Column: Court case shines a harsh light on London Metal Exchange

LONDON, June 23 (Reuters) – The first part of the London Metal Exchange’s (LME) courtroom drama is over after three days of legal argument at London’s Royal Courts of Justice.

The LME, owned by Hong Kong Exchanges and Clearing (0388.HK), now awaits judgment on whether its cancellation of nickel trades on March 8 last year was lawful.

U.S.-based hedge fund Elliott Associates and market maker Jane Street Global Trading (Jane Street) argue its action was unlawful and are demanding $472 million in damages.

The 146-year-old exchange contends it was justified in closing the market and cancelling trades because $19.7 billion of margin calls would otherwise have triggered a “death spiral” of member defaults.

The legal spotlight has not been kind to either the LME or its chief executive Matthew Chamberlain, who made the fateful decision that the nickel market had become disorderly.

How to define that word is a tricky question.

Two other tricky questions emerging from the court proceedings are why no-one spotted the nickel storm coming and why such a momentous decision came down to one man’s call.

DISORDERLY, IRRATIONAL OR BOTH?

LME three-month nickel closed at $50,300 per tonne on March 7. Chamberlain viewed the price as rational given the heightened speculation around the possible sanctioning of Norilsk Nickel metal after Russia’s invasion of Ukraine at the end of February.

The LME’s Special Committee, tasked with overseeing emergency situations, agreed.

When Chamberlain woke the next morning at 05:30 London time, nickel was breaking up through $60,000 per tonne. Fifteen minutes later it breached $70,000 and then accelerated up to $101,365 per tonne at 06:08 before plunging back to $80,010 in the space of seven minutes.

Based on the scale and speed of price move and the absence of any Russian news, “there was no doubt in my mind that the market had become disorderly,” Chamberlain said in court documents.

What he didn’t know at the time was the LME’s own operations team had removed nickel price bands during the early Asian trading hours, which contributed to the market wildness, according to Elliott and Jane Street.

The bid-ask spread on the LME’s Select platform reached $5,500 per tonne and the average price impact of a one-lot order widened to over $225 per tonne during the spike, according to consultancy Oliver Wyman’s independent review of the March meltdown.

Somewhat surprisingly given the extreme volatility, “almost a thousand lots traded at a price over $95,000/t between 06:00 and 06:26,” as short position holders reduced their exposure, the review said. A net 1,400 lots of short positions were covered by the time the market was suspended at 08:15.

Xiang Guangda, the charismatic head of China’s Tsingshan Holding Group, has attracted much media attention for being the big nickel short. But he wasn’t alone. The Oliver Wyman report identified “two main buyers that had been risk-reducing in the run-up”.

This was the climax of the short squeeze that had been building over the previous days and weeks.

It was ugly, bordering on the disorderly, and, without any inside knowledge, seemingly irrational.

However, as John Maynard Keynes famously quipped, markets can remain irrational longer than you can stay solvent.

As several LME members were experiencing under the crushing weight of ever expanding margin calls.

DIDN’T SEE IT COMING?

The existence of at least once big nickel short wasn’t exactly a secret in the market. Bloomberg outed Xiang in a Feb. 14 article.

The LME, however, said it was unaware of the size of the shorts held by Xiang and others because the bulk of the positions were sitting in the over-the-counter (OTC) shadows rather than on the LME itself.

Only after trading had been suspended and the decision taken to cancel all morning trades did the LME investigate Tsingshan’s OTC positions, allowing it to understand the full picture.

This suggests a yawning information disconnect between exchange and market.

The LME compliance department, it seems, may be proficient at monitoring on-exchange trading activity but doesn’t have an ear to the ground, or at least in the bars frequented by LME traders.

It lacked what security agencies term “human intelligence” that would make sense of its “signals intelligence”.

IT’S LONELY AT THE TOP

The LME employed 310 people as of the end of December 2022 yet the full weight of the exchange crisis was largely borne by one man.

Within an hour of waking on March 8 Chamberlain was fielding a series of calls and e-mails from panicked members worried about the impact of the price rise on the next round of margin calls.

LME nickel crisis had turned into potential LME clearing house crisis with Chamberlain having to juggle both parts of the meltdown while also being a nickel market specialist.

Alternative counsel doesn’t appear to have been given. And alternative pathways were missed, according to Elliott and Jane Street.

They argue that the LME Clear rule-book has a provision for setting variation margin at a level other than last price if that price is deemed to be unrepresentative.

Using the previous day’s close as a basis price for margining would have cut the collective pain from $19.7 billion to $570 million.

The LME argues that this would still have caused member defaults after the scale of previous margin calls, leaving it no choice but to go down the trade cancellation route.

NICKEL CRISIS PAST

Underlying the legal complexities of the case is the simple truth that the LME seems to have lost touch with the reality of the market it serves.

Large OTC positions are nothing new in the metal markets. Some LME members even structure their business models this way, creating dark liquidity pools that co-exist with the exchange.

The market knew the heightened risks around the big nickel shorts but the LME didn’t. When did the two stop speaking?

When the LME last suspended its nickel contract in 1988 after a blow-out on the official ring session, an emergency board meeting was convened.

Most board members excused themselves due to conflicts of interest. The handful that remained, as one participant later recalled, knew nothing whatsoever about what was going on in the nickel market so decided to call everyone else back into the room.

There the board directors, most of them market principals and all of them self-confessedly conflicted, hammered out a deal to allow nickel trading to resume in the afternoon ring session.

It wouldn’t happen these days.

But no-one got sued and there was no nervous wait for a court judgment.

The opinions expressed here are those of the author, a columnist for Reuters

Editing by David Evans

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