There should not be a lengthy discussion on what investors want from a metals exchange or futures contract—liquidity, liquidity, and liquidity. We use the word three times for each liquidity form that attracts trading. It does not matter if you are a hedger or speculator; the demand is the same; deep liquidity, so the cost of transacting is low.
Three Types of Liquidity
• Liquidity from tight bid-ask spreads.
• Liquidity from the low transaction, hedging, and processing costs.
• Liquidity from deep markets that will not move when size is entered.
Liquidity just does not appear. It is a function of the structure surrounding the market. The rules of the game matter if you want to create liquidity, so the new discussion paper from the LME is a provocative approach to open a discussion on market structure (LME Discussion Paper on Market Structure – April 2017).
The paper is a description and justification of the current LME environment but also a call for help from investors to ask what they may need for a better market structure. This paper may be the best description of the current LME structure, but it also clearly shows how it is out of step with other futures markets. The recent sale of the exchange for over $2 billion suggests that the buyers are looking for a return on their investment. They want to provide an exchange service, but they also want to make a profit.
When we talk about liquidity in the context of three types, we discuss three cost levels. First, the bid-ask spread is the immediate market transaction cost. There are also a set of costs that affect any transaction. We call this the structural costs. Finally, there is the implicit cost associated with deviations from fair value. Of these three costs, the structural costs associated with market mechanics can be controlled by an exchange. If the cost of trading on an exchange is minimized, the result will be deeper markets with lower bid-ask spreads.
LME Market Structure and Challenges
So what impacts the trading structure? For an exchange, we can explicitly focus on a few areas.
1. The contracts that are offered, the terms and conditions. For most exchange markets, there are limited futures contract expirations. The LME is different from other exchanges in how they offer contracts. The focus is on the hedger/producer and their business needs, not the speculator, who would like a more focused set of market contracts. The dispersed set of LME contract expirations may limit liquidity. For example, a three-month contract offered every week creates less liquidity if you try and sell before expiration.
2. The margin system. Again, given the focus on producers, the margin payment system is different, with present valuing back to cash price and not the daily market-to-market process found in most other futures contracts. This impacts the actual cash outlay and the cost of trading at the LME, making it more expensive to be a short-term trader.
3. The actual prices charged for using the exchange. The cost of trading the LME is higher than other futures contracts.
Drivers of Market Structure
The drivers of the market structure have been the ease for commercial users who price against the LME and not speculative accounts that can increase volume; the current contracts specs reduce the potential basis risk and allow for more direct hedging at the expense of volume. Moving to more “standard” futures may help with speculative activity but harm hedger opportunities. It is a balancing act for any exchange, but the LME wants to touch this issue directly through the engagement of all traders. This is an interesting experiment. We wish them well.