In March of 2022, a crisis transpired on the London Metal Exchange.
It revolved around a colossal short position that one market participant amassed in nickel, betting that the price would fall. Instead, it surged. The resulting liabilities were so staggering that the whole exchange was at risk of collapse. To prevent implosion, the LME retroactively annulled several trades.
Elliott Associates, a US-based hedge fund, brought a lawsuit against the LME claiming that the exchange acted unlawfully in cancelling those transactions. Jane Street Global Trading also sued for damages.
This past June, the claimants had their day in court—three, actually—as they argued their case in London’s High Court. The judges recessed to take up their review and kept the world waiting for months. Last week the verdict came in. The Court ruled in favor of the LME.
In the written decision, the judges affirmed the LME’s obligation to maintain orderly markets and endorsed its use of powers to achieve that end. This, the judges stated, includes cancelling transactions.
The verdict has been hailed as a victory for the LME, but the exchange should not be so quick to raise its flag. Rather than being an anchor of assurance, this decision may prove just the opposite.
What the Court has just confirmed is that anyone trading on the exchange is no longer standing on solid ground. Even though two parties can agree to a transaction on definite terms, the prevailing jurisdiction in which the exchange operates has held that all contracts are subject to a third-party potentate who may void the agreement.
We can assume the LME will act in good faith. But the world’s predominant producers and traders cannot operate on the basis of assumptions. And because of the precedent that has just been set, the question of whether a contract is going to be upheld will now always hang suspended in midair, casting a shadow of doubt over the market’s activity.
Is there going to be another catastrophe? Which transactions might be cancelled? Why one party’s agreement instead of another?
The ruling does more to undermine confidence in the exchange than it does to bolster it.
The implications of this lingering uncertainty are not trivial. Besides nickel, the LME is authorised by the UK’s Financial Conduct Authority as an official benchmark administrator for aluminum, cobalt, copper, lead, tin, and zinc.
Not only have these reference prices long contributed to London’s leading status as a global financial centre, but these benchmarks are the economic engine of an international mining industry; which may seem remote, but it is not. It affects all of us. These prices ripple through every reach of the real economy, the one you and I interact with every day.
The entire edifice of modern life is made from metals. If producers do not have a reliable pricing mechanism by which to govern their investment decisions, they cannot reliably produce the products society needs to maintain its standards of living. How can these companies be asked to rely on a reference price whose constituent transactions can be abrogated by diktat?
Moreover, if the Court’s conclusion does not incite immediate misgivings about other exchanges operating within the Court’s jurisdiction, it at least validates asking questions about their terms of service.
But direct participants in commodities markets will not find the stability they crave by hanging their hopes on the outcome of a lawsuit. No matter its decision, the Court was never in a position to solve the real issue, because at its heart, this was not a problem of governance—it was a problem of market structure.
The key to understanding the predicament is risk. Whenever two parties agree to a transaction that settles in the future, there is risk that one side might not hold up their end of the deal. To handle that risk, the LME routes all trades through a clearinghouse.
This entity acts as a counterparty to every transaction—sellers sell to the clearinghouse and the clearinghouse sells to buyers. The clearinghouse then guarantees the performance of every contract. To fund those potential payments, the exchange requires its members to contribute to a pool that can be used to cover losses in the event of a default.
Ostensibly, using a central counterparty creates a more efficient market. Two parties who do not know each other can agree to a trade without direct concern for the other defaulting since they are actually dealing with the clearinghouse, not the other party. But that risk does not disappear. It is instead concentrated onto the shoulders of the single central counterparty, building beneath the surface where its total accumulation cannot be plainly seen.
Central clearing also puts the exchange in conflict: The LME operates a market where prices can move so fast that the consequent liabilities may exceed its ability to collect, while at the same time, it operates a clearinghouse that is on the hook for those liabilities. And should it find itself with obligations that cannot be paid, it now has juridical approval to eliminate those debts by terminating contracts, should it deem the situation grave enough to exercise that authority.
Centralising and socialising risk is the mainspring from which the problem flowed. It did not ultimately emerge from contentions over fine print in the LME’s rule book nor from discrepant interpretations of a market operator’s rights and duties. It was a result of the way the exchange processes trades—and that is something which cannot be laid at the bench of a court or the feet of a regulatory body. More rules, greater penalties, and stricter oversight may help, but they do not reroute plumbing.
Unless the underlying market structure is addressed, then every measure intended to prevent the next crisis will only stack up, burying the market in such a thick covering of overburden that it will no longer be able to function freely.
If we want fair markets, we have to start from a clean sheet of paper. No tenet of tradition can be held as sacrosanct. It calls for an entire rethinking of the way a market can—and should—work.
That is the message written in-between the lines of the Court’s decision.
Alex Godell is a managing member at Santeri Holdings