Understanding the LME

As a truly international market, with some 95 percent of its business coming from overseas, the LME is a significant contributor to the United Kingdom’s invisible earnings. Recent surveys suggest a current contribution in excess of £250 million annually emanating from an annual turnover in excess of £2 trillion sterling.

Firmly entrenched in the world’s nonferrous base metals market, the Exchange owes much of its considerable success to its continued commitment to being a trade-oriented market, with the vast majority of its turnover coming from producers, processors and consumers of base metals.

Consequently, the LME acts as a barometer of supply and demand for metals worldwide and its official prices are used by industry as the basis price for contractual purposes. These prices can in turn be protected by hedging on the Exchange through a variety of futures and options contracts.

HISTORY OF THE LME

The Exchange, which is more than 120 years old, was formed as a direct result of the Industrial Revolution of the 19th century. This industrialization in Britain led to the import of large quantities of metal from abroad. Because the ships carrying these metals were exposed to long and hazardous voyages, the value of the cargoes was often at risk to market prices movements.

As a result, merchants began to meet informally in coffee houses to buy and sell forward cargoes, in order to protect themselves against risk. This type of trading is known as hedging.

There quickly became a need to formalize both the method of trading these contracts and the specifications of the metals for delivery. So in 1877, the London Metal Exchange was established. Here, contracts were negotiated by traders standing in a ring and calling out the prices at which they were prepared to buy and sell. Ring dealing by open outcry is still seen on the floor of the Exchange today.

Soon after the LME was established, the prices being quoted began to be published in the financial press, and those published prices started to be used by all sections of the metal industry as a reference for physical contracts. This, in turn, led to an increase in the types of businesses using the Exchange for hedging purposes.

Over the years, the Exchange has developed and expanded its business. Today it is used by producers, semi-fabricators, stockists, consumers and recyclers as well as merchants in an arena where they can protect themselves against the loss of value to the metal due to price fluctuations during the period that it remains in their possession.

When the LME first formed, copper, tin, and – for a short time – pig iron were the metals traded. These were soon followed by lead and zinc, but it was not until the late 1970s that nickel and primary aluminum were introduced. Aluminum alloy was introduced in 1992.

Because LME contracts were originally based on shipping dates as opposed to harvest months (as with agricultural commodities), LME uniquely adopted a system of daily delivery dates out to three months. This coincided with the approximate sailing times for copper from Chile and tin from Malaysia. Because sailing times were not exact, the daily prompt system enabled the users of the Exchange to move their positions backwards or forwards to coincide with the eventual arrival dates.

In recent years, to meet industrial demand, the old three-month trading period has been superceded by a period of up to 27 months for copper, aluminum and zinc and up to 15 months for lead, nickel, tin and aluminum alloy. The quality of the metals that underpin the LME’s contracts is strictly controlled and these specifications are updated from time to time to ensure that the contracts best serve industry needs.

The LME remains a terminal market in which every contract assumes a commitment to deliver or take delivery of metal. Reflecting its international role, the LME now has approved warehouses listed for receipt of approved brands of metal in locations throughout Europe, the Far East and the United States.

The LME is not a speculative market, but a trade-driven, trade-oriented market used in the main by producers, processors and consumers of metals, and it has virtually no private speculative investors. There has undoubtedly been a growth in fund business, but this is not so large on the LME as it is on other markets. One of the reasons for this is that the Exchange operates a settlement on a prompt basis, which makes it very suitable for trade business but less attractive to the financial investor.

LME prices, though, are now tracked by the second and distributed by computer through the major news vendor companies. Trading takes place either through the “open outcry” floor trading sessions or via a 24-hour telephone based inter-office market.

There have been other significant changes over the years, including, in 1986, the passing of the Financial Services Act which resulted in the LME becoming a more formally regulated “Recognized Investment Exchange” and, in 1987, the introduction of a clearinghouse which matches, clears and guarantees Exchange contracts.

Also in 1987, traded options – which had previously been traded off market – became official LME Traded Contracts, and in February of 1997, LME Traded Average Price options (TAPOs) for copper and primary aluminum were introduced.

INDUSTRIALLY DRIVEN

But despite the many changes and the sophisticated uses of today’s market, the Exchange has never lost sight of the fact that it is an industrially driven market.

The three main industrial services which were established when the Exchange was first formed remain the main considerations behind all policy and decision making on the LME. Those services are hedging, physical delivery and reference pricing.

Defining hedging is not an easy exercise, as there is a huge variety of hedging vehicles available to clients. These include not only the use of futures, options and swaps, but also a whole range of other hybrids designed to put producers, processors and consumers of metal in the position of not having to worry about future metals price movements. But there are, in fact, only two main reasons for hedging. These are referred to as price-fixing and off-set hedging.

