LMEprecious - Joining the futures world?

Any managed futures trader will tell you that trading metals on the LME is much more difficult than other "futures" contracts. Structural differences make for a more challenging environment from monitoring and capital usage to transaction costs. The continuous forward contracts of the LME are just more difficult to trade than the focused discrete delivery dates of futures because market liquidity is spread over a wider set of dates. Even if liquidity is centered at a three month prompt, the liquidity on exit before expiration may be more difficult to find. 

This liquidity difficulty may be offset by the greater flexibility in contract expirations at the LME versus a futures contract. Hence, hedgers may find the LME a more attractive alternative than the traditional futures contracts which have greater basis risk from the limited contracts expirations. Speculators, on the other hand, who place a premium on liquidity and consolidation of order flow will find futures contracts more appealing. Nevertheless, it always becomes an issue of networking. Pardon the language, but traders trade where others trade. However, for speculators, there always is a choice of just avoiding markets that are more costly and difficult to trade which hurts overall liquidity and development. Market design matters. 

These costs and issues show up in the convenience yield for different market participants. The convenience yield embedded within the futures price includes the cost of transacting but creates noise in the price discovery from the full cost of carry relationship. The convenience yield associated with using LME is higher for hedger because they can hold a forward that matches their industrial needs.  The convenience yield for speculators is lower because the round-trip cost and uncertainty of liquidity is higher. Contract and market design has to be structured to minimize the dispersion in convenience yield to allow for maximum price discovery and minimum basis risk. 

The reason for this discussion is that the LME will be offering new gold and silver contracts called LMEprecious that will have most of the characteristics of a traditional futures contracts and will not take the traditional form LME forward contracts. The LME has introduced other forward contracts that are more futures-like to consolidate liquidity and trading at specific points through their third Wednesday contracts. 

The new LMEprecious contacts for gold and silver when they launch in June, will be subject to the same difficulties of most new futures contracts. New contracts will normally be relegated to failure with an occasional success. The success or failure of the futures contract will be based on its ability to gain a network and scale with liquidity and trading. If there is no liquidity, the trading convenience yield will be outside the range of other comparable futures contract with no mechanism for arbitrage, a market failure. However, the LME is doing more than most to help with success of these contracts. From the World Gold Council to selected dealer banks, the LME has attempted to solve the network problem on day one.

The gold market is especially crowded with alternative markets structures, in New York, Shanghai, and the host of OTC alternatives. Any gold contact has to overcome three structural issues: geography, (the market is moving east); clearing (the market is moving to centralized clearing and away from OTC), and liquidity (the market will always seek the highest liquidity place for trading). However, some strong trading backers, centralized clearing and the new regulatory regime may give LMEprecious a good chance for survival and a meaningful share of the gold trade.