(Bloomberg) -- Exchanges exist to be places where trades can happen. They sometimes halt trading or very occasionally cancel transactions when technology glitches or “fat fingers” cause one-off mistakes. But it's rare for one to cancel whole sessions after the fact, or to take more than a day to allow trading to resume freely. But that's what's been happening on one of finance's oldest institutions, the London Metal Exchange, known as the LME. The chain of extreme events -- and repeated blunders -- that began after Russia's invasion of Ukraine has created an existential crisis for the exchange. The effects will be felt as well by the manufacturers who rely on metals whose prices are benchmarked to LME trading.
1. What is the LME?
The exchange sets global prices for bellwether commodities such as copper and aluminum and trades about $64 billion in futures contracts daily. The LME's history dates back to the early 19th century, when metal traders drew a circle in the sawdust on the floor of the Jerusalem Coffee House in the City of London. Today, in addition to its electronic market, it's one of the last exchanges with an open-outcry trading floor, known as “the Ring,” where brokers gather in person to yell orders at one another for part of the day. Its participants are a mix of the industrial metals companies, which tap the market to offset their price risks, and hedge funds, which use it to speculate. Still, contracts on the LME are backed by physical metal in a network of warehouses around the world, providing a direct link with the real-world metals industry.
2. What went wrong?
Nickel prices on the LME spiked 250% in little more than 24 hours, leading the exchange to suspend trading on March 8 for the first time in three decades. The seeds of the crisis had been planted by a Chinese tycoon, Xiang Guangda and his closely-held enterprise Tsingshan Holding Group Co., a dominant force in the world's nickel and stainless steel production. Tsingshan had been shorting nickel -- betting that prices would fall -- because Xiang expected that a rapid production increase in his Indonesian factories would weigh on global prices. Then came the invasion of Ukraine by Russia, a major nickel producer, which was followed by a raft of economic sanctions against Moscow. The expectation that the disruption would drive nickel prices higher fueled a “short squeeze” -- a term for what can happen to people who have bet on a price falling when it rises. Short sellers and their brokers have to buy back the securities they have sold in order to stop the losses, accelerating the increase.
3. What did the LME do?
Along with suspending trading, it decided to cancel $3.9 billion in trades. Effectively, it rewound the market to the closing price on March 7 of $48,078 per metric ton, down from a high of over $100,000 in the early hours of March 8. The chief executive officer of the LME defended the decision as necessary to protect market stability, saying the prices were “becoming disconnected” from “physical reality.”
4. What happened in the reopening?
LME suspended trading in nickel for a week, to give market participants -- including Xiang -- time to get their financing in order. But its first three days of trading, from March 16 to March 18, produced short sessions hampered by technical glitches in which only a handful of trades were conducted before a limit for price swings was hit. When trading was allowed, there was a gulf between bids and offers, leading to highly illiquid trading conditions in the world's benchmark pricing venue.
5. What does it mean for the pricing of metals?
Not only is nickel a crucial element in the stainless steel used in everyday appliances, but it's also important for the world's transition away from fossil fuels. Higher prices for nickel means higher costs for the battery-makers and auto giants in the midst of electrifying the world's car fleet. Elon Musk, Tesla Inc.'s chief executive officer, once said that nickel was the metal he worries about most. Also, the fact that such a vital commodity can rocket in price so suddenly because of machinations on a relatively obscure exchange might grab the attention of regulators.
6. What does this mean for the LME?
The nickel crisis is threatening to engulf the LME -- already, some angry investors have said they will walk away from trading on the market, which is owned by Hong Kong Exchanges and Clearing Ltd. In private, exhausted traders and brokers -- many of whom worked around the clock for several weeks -- expressed their exasperation with the glitches on the exchange's electronic platform. To make matters worse, many were stuck holding long positions they couldn't redeem because the market had barely traded. With prices falling by a daily limit on the electronic market, the floor hasn't played its usual role in setting some of the LME's benchmark prices, and trading there has been similarly muted. The most active trading venue has been the LME's telephone-based market, which is favored by banks, hedge funds and trading houses with large and complex orders to place. Long before this crisis, there were questions about the long-term viability of the LME, which saw its trading volume slide to the lowest in a decade in 2021 after closing the Ring temporarily during the pandemic and shifting toward electronic trading.
7. What's the alternative to the LME?
Currently, there isn't an easy one for most industrial metals -- meaning that, however much traders complain about the exchange, many of them have little choice but to stick with it. Some nickel traders have started persuading their clients to use alternative benchmarks, such as the one traded in Shanghai, to price the physical trade. But using Chinese prices has major challenges. China's markets are largely inaccessible to international participants. And the country is a net nickel importer. Moreover, unlike the structures in copper, steel and crude oil trading, refined nickel output from China makes up a relatively smaller proportion of global production.
The Reference Shelf
- A blow-by-blow on “The 18 Minutes of Trading Chaos That Broke the Nickel Market” and a story on why hedge funds are walking away from the LME.
- Bloomberg Opinion's Matt Levine wrote about the nickel market blowup.
- Related QuickTakes on Chinese tycoon Xiang Guangda, the pros and cons of circuit breakers and “fat finger” trades.
- Bloomberg reported about the closure of the Ring, and how metals traders set prices at home during the pandemic.
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