A price fix is a situation where the hedger is locking in forward prices simply because they are attractive, whereas an off-set hedge refers to the operation of protecting a profit written into a contract, which is based on current prices.

Hedged contracts are rarely perfect, because there are invariably aspects of the contract which cannot be hedged, or some costs in the operation of the hedge which are variable, but the vast majority of the value of most contracts can be hedged successfully.

Also, when hedging with futures, you are locking in a price, so one of the costs is the forfeiture of additional profits which might accrue if the market moves in a favorable way. It is vital, therefore, that the hedging program is carefully managed and the right tools for the job are used.

PHYSICAL VERSUS FORWARD

Understanding how the Exchange and its members operate must begin by defining the difference between the physical market and the forward market. The physical market is made up of transactions which result in the delivery of goods. The goods can be at any stage of production. In the case of the metal industry, this can be from ore concentrates or scrap metal through semi-fabricated and fabricated metals up to the end products – such as cable, electrical products, or even pots and pans.

The futures market is the purchase or sale of contracts for the future delivery of goods. On the futures market the goods that underlie the contract are always at a specific stage of production. On the LME, this is at the semi-processed stage, where the raw material has been turned into an easily handled, non-perishable form such as ingots, cathodes or pellets. If delivery of these goods takes place, then a futures contract has become a physical contract. But this generally does not happen. Futures contracts are usually cancelled out by an equal and opposite contract: buy/sell back.

In other words, the physical market is about the actual movement of metal from one place to another, whereas forward trading is about price. Sometimes, it is solely about price – buying low and selling high – but usually it is about price risk and the offsetting of risk by hedging.

Futures contracts can be used as hedging tools against any stage of physical activity, as long as the physical contract is priced based on the futures market.

In order for industry to price its contracts based on the LME, a single price is needed. The problem is that LME trade throughout the day (and night) and quoted prices are constantly changing. So each day the LME announces official prices for this purpose. These are the last prices bid and offered in the second ring of the morning session. The cash sellers’ price is known as the settlement price, and it is this price that industry generally uses for its basis.

The cash price is the price quoted for the first tradable prompt date on the LME, which for clerical purposes is two days forward from the trading date. So Monday’s cash price (the price that is being traded on the Monday) refers to the Wednesday delivery date, whereas Friday’s cash price refers to the following Tuesday.

The delivery date of any LME contract, by which time either the position must be closed or a delivery will take place, is known as the prompt date. So the final trading day – the last day a position can be closed – is two days before the prompt date. This is important to bear in mind when placing a hedging contract.

A unique aspect of the LME as opposed to other futures markets is that contracts are not settled until the prompt date. Initial margins and variation margins against risk exposure can be called during the term of the delivery, but the value of the contract is not paid until delivery. This is one of the reasons that the LME is referred to as a forward market rather than a futures market. This is attractive to genuine trade customers from a cash-flow point of view. The downside, however, is that any profits accruing from closing a position early cannot be realized until the prompt date.

The LME is a terminal market whereby every futures contract anticipates that a delivery will take place. While the majority of contracts are for financial purposes and are cancelled out by equal and opposite contracts, there is a physical commitment behind the original contract. Should the contract not be cancelled out, a delivery will take place in the form of warrants.

A warrant is a bearer document which the seller passes to the purchaser on the prompt date. It confers to the holder the right to take possession of specific metal in a specific LME registered warehouse. Each warrant represents one lot of metal. The holder of the warrant is responsible for warehouse costs until such time as they present it at the warehouse in exchange for the metal. Delivery of warrants is at the seller’s option.

Forward prices are the prices being quoted for any delivery date beyond cash. It should be stressed that forward prices are not a speculation as to what the price will be in the future. They allow for the current demand and supply factors ruling on the future date, the cost of warehousing and insuring metal for the period and the cost of financing the metal for the period (the current interest rates).

Contango is the phrase used to describe the increase in the price of metal from a nearby date to a forward date. In a constant demand/supply situation it would follow that the forward prices would rise by a constant amount, or contango, each day. However, supply and demand are rarely constant and you will sometimes find more pressure on the nearby price than on the forward price.

Backwardation or back, therefore, refers to a situation where the nearby price is higher than the forward price.

Borrowing/lending (carries) refers to a simultaneous purchase and sale of the same tonnage of metal on different delivery dates. If the purchase is for the nearby date, the party is said to be borrowing. If the sale is for the nearby date, it is a lend.

A holder of warrants, who does not need the metal immediately, can lend it to the market, releasing its capital value for the period.

Adapted with permission from a presentation given by the London Metal Exchange’s Raymond Sampson at the Bureau of International Recycling’s spring 1997 convention in Istanbul, Turkey.