Streetwise Professor

March 11, 2022

A Nickel is Now Worth a Dime: Is the LME Too?

Filed under: China,Clearing,Commodities,Derivatives,Economics,Energy,Regulation,Russia — cpirrong @ 12:18 pm

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.

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  1. Russian Debt Default? Even in the smoothest of economic waters, does anybody really believe the Russian government doesn’t run a high risk of defaulting on its debt? They seem to have a lot of practice at this over the past couple hundred years. Nothing like an unnecessary war that they started as a great excuse to do it again.

    How does the Chinese nickel bet compare to the Hunt brothers trying to corner the silver market in ~ 1980? Was it more sophisticated and just poorly timed, or was “Big Shot” Guangda just as dumb as the Hunts? And does Big Shot also look like a young Jabba the Hut just as “Bunkie” Hunt did?


    Comment by Joseph Bonner — March 11, 2022 @ 2:45 pm

  2. So a Chinese casino is being screwed by a Chinese gambler. Film at 11.

    Comment by philip — March 11, 2022 @ 7:34 pm

  3. @prof
    Doesn‘t the fact that the guy could not get broker loans to meet the margin calls suggest that the amount owed is more than 2 years production (an unsecured loan for 2 years out, doesn‘t sound unfeasible to me)?
    Further, maybe the problem is compounded by margin calls in other markets (Aluminium) and nuckelndem just the tip of the iceberg…

    Comment by Viennacapitalist — March 12, 2022 @ 4:02 am

  4. There has to be a better way.

    Hopefully those interested purely in trading physical metal will finally get fed up with the shenanigans and failures and create a durable work around. I can’t think of a better outcome than these joke ‘exchanges’ close as a result both of irrelevance and of having their arses handed to them in court.

    Comment by Ex-Global Super-Regulator on Lunch Break — March 13, 2022 @ 2:55 am

  5. The photos are great though. While working at the Global Super-Regulator, I kept on my desk a pic from the exchange of those mad lads on the red benches, and those behind them with a phone at each ear, which looked like a scene from a Renaissance painting. I’ve found it, I’ll try to paste a link to it without melting down your server.

    Comment by Ex-Global Super-Regulator on Lunch Break — March 13, 2022 @ 3:03 am

  6. Do a search for the phrase ‘London Metal Exchange chief executive to step down’, and then press the ‘images’ button. Pic (and story) are from January 23, 2017.

    Comment by Ex-Global Super-Regulator on Lunch Break — March 13, 2022 @ 3:05 am

  7. Tin-foil hat time:

    Tom Luongo over at Gold, Goats and Guns conjectures that it isn’t an accident that the Chinese-owned LME has just blown itself up, nor that the plunger was pressed by a Chinese tycoon. It occurred to me early that the Chinese could solve this very quickly, the way they ‘solved’ the market meltdown in Autumn 2015: invite any portfolio manager who dared even to think of selling their positions to the Ministry of State Security for tea and scones, indefinitely. But they haven’t – indicating to me that Beijing at least doesn’t have a problem with what the tycoon is doing. What better way to destroy the credibility of the commodity markets in London (and New York and Chicago) than to reveal them to be dysfunctional – and not a patch on your orderly markets over in Shanghai.

    Things are moving very quickly across a wide range now. It seems that Putin’s sending his tanks to Kiev may be just the most visible element of what is a much larger, coordinated push-back against the west, across all fronts. Everyone is being asked to choose sides, with that choice affecting vital fundamentals such as access to energy, food, and metals. And the White House is completely on the back foot, with a senile machine politician at the helm. Amazing to watch.

    Comment by Ex-Global Super-Regulator on Lunch Break — March 14, 2022 @ 4:19 pm

  8. Craig, I’ve wondered about regulators dealing with liquidity squeezes by…reducing liquidity. I’m no expert in the this (especially with regards to metals) so don’t roast me please but my observations are that when the market gets volatile (in the possibly incorrect sense that prices move a lot and fast in one direction rather than just up and down frequently), the intermediaries in the futures/hedging chain [that is the exchanges, the clearing brokers and financing banks etc] all engage in a race for more security from the principals.
    This may take the form of either reducing credit limits or demanding more collateral/credit support for positions. The exchanges do this too, witness the ICE’s doubling of IM requirements on Gasoil over the weekend. Natural that these parties worry about their own protection but doesn’t this actually reduce liquidity?
    Basically it makes it more expensive or even impossible for some otherwise sound market participants to continue to trade, reducing market liquidity and concentrating the market among fewer players…presumably with big axes (or worse, egos) to wield. If the small and medium size producers/consumer/hedgers who provide market diversity and liquidity are forced out then I guess it does turn the place into a rigged casino…and commenter #4 might have a very good point. The analogy I used when explaining to a civilian was trying to solve traffic problems on the motorway by making everyone drive much faster and closer together…
    I guess my real question is that presumably all of this is entirely predictable? Is the system actually designed to fail or just its regulation?
    And who will get rescued…the small physical market particpants who use commodity exchanges as genuine price risk management tools or the gamblers and charlatans who are respnsible for these types of mess in the first place?

    Comment by John — March 14, 2022 @ 4:19 pm

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