4 September 2024
Dear LME market participant,
Today the LME published a white paper on enhancing liquidity. We at the LME believe that these changes are very important for the continued growth, health and transparency of our market – and I wanted to explain exactly why we feel this way.
Since 2017, we have been committed to our strategic principles of serving the physical market, ensuring fairness, increasing user choice and maximising trading efficiency, while also being led by the regulatory direction of travel. What we’re announcing today is fully aligned with these principles:
- LME market structure modernised to boost transparency and increase price competition, for the benefit of all market participants
- Protection of the daily prompt date structure and Cash price, which are crucial for physical market trading
- Introduction of industry-standard block rules with a liquidity provider programme to support on-screen liquidity
- Crossing rules and increased market data transparency for inter-office trades
- Corresponding rules for OTC lookalike trades to ensure a level playing field with the on-exchange market
To support these initiatives, we have made an unprecedented investment into our core technology, underscoring our commitment to the market. Earlier this year, we seamlessly rolled-out our enhanced electronic closing pricing methodology, which we believe has been well-received by market participants. You may also have seen that, last month (on 19 August), we made available the production test version of our new trading platform, LMEselect v10 – which is a key step in our graduated roll-out of the system, in a safe and operationally resilient manner, and which give us high confidence in fully launching in the coming few months.
The LME date structure
One of the single greatest assets of the LME is our prompt date structure. Most futures markets are monthly, only offering one physical delivery period (sometimes a single day or a range of dates) in each calendar month. The LME, by contrast, caters for physical delivery on every business day for the next three months, every week out to six months (the Wednesday of each week), and every month thereafter (the 3rd Wednesday).
We know how important this facility is for our physical clients. Moreover, we publish a “Cash price” every day, which is embedded into a vast range of physical supply contracts around the world. More broadly, the date structure allows contracts matching specific physical delivery dates, including averaging. We understand how important these bespoke dates are for our physical clients and we remain committed to supporting this offering.
A strength of the LME is that there is no inherent conflict between our unique range of bespoke delivery dates and the standard monthly structure seen on most other exchanges. This is because monthly dates (3rd Wednesdays) are naturally embedded within our date structure. Currently 75% of our total open interest (open positions) are on those 3rd Wednesday monthly dates. That comprises almost all of the positions from our financial investors but increasingly, we are aware that some physical clients also prioritise managing their hedging through monthly exposures.
The liquidity challenge
Given the LME supports both monthly and bespoke dates, is there in fact a problem to solve? We believe that there is and that problem arises from the way that users open and close positions on our market. For historical reasons, the liquid date for outright trading is our “rolling 3-month” contract. If you log on to LMEselect today (4 September), the most liquid trading date is for 4 December (i.e. in 3 months). Tomorrow, that liquid date will be 5 December.
This is a major source of frustration for clients who are looking to secure access to our monthly dates. We know that, today, many clients will want to buy and sell the December monthly date (the 3rd Wednesday in December, this being 18 December). Some will want to buy that date, and some will want to sell it. Our exchange needs to simplify that process.
Currently it is not easy because our liquid date today is 4 December, so a client requiring access to that 18 December monthly date will need to trade for prompt 4 December, and then trade an adjustment (a “spread”) to move the position to the 18 December. This requires more trades, more effort and higher fees. Indeed, many clients will not engage with that process – instead requesting that members provide them with direct monthly pricing. While that’s a valuable service, it has the effect of creating multiple liquidity pools – which will never be as efficient or transparent as a central exchange market.
The complexity for those wishing to trade monthly contracts might be justified if the 3-month rolling date convention were helpful for those looking for exposure to bespoke dates, but that’s not the reality. The point about bespoke dates is that they are just that – bespoke. A client looking for bespoke averaging will require a complex set of date adjustments – whether they open their position on the rolling 3-month date or a 3rd Wednesday. They will still require an adjustment service from a member – and our members can provide client exposure to those bespoke dates under any of those scenarios.
The solution: a block limit – improving transparency and liquidity for the market overall
How can we improve our modus operandi? Let’s consider that monthly (3rd Wednesday) December date. LMEselect already supports trading on every LME date, including monthly dates. As such, a client looking to buy or sell the December monthly date could put a bid or offer on LMEselect. But they don’t want to do this when the liquidity is not visible. We need a way to demonstrate that, if they make their orders visible, other counterparties will follow, delivering mutual benefit.
The solution to this is already implemented on virtually every other peer exchange. It is generally called a “block limit” and it means, very simply, that for small trades on liquid dates, trades are required to be executed on the central trading screen. So, for the LME, we intend to implement this for trades of 10 lots and below, for each monthly date out to one year (and carries between those monthly dates), on our five most liquid metals (aluminium, copper, zinc, nickel and lead).
Block limits in action
Let’s consider a client who wishes to buy one lot of copper on the December monthly date. Currently, that client may go directly to a member, who would quote a price of say $9,500/tonne. That price will include the member’s fees for providing the trade, clearing, credit, etc, and the member may include a margin to compensate for the proprietary risk they are taking, given that the trade may not be directly offset onto the LME. Because there isn’t always a liquid price for the December date on LMEselect, it’s difficult for the client to be confident that they are securing best-execution, and currently some clients will speak to several members to compare prices. Overall, this may not produce the best client outcome or reflect the regulatory direction of travel.
