Monday, May 8, 2017

LME Discussion paper on market structure - what do investors want?

There does not have to be a long discussion on what investors want from a metals exchange or futures contract. Liquidity, liquidity, and liquidity. We use the word three times for each of the liquidity forms that attract trading. It does not matter if you are a hedger or speculator, the demand is the same; deep liquidity so the cost of transacting is low. 
  • Liquidity from by tight bid-ask spreads.
  • Liquidity from low transaction, hedging, and processing costs.
  • Liquidity from deep markets that will not move when size is entered.  
Liquidity just does not appear. It is a function of the structure surrounding the market. The rules of the game matter if you want to create liquidity, so the new discussion paper from the LME is provocative approach to open a discussion on market structure (LME Discussion Paper on Market Structure - April 2017)

The paper is a description and justification of the current LME environment, but also a call for help from investors to ask what they may need for a better market structure. This paper may be the best description of the current LME structure, but it also clearly shows how it is out of step with other futures markets. The recent sale of the exchange for over $2 billion suggests that the buyers are looking for a return on their investment. They want to provide an exchange service, but they also want to make a profit.

When we talk about liquidity in context of three types, we are discussing three levels of costs. The bid-ask spread is the immediate cost of transacting in the market. There are also a set of costs which effect any transaction. We call this the structural costs. Finally, there is the implicit cost associated with deviations from fair value. Of these three costs, the structural costs associated with market mechanics is what can be controlled by an exchange. If the cost of trading on an exchange is minimized, the result will be deeper markets with lower bid-ask spreads. 

So what impacts the trading structure? For an exchange, we can explicitly focus on a few areas.
1. The contracts that are offered, the terms and conditions. For most exchange markets there are a limited number of futures contract expirations. The LME is different from other exchanges with how they offer contracts. The focus is on the hedger/producer and their business needs not the speculator who would like a more focused set of market contracts. The disperse set of LME contract expirations may limit liquidity. A three-month contract offered every week creates less liquidity if you try and sell before expiration. 
2. The margin system. Again, given the focus on producers, the system of margin payments are different with present valuing back to cash price and not the daily market to market process found in most other futures contracts. This has an impact on the actual cash outlay and the cost of trading at the LME, making it more expensive to be a short-term trader.
3. The actual prices charged for using the exchange. The cost of trading the LME is higher than other futures contracts. 

The drivers of market structure have been the ease for commercial users who price against the LME and not speculative account who can increase volume, The current contracts specs reduce the potential basis risk and allows for more direct hedging at the expense of volume. A move to more "standard" futures may help with speculative activity, but may harm hedger opportunities. It is a balancing act for any exchange but the LME wants to touch this issue directly through the engagement of all traders. This is an interesting experiment. We wish them well.

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