COLUMN-Tin squeeze tests regulator’s mettle in U.K.: John Kemp
— John Kemp is a Reuters columnist. The views expressed are his own —
By John Kemp
LONDON, Oct 5 (Reuters) – The year-long squeeze in the London Metal Exchange’s tin contract has renewed intense criticism about the ineffectiveness of commodity regulation in London. It comes at an awkward time, just as the UK authorities try to resist pressure from the United States to introduce stricter market oversight and tougher position limits.
The squeeze has focused attention on contrasting approaches to market regulation. U.S. regulators have long relied on position limits to ensure markets cannot be cornered by a single participant and prices reflect a diversity of views.
Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler cited the need to prevent “excessive concentration” during this summer’s hearings on energy market regulation. The Commission is expected to reinforce the existing system, imposing stricter limits with fewer exemptions, when the review’s findings are published in the autumn.
In contrast, London regulators have preferred a more “behavioural” approach. Market participants are free to build a dominant position in a futures contract (even hold more than half the open interest in a contract approaching expiry) provided they do not intentionally attempt to manipulate prices, and comply with directions from the exchange and the Financial Services Authority (FSA) to ensure the market remains “orderly”.
THE SQUEEZERS’ CHARTER
Nowhere is London’s behavioural approach more developed than on the LME, where participants are free to amass dominant positions and take them all the way to expiry, provided they comply with the exchange’s “lending guidance”.
The guidelines require the holder of a dominant position amounting to 50 percent or more of the stock in exchange-registered warehouses to offer them for sale, one day at a time, to other market participants with a short position for no more than a specified percentage of the cash price. In effect, the position is loaned to the shorts one day at a time at a (penal) rate capped by the exchange.
The rate is capped at 0.0-0.5 percent of the spot price per day, and tightens progressively over time. But even the capped rates amount to a huge return on an annualised basis, and progressive tightening of the limit can be circumvented by making slightly longer term loans every few days, causing the cycle to re-set.
Compliance with the guidelines provides a carefully designed “safe harbour” from prosecution for market abuse under UK/EU law. The exchange does retain the right to impose additional restrictions through its “Special Committee”, but interventions have been infrequent, and remain secretive and discretionary. In practice, the guidelines have become the principal, and often only, system of control.
The problem is the guidelines, designed originally to protect the clearing house and clients from abusive squeezes, have instead become a squeezers’ charter. By spelling out precisely how far market participants can go without breaking the rules, and providing a safe harbour, the guidelines have encouraged market participants to build dominant positions and exploit them to the fullest extent, safe in the knowledge that such behaviour will not result in action for market abuse. Rather than protecting the shorts from a squeeze, the guidelines protect the longs from intervention.
SERIAL MARKET TIGHTNESS
Under the lending guidelines, the market has witnessed a succession of squeezes, in which one or more market participants have amassed a dominant position, run it to expiry, and then lent it forward one day at a time at the penal rate set by the exchange. In recent years, squeezes have occurred in most contracts, including nickel (2007), aluminium (2006 and 2008) and copper (repeatedly).
The tin squeeze is only the latest in a long line. What is unusual is the length of time for which the squeeze has persisted, which risks bringing the lending guidelines, and with them the entire system of behavioural regulation, into disrepute.
The attached charts show warehouse stocks for the six major metal contracts traded on the LME as well as the percentage of backwardation or contango in each contract (http://graphics.thomsonreuters.com/ce-insight/TIN-SQUEEZE.pdf).
Tin is the only contract in persistent backwardation. The difference is not related to fundamentals. While tin stocks remain low (around 25,000 tonnes) they are equal to more than a month of current consumption and have tripled since March. The accumulation of tin has not been markedly different from other metals (charts 1 and 2) and availability is better than for other metals such as copper, which are trading in contango.
Yet the tin cash price has traded at a premium of 2 percent or more to the price three-months forward for most of this year. In contrast, cash prices for most other
contracts have been trading at a discount (chart 3).
It cannot be a coincidence tin is the only market with a dominant position nearby. The LME’s compliance report shows one market participant, or group of related participants, had a physical and close-to-expiry futures position amounting to more than 90 percent of all stock available in LME warehouses on October 1. For contracts such as copper, lead and nickel, no market participant had a position of more than 40 percent, and for aluminium the largest position was below 30 percent.
The backwardation has prompted one European tin consumer to complain “this is not an orderly market…To have such a concentration of warrant by one single holder leads to prices higher than fundamentals.”
But as one trader noted, “Trade customers are extremely unhappy. But there’s nothing illegal going on so they can’t actually do anything about it. It’s all within the rules but there are loopholes being created.”
WHY SQUEEZING MATTERS
The type of squeezes that have become routine on the LME would not be possible under a U.S.-style system of position limits, since no market participant would be allowed to take such a dominant position close to expiry. But exchanges and regulators in London have indicated they have no intention of following the CFTC if it decides to impose more stringent position limits on energy and other commodity contracts as a result of the current review.
There is a strong sense current rules are working well and should be left alone. If the United States decides to impose tougher restrictions, it is seen as a competitive opportunity for London to attract more business (an unfortunate replay of the regulatory arbitrage between financial centres which played such a damaging role undermining banking regulation in the run up to last year’s crisis).
In their defence, regulators and exchanges note that for every long (buyer) there was a willing short (seller). If the short sold something they do not own they cannot complain if they are charged a steep price to cover their obligation. The short knew at the time they sold the contract they had an obligation to deliver metal or go into the market to buy their position back at whatever price is available.
But many manufacturers use derivative markets to hedge their working inventories, and cannot deliver against short positions without disrupting their operations. They are always vulnerable to artificially created tightness. If the market is supposed to serve a “socially useful” hedging function, as its proponents claim, persistent artificial backwardations undermine that role.
Nor is it clear why dominant positions and artificial backwardations should be allowed when no other market would permit them. Positions on this scale with such an obvious impact on market structure are not permitted in equity and bond markets, or in commodity markets in the United States. The impact on forward market structure would be deemed ipso facto distorting, whether the position holder intended it or not.
The danger with the existing system is that it creates the unfortunate impression the market is a game, in which the well-connected make handsome rewards to the detriment of everyone else by creating a series of artificial squeezes. Given the repeated emergence of dominant positions coupled with backwardations over the last decade, it is an impression that is hard to refute.