Streetwise Professor

If you use the official LME nickel and copper prices from Monday, before the exchange stopped trading of nickel, you can determine that the value of the metal in a US nickel coin is worth a dime. As the shutdown lingers, one wonders whether the LME is too.

The broad contours of the story are understood. A large Chinese nickel firm (Tsingshan Holdings, largest in the world) was short large amounts of LME nickel, allegedly as a hedge. But the quantity involved seems very outsized as a hedge, representing something like two years of output. And if the position was concentrated in nearby prompt dates (e.g., 3 months) it involved considerable curve risk.

The Russian invasion juiced the price of nickel, not surprising given Russia’s outsized presence in that market. That triggered a margin call (allegedly $1 billion) that the firm couldn’t meet–or chose not to. That led its brokers to try to liquidate its position in frenzied buying on Monday evening. This short covering drove the price from the close of around $48,000 to over $100,000.

That’s where things got really sick. The LME shut the nickel market. It was supposed to reopen today, but that’s been kicked down the road. But the LME didn’t stop there. It decided that these prices did not “[reflect] the the underlying physical market,” and canceled the trades. Tore them up. Poof! Gone!

Now in a Back to the Future moment echoing the 1985 Tin Crisis, the LME is trying to get the longs and shorts to set off their positions. “Can’t we all just get along?” Well likely not, because it obviously requires agreeing on a price. Which is obviously devilish hard, if not impossible given how much money changes hands with every change in price. (In my 1995 JLE paper on exchange self-regulation, I argued that exchanges historically did not want to intervene in this fashion even during obvious manipulations because of the rent seeking battles this would trigger.)

So the LME remains closed.

Some observations.

First, told ya. Seriously, in my role as Clearing Cassandra during the Frankendodd era, I said (a) clearing was not a panacea that would prevent defaults, and (b) the clearing mechanism was least reliable precisely during periods of major market stress, and that the rigid margining mechanism is what would threaten its ability to operate. That’s exactly what happened here.

Second, clearing is supposed to operate under a “loser pays/no credit” model. That’s really something of a misconception, because even though the clearinghouse does not extend credit, intermediaries (brokers/FCMs) routinely do to allow their clients to meet margin calls. But here we evidently have a situation in which the brokers (or Tsingshan’s banks) were unwilling or unable to do so, which led to the failure of the loser to pay.

Third, by closing the market, the LME is effectively extending credit (“you can pay me later”), and giving Tsingshan (and perhaps other shorts) some time to stump up some additional loans. Apparently JPM and the Chinese Construction Bank have agreed in principle to do so, but a deal has been hung up over what collateral Tsingshan will provide. So the market remains closed.

For its part, Tsingshan and its boss Xiang “Big Shot” Guangda are hanging tough. The company wants to maintain its short position. Arguably it has a strong bargaining position. To modify the old joke, if you owe the clearinghouse $1 million and can’t pay, you have a problem: if you owe the clearinghouse billions and can’t pay, the clearinghouse has a problem.

The closure of the market and the cancelation of the trades suggests that the LME has a very big problem. The exact amounts owed are unknown, but demanding all amounts owed now could well throw many brokers into default, and the kinds of numbers being discussed are as large or larger than the LME’s default fund of $1.2 billion (as of 3Q21 numbers which were the latest I could find).

So it is not implausible that a failure to intervene would have resulted in the insolvency of LME Clear.

The LME has taken a huge reputational hit. But it had to know it would when it acted as it did, implying that the alternative would have been even worse. The plausible worst alternative would have been a collapse of the clearinghouse and the exchange. Hence my quip about whether the exchange that trades nickel is worth a dime.

Among the reputational problems is the widespread belief that the Chinese-owned exchange intervened to bail out Chinese brokerage firms and a Chinese client. To be honest, this is hard to differentiate from intervening to save itself: the failure of the brokerages are exactly what would have brought the exchange into jeopardy.

I would say that one reason Xiang is hanging tough is that the CCP has his back. Not CCP as in central counterparty, but CCP as in Chinese Communist Party. That would give Tsingshan huge leverage in negotiations with banks, and the LME.

So the LME is playing extend and pretend, in the hope that it can either strongarm market participants into closing out positions, or prices return to a level that reduce shorts’ losses and therefore the amounts of variation margin they need to pay.

I seriously wonder why anyone would trade on the open LME markets (e.g., copper) for reasons other than reducing positions–and therefore reducing their exposure to LME Clear. The creditworthiness of LME Clear is obvious very dodgy, and it is potentially insolvent.

Fourth, in an echo of the first point, this episode demonstrates that central clearing, with its rigid “no credit” margining system is hostage to market prices. This is usually presented as a virtue, but when markets go wild it is a vulnerability. Which is exactly why it is–and always was–vain to rely on clearing as a bulwark against systemic risk. It is most vulnerable precisely during periods of market stress.

All commodity markets are experiencing large price movements that are creating extraordinary variation margin flows, potential positive feedbacks, and the prospect for troubles at other clearers. Further, the broader economic fallout from the Ukraine war (which includes, for example, a large recession resulting from the commodity price shocks, or a Russian debt default) has the real potential to disrupt equity and bond markets. This would put further strains on the financial markets, and the clearing system in particular. Central Banks–notably the Fed–had to supply a lot of liquidity to address shocks during the Covid Panic of March 2020. Two years later, they may have to ride to the rescue again.