The Last Look…

You probably read last week that the London Metal Exchange managed to successfully defend charges relating to the meltdown in its Nickel market earlier this year, and although the LME is still facing a regulatory probe over its actions and the threat of appeal from the plaintiffs, it can, for now, breath a sigh of relief. There are still so many questions unanswered, however, following the High Court decision, and it’s probably not just the metals markets that should be addressing them.

The judges’ decision rested largely on the LME’s rulebook, which allows it to “temporarily halt or constrain” trading, as well as “cancel, vary or correct any agreed trade or contract” when the market is disorderly. This is all well and good, but do we need to ask who decides when and if a market is disorderly?

The court says that it is more for the LME, with its expertise, to decide this that a judge, and that is a decision I think we can all get behind, but it does ignore the fact that those making the claim against the exchange were also experienced, in fact it could be argued they are more so because they trade on more than one exchange.

That aside, I have no problem with the general principle that an independent party – normally the platform operator – has the power to make such decisions, but I would have thought it better to be done in association with the major trading firms in the market? Post-SNB Day, EBS convened a meeting of major players in CHF and achieved a consensus of a market low of 0.85 – and while I don’t agree with imposing artificial highs and lows, the process to arrive at the decision was sound and prudent.

The problem for the LME is the perception in some quarters that as a Hong Kong-owned exchange, the fact that the biggest loser in the whole debacle was a Chinese-owned firm influenced its decision. Had it involved a group of members, perhaps selected at random and with no skin in the Nickel game at that time, the decision might have been easier to accept by those most likely to lose out from the cancellation of all trades.

The suggestion that monitoring will help avert disorderly markets can also send a signal to participants that they can have as big a position as they like, but I don’t believe we should reward irresponsible trading

I was glad to see that the judges dismissed some of the points made by the plaintiffs, most notably that the LME should better monitor positions in its markets. The inference seems to be that if it knows there are big positions out there it can do something about it, but I can’t think what form that action could tackle.

What can an exchange or platform do if a trader runs up a huge position, for all the world to see, and then have it go wrong? The responsibility is with the player in question, not the exchange or platform, which is largely just facilitating trading. My concern with the suggestion that monitoring will help avert disorderly markets is that it can also send a signal to participants that they can have as big a position as they like, because the exchange will establish conditions for them to unwind without too much damage? I don’t believe we should reward irresponsible trading.

Equally, had the exchange had known of the positions – there were actually four major shorts – what could it do? Warn everyone? That’s effectively what happened with the publicly-available data and look what happened to the market.

Position limits is another suggestion, but there is also a concern that this inhibits some genuine traders. The limits may be set high enough not to worry most firms, but this is still creating an artificial market and could be construed as market manipulation, because it effectively says, ‘OK, you’ve bought/sold enough now, no more”.

In an exchange environment, there is something to be said for certain products having price limits, but certainly not all and certainly not those underpinned by an OTC market. Admittedly it happens very rarely, but events can conspire to deliver out-sized moves in prices, how quickly can the price limits be adjusted without losing track of the OTC market? Is this again establishing an artificial market? What do we do about market halts when there are genuine needs to exit positions – especially if the eventual exit will cost a lot more?

The over-rising concern with the events of March is that someone behaving carelessly or with wilful irresponsibility is being let off the hook. I have no desire to see firms or traders ground into the dirt, but there has to be a degree of responsibility – it is not the counterparties’ or exchange’s fault that these firms built up such a large short position, so why do they have to resort to expensive legal processes?

This can all be avoided – and I suspect it will be – by exchanges and platforms trying to establish something in their rulebooks about how they decide if a market is disorderly. The problem is that just about every market event has different characteristics, so codifying this will be some challenge, but the sense is there has to be a starting point.

For what it is worth, I don’t think the markets have got it right yet – but they need to, because one thing is clear; in a world flushed with data (a lot of it on participants’ positions), and dominated by algo trading, these sorts of events are going to happen more often than ever before.

colin@thefullfx.com