Under the new structure, the client can still approach a member who could provide a quote of say $9,500/tonne. This, however, would be an indicative price and would be broken down into the “clean” market risk price (let’s say $9,495/tonne) and an additional amount to cover credit risk, the execution commission and post-trade services (let’s say $5/tonne – please note that this figure is entirely indicative, and will depend on the full nature of the services being provided by the member in question).
If the client wants to proceed, the member will then be required to place the client’s order onto LMEselect. In this case, a bid for one lot of December copper at $9,495/tonne. Then generally one of two scenarios will occur:
- The bid stays on the screen, but nobody trades with it. After five seconds, the member will be able to match with the client bid, at the $9,495/tonne level. The member can then add the $5/tonne commission and provide the all-in trade to the client at $9,500/tonne. The client receives the same price as they would under the current model with confidence that they received best execution thus reducing the need to call around multiple members. The market also benefits from the transparent publication of the trade, providing visibility around market pricing, which also aligns with the regulatory direction of travel. In this scenario it is likely that clients can execute at better prices than before as market liquidity is pooled and clients are able to clearly see both the market price and – in the “unbundled” pricing structure – easily compare the commissions charged by different members.
- Possibly (as we build monthly contract liquidity), when the client’s bid is placed on screen, it will interact with the liquid order book. Therefore, in certain circumstances, it is possible that better pricing will be available on LMEselect because there will be offers from other clients who have a fundamental desire to sell (per this example) the December copper contract. So it may be, for example, that the client’s bid matches at an improved price – let’s say that’s $9,492/tonne. The member can then add their $5/tonne commission and the client buys the December copper at the improved all-in price of $9,497/tonne. Of course, the member may wish to be compensated for the service, but they are free to set their commission to cover this (and, again the “unbundled” pricing structure allows clients to easily compare the commissions charged by different members).
Once liquidity grows on those monthly dates, more clients may wish to simply trade directly on the screen (facilitated by their member’s market access infrastructure). But we anticipate that many clients will still wish to benefit from the direct service provided by our members and, as set out above, that is compatible with the new execution approach (but with enhanced pricing transparency and liquidity that benefits all market users).
The right way forward
We are confident that this improved transparency and price competition will yield significant benefits for three reasons:
- Firstly, we want to ensure that our existing clients looking for monthly dates have the most efficient execution experience.
- Secondly, we believe that a more efficient market structure will attract significantly more participants to the LME, thereby growing exchange liquidity and volumes to the benefit of all market participants and the LME itself.
- These enhancements align with the global regulatory trends and direction of travel.
If the client is executing a trade larger than 10 lots, the new rules won’t apply and so they can continue to execute as they are currently, especially if they are concerned that showing a large order on LMEselect could adversely move the market. However, we consider that, once liquidity starts to build on those monthly dates, it will be easier to execute larger trades on LMEselect.
If a client is looking for a bespoke date or averaging contract, then nothing will change – the client will continue to engage with their member in the same way as today. The Cash price (which we also know is crucial for physical market participants) will also continue to trade and price as it does currently. For those physical clients who use 3-month forward pricing in their contracts, we will continue to publish those prices on a daily basis – as we publish prices for every single date along our forward curve. And, because our date curve is interconnected, greater liquidity on our monthly dates will also enhance liquidity on bespoke dates.
To facilitate the above, we now look to the LME community to play their part. Enhanced monthly liquidity will benefit everyone, but it’s important that that members have the opportunity to contribute to the outcome. We know that many of our members have built “dealer-to-client platforms”, which offer proprietary monthly pricing direct to their clients. For these platforms, we will be requiring members to ensure that, where they are offering monthly prices below the block limits, their platform follow the same rules as outlined above to evidence the trades on LMEselect. Similarly, we know that some clients prefer to trade “over-the-counter” (OTC) monthly contracts with their members. And again, this will remain unchanged – but we will require members to ensure that the underlying trades are evidenced on LMEselect, even if the eventual client exposure is booked OTC. We consider that it’s fair that, if parties are using LME prices (be that on-exchange or OTC), they contribute to liquidity, transparency and price discovery.
That’s the key change. But as you will see in the whitepaper, there are a number of linked items, including providing greater transparency around all trades (including those above the block limit).
Maintaining market health and vibrancy – next steps
We are confident that the above way forward will benefit the overall market and we will proceed to implement these changes in due course. Of course, we need to work closely with the market to ensure that we make such changes as effectively as possible, and we will be hosting a series of working group meetings with LME members to ensure that the new rules work with all the myriad ways that clients use the LME. We will also allow appropriate time for all stakeholders to prepare for the new rules – we currently anticipate implementation to begin in the second half of 2025. And of course, we will consult on any rulebook changes, as required under regulation.
We do, however, wish to be clear that this is the way we will progress and enhance our market. The LME’s vibrant 147-year history has only been possible because we have continually adapted to the requirements of our market participants and allowed our end users to hedge and invest as efficiently as possible. The changes that we are setting out are the next part of our journey. We’re extremely grateful for your ongoing involvement in our market and hope that you’ll find these initiatives make your market experience more efficient and cost-effective.
Please treat this letter as a high-level summary of the whitepaper and I would encourage you to read the full document. The LME team would also be only too happy to speak or meet with you if that would be helpful.
Yours sincerely,
Matthew Chamberlain
LME CEO