January/February 1989
Its influence spans the globe:
From North America to Africa to Russia, the LME's century-old traditions
combined with its sense of urgency about the future make it an institution
worth understanding. Read on.
By Si Wakesberg
Si Wakesberg
is a New York City-based consultant to the Institute of Scrap Recycling
Industries.
When the bell rings for the start of the
day's trading on the London Metal Exchange (LME), its peals echo in the
most distant Asian and African metal markets. For the LME is an
international exchange and its daily activities in copper, aluminum, lead,
zinc, nickel, and silver are sent out over tickers, teletypes, and
computers to metals offices throughout the world. Among metal exchanges,
the LME has the widest scope: Even the Soviet Union and some of the
Eastern Bloc countries conduct business on this exchange.
The
LME residually affects untraded metals and scrap. For example, stainless
steel is the major consumption base for nickel, scrap aluminum is used as
a substitute for virgin aluminum by some producers, and both are
influenced by price trends on the LME. In addition, in Europe, lead
battery scrap is priced based on LME lead prices.
On
a visit to the London Metal Exchange a few years ago, after it had moved
into its present location at Plantation House, I was impressed by its
modern look and operational efficiency. It had been housed for 98 years at
its historic Whittington Avenue address before relocating in 1980, and
Michael Brown, LME chief executive, was eager to show me the latest
computers and electronic equipment.
Despite
the LME's ultra-modern, varnished look, however, the feeling of tradition
is what lingered in my mind. Before the LME's establishment in 1876,
merchants met in London coffeehouses to trade in commodities, sitting in a
ring drawn on the sawdust floor. The sawdust is gone, but the ring still
exists at the LME. And business is still done by what is known as
"public outcry," similar to an auction method but somewhat more
complex. To an outsider it may seem like a cacophonous babble, but to the
professionals in the ring it translates into smooth business
communication.
The
LME Metals
Over
the years there have been changes in both the kind and quality of metals
traded on the LME. Copper and tin were among the earliest commodities
listed on the exchange, as was pig iron. Later, pig iron ceased to be
traded but lead, zinc, and silver were added. In 1978, the aluminum
contract was introduced. Aluminum had an uphill struggle at the beginning
because its turnover was slim and trading was sluggish. But back in 1982,
Michael Brown predicted, "Existent producer opposition will lessen as
time goes on, and what's happened in copper will also happen in
aluminum." His prediction was correct, especially during 1987 and
1988 when LME aluminum prices dominated international markets. Nickel
trading began in 1979; here, too, the influence of LME prices has been
spectacular.
The
exchange suffered a serious setback in 1-985, when the large default by
the International Tin Council took place. Many ring-dealing members were
financially affected by this, resulting in numerous lawsuits and
government intervention. As a result, tin trading on the LME has not
resumed.
One
consequence of the tin fiasco was the passage of the Financial Services
Act of 1986 and the establishment of a clearing house system for the LME.
(COMEX has always had such a system.) The clearing house is an independent
corporation, with substantial capital, 'composed of exchange members,
which assures performance of all contracts. All ring-dealing members must
also be clearing house members.
The
LME has made other changes, particularly in the type of material accepted
in its contracts. It is currently phasing out its standard-grade contracts
in copper and aluminum, replacing them with higher-grade contracts. It is
also phasing out its silver contract.
How
to Trade on the LME
The
latest LME membership list shows 21 ring members, a drop from the 36
listed in 1987. Ring members must be incorporated in the United Kingdom
with an established London office.
Interestingly,
LME statistics show that 80 percent of the ring-dealing members either are
overseas companies or are affiliated with overseas companies. Other
categories of membership on the exchange include associate broker clearing
members, associate broker members, associate trade members, and individual
members.
LME
trading occurs during morning and afternoon sessions, both of which have
two trading periods of five minutes for each metal. For example, the day's
first copper trading session begins at noon and ends at 12:05 p.m.; it
resumes at 12:30 p.m. and ends again at 12:35 p.m. Trading in Grade A
copper starts at 3:30 p.m. and ends at 3:35 p.m., then occurs from 4:15
p.m. to 4:20 p.m. All sessions are followed by "kerb trading,"
during which all metals can be traded. In early days, after trading was
ended in the coffeehouses, the merchants adjourned outdoors--on the "kerb"--for
additional business. Although those activities have been moved indoors,
the term "kerb trading" remains.
Trading
takes place in minimum quantities of 25 metric tons (mt) for copper,
aluminum, lead, and zinc and 6 mt for nickel. The LME prices some
commodities (like nickel) in dollars, and others (like copper) in pounds
sterling.
