.
The forward months following the front month, on the other hand, will not have any component that is known; therefore, their price will be reflective of the latest market information and sentiment, including trades and quotes in both the physical and derivatives markets.
Fig 3. Forward curve for LME Steel Scrap on 5 July 2021. In this example, the forward curve demonstrates “backwardation”.
Hedging your metals price risk using cash-settled futures
Physical and cash-settled futures and options offer firms at all stages of the metals value chain the opportunity to hedge their price risk and gain protection from adverse price movements.
Hedging simply means establishing a financial position that is equal and opposite to an existing risk exposure, for example, on a physical commodity. Physically settled LME futures allow you to tailor your financial position to a specific daily, weekly or monthly prompt date (or personalised average period), whereas cash-settled futures allow you to hedge against a monthly average price. The simpler date structure of cash-settled futures allows for the concentration of liquidity into fewer instruments and can facilitate trade execution.
To ensure the most effective risk management, it is important to minimise basis risk between the physical exposure and the financial instrument used. This can be achieved by using the LME prices as a reference in physical supply contracts. More detail can be found in LME Insight – How are LME reference prices used in physical metals contracts?
Let’s now look at a couple of examples of hedging with cash settled futures…
Hedging a long physical position using a cash-settled futures contract
The typical example of a long physical position is a company holding inventory. A similar situation also arises when you buy at a fixed price for a future date – for example, you are a consumer of metal – you generate a long physical position, and will receive material at a previously agreed price.
The financial transaction needed to hedge the price risk is forward-selling an equivalent quantity (or fraction of it) to create a short financial position.
BatteryMaker ABC holds 100 metric tonnes of lithium hydroxide in inventory and plans to use them in three months to make a specific batch of batteries. The material was purchased for $15/kg, or $15,000 per metric tonne, and ABC would like to protect the value of this material on its balance sheet for the following three months. To hedge this position, BatteryMaker ABC decides to forward-sell 100mt of lithium hydroxide on the corresponding LME futures contract three months forward at the price of $15,000 per tonne.
For simplicity this example assumes a forward curve that is flat (ie neither in contango nor backwardation) and no transaction costs.
After three months, the price of lithium hydroxide …
|…drops to $14,000||…rises to $17,000|
With a physically settled contract, you would need to close out your position before maturity in order to avoid the need to make a delivery of physical metal (via an LME warrant) to settle the position at maturity. With cash-settled futures, there is no physical delivery so this step is not necessary.
Hedging a short physical position using a cash-settled futures contract
Hedging a short physical position works in exactly the same way as above, but in reverse.
You typically generate a short physical position if you sell at a fixed price for a future date – for example if you are a producer of metal – as you will deliver material at a previously agreed price
The financial transaction needed to hedge the price risk is forward-buying an equivalent quantity (or a fraction of it) to create a long financial position.
SteelMill XYZ agrees to sell 5,000mt of HRC for delivery in six months at the price of $1,400 per tonne to a European carmaker. To hedge this position, SteelMill XYZ decides to forward-buy 5,000mt of European HRC on the corresponding LME futures contract six months forward at the price of $1,400 per tonne.
To keep things simple, this example also assumes a flat forward curve and no transaction costs.
After six months, the price of European HRC…
|…drops to $1,200||…rises to $1,500|
As we have seen, hedging your metals price risk can be very simple with cash-settled futures. The above examples imply the use of specific LME contracts (LME Lithium Hydroxide CIF (Fastmarkets MB) and LME Steel HRC NW Europe (Argus)), but the same principle applies for all our cash-settled futures – for example, an aluminium used beverage can recycler could hedge their physical position with the LME Aluminium UBC Scrap US (Argus) contract, whilst a cobalt producer could hedge their physical position with LME Cobalt (Fastmarkets MB).
Accessing the LME
Whether you are an industrial hedger, physical market trader or financial investor, accessing the market via an LME member is simple.
For direct access, an account with an LME category 1, 2 or 4 member is required. Clients who have successfully opened an account with an LME member are able to trade with and through them to access the market.
Trades in the cash-settled futures can be executed in various ways. Some common execution options are:
- Electronically via an LME member’s or independent service vendor’s trading platform, which is connected to LMEselect
- Execution of trades in the interoffice market (usually agreed via telephone, instant messaging or email) directly with your clearer
- Execution of trades in the interoffice market via an LME member that is not your clearer (this will require what is known as a “give-up” agreement to be put in place beforehand)
- Execution of trades in the interoffice market via a Registered Intermediating Broker (RIB) – this requires the appropriate permissions through your clearer to be in place beforehand.
Find a full list of LME members who offer clearing of LME cash-settled futures here.
LME cash-settled futures contracts
Despite the differences outlined in this LME Insight article, all LME futures contracts share the same goal of providing the metals value chain with the opportunity to hedge and the financial community with opportunities to trade metals markets. It’s what we’ve been doing for over 140 years and we continue to launch new contracts to meet the needs of the industry to this day. As of 19 July 2021, the LME offers cash-settled futures for ferrous, minor metals, aluminium products and EV and battery materials:
LME Alumina (CRU/Fastmarkets MB)
LME Aluminium Premium Duty Paid European (Fastmarkets MB)
LME Aluminium Premium Duty Unpaid European (Fastmarkets MB)
LME Aluminium Premium Duty Paid US Midwest (Platts)
LME Aluminium UBC Scrap US (Argus)
LME Cobalt (Fastmarkets MB)
LME Lithium Hydroxide CIF (Fastmarkets MB)
LME Molybdenum (Platts)
LME Steel HRC FOB China (Argus)
LME Steel HRC N. America (Platts)
LME Steel HRC NW Europe (Argus)
LME Steel Rebar
LME Steel Scrap
LME Steel Scrap CFR India (Platts)
LME Steel Scrap CFR Taiwan (Argus)
Full details of all LME contracts are available here.
To support the industry and those new to hedging, the LME offers a broad variety of educational materials and opportunities, including webinars, virtual training and educational courses. Find out more here.
For more information on accessing LME cash-settled futures, please contact the LME Sales team.