Expanding
the Warehouse System
LME
officials say the LME is ultimately a physical market where metals can be
bought and sold at any time. They point out that delivery to a buyer from
an LME-approved warehouse is guaranteed and that the quality must be a
brand listed by the LME and independently assayed so as to meet LME
contract standards.
Where,
however, are the warehouses from which the material is to come? Until
recently, the only delivery points were in the U.K. or in Europe. But as
the LME's trading in aluminum and nickel broadened, the desirability of
Far East delivery points grew. In 1987, the LME established a Singapore
delivery point; last year, there were negotiations to set up warehouses in
Japan, a move that is expected to be realized this year. There also has
been talk that the LME is seeking to establish warehouses in the United
States.
The
LME issues a warrant, or document of title to metal stored in an LME-registered
warehouse, to a purchaser. The delivery date is the date on which a metal
must be delivered to fulfill a contract. (Incidentally, on the LME, the
futures contract is three months and expires at the end of that period.)
A
Look at Hedging and Speculation
In
Shakespeare's The Merchant of Venice,
the merchant Antonio believes he has been financially ruined because his
ships, carrying valuable commodities, have been lost at sea. This need to
alleviate the risk of transporting goods over water for extended periods
of time gave rise to the establishment of futures exchanges. Every futures
exchange uses "hedging" as a kind of insurance against losses
incurred through price fluctuations.
Hedging
is defined as the establishment of a position in the futures market equal
to and opposite from that held in the cash (spot) market. For example, an
owner of a commodity in the spot market sells an equivalent quantity of
futures as a hedge. This is called a "selling hedge" and he is
said to have a "long position." "Going short," on the
other hand, means initiating a transaction by the sale of futures first,
without prior purchase of the commodity.
LME
officials contend that because hedging transactions on the LME can be
accurately related to physical trading, the exchange attracts hedging
business from all over the world. Some large producers in recent years
have availed themselves of the LME's hedging opportunities, but there is
still opposition by others.
The
uptrend in metal prices this year has been staggering. One reason to which
the pace of the market is ascribed has been the increase of speculative
activity on the LME. At a 1988 Institute of Scrap Recycling Industries
roundtable, Mo Ahmadzadeh, president of Rudolf Wolff & Company, Inc.,
New York City, was asked, "Don't you think the price volatility of
nickel on the LME this year has given rise to apprehension in industry
quarters?" He answered, "I think when people talk about price
volatility on the LME they really mean price visibility, since the LME is
the most visible barometer of prices each day."
Exchanges
(including the LME) admit that speculators play a vital role in their
trading operations, taking risks in order to garner profits. Unlike the
hedger, the speculator stands to lose his investment if his guess is
wrong.
LME
publications and books on futures trading warn speculators of the rough
waters ahead. From the viewpoint of LME leaders, though, speculators bring
liquidity to a market, absorbing the risk that the trade hedger seeks to
avoid. According to some merchants, when speculators leave the market the
volume of contracts traded thins out.
Here
to Stay
If
producers in past years were stubborn opponents of the LME, that
opposition seems to have largely dissipated. Earlier this year, David J.
Anderson, president of International Nickel Inc., Saddle Brook, New
Jersey, said, "The LME ... appears to be the only alternative pricing
method feasible currently. ... It's quite apparent that the LME is the
only practical mechanism that can reflect a world price level for
nickel."
Paul
H. O'Neill, chairman of the Aluminum Company of America (Alcoa),
Pittsburgh, in an interview for Scrap
Processing and Recycling, said, "We see the LME as an exchange
mechanism like any other commodity exchange, one that serves a useful
market function. The LME reflects world market conditions, but I don't
believe it dominates the aluminum market. Yes, Alcoa uses the LME--let's
say in the same way a grain producer would use its exchange."
On
the other hand, Charles de Kersaint, executive vice president of
Eramet-SLN (formerly called the Societe Metallurgique le Nickel), Paris,
opposes LME-based nickel pricing and calls for "long-term,
ceiling-floor contracts" between producers and mills.
No
doubt the LME will continue to be a source of controversy in metal
circles. Last year's dramatic upsurge in prices of aluminum, nickel, zinc,
and copper added fuel to the fire. But most metalmen see the London Metal
Exchange as an established and accepted metals price barometer. With
modernization of its operations, establishment of high-grade contracts,
and expansion of its warehouse system, it appears that the LME will exert
even more influence on the metals markets as we move into the 1990s.
Its influence spans the globe: From North America to Africa to Russia, the LME's century-old traditions combined with its sense of urgency about the future make it an institution worth understanding. Read on.