PUBLIC CONSULTATION REVIEW OF THE MARKETS IN FINANCIAL INSTRUMENTS DIRECTIVE

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1 Diarmuid O Hegarty - Deputy Chief Executive 28 January 2011 European Commission Directorate General Internal Market and Services Financial Services Policy and Financial Markets Securities Markets by Dear Sirs PUBLIC CONSULTATION REVIEW OF THE MARKETS IN FINANCIAL INSTRUMENTS DIRECTIVE Introduction 1 The London Metal Exchange welcomes the opportunity to comment on the Commission s public consultation on a review of the Markets in Financial Instruments Directive (MiFID). 2 The London Metal Exchange (the LME ) is a UK recognised investment exchange and an EU regulated market. The LME was established in London in 1877 as an exchange for trading futures and options in base metals. The metals currently traded on the LME are aluminium, copper, lead, nickel, tin, zinc, two grades of aluminium alloy, steel billet, cobalt and molybdenum. The LME s futures and options contracts are based on physical settlement by the transfer of ownership of metals stored in LME approved warehouses. More than 450 brands of metal from over 60 countries are approved as good delivery against LME futures and options contracts. There are over 500 LME approved warehouses in 39 locations covering Europe, Asia and North America. 3 The LME is the only base metal exchange in the world that attempts to discover a global price for base metals. The other major base metal exchanges are the Shanghai Futures Exchange in China and COMEX in the United States. The Shanghai Futures Exchange has base metal markets in aluminium, copper, zinc and two shapes of steel. The Shanghai Futures Exchange s approved warehouses are in China and therefore the Shanghai Futures Exchange discovers Chinese regional prices for its base metals. COMEX is a division of the CME and is located in New York. COMEX has one base metal contract: copper. COMEX s approved warehouses are in the US and therefore COMEX discovers US regional prices for copper. The LME is the only base metal exchange that includes European delivery locations in the base metal prices that it discovers. The physical base metal trade and industry use the LME to discover settlement prices for their physical metal transactions; and as a forum for hedging the price-risk they have to the value of those base metals. Set out in the attached appendix is a summary of the role that the LME plays in the international base metals trade and industry. DOH11005.doc

2 General Comments on Consultation 4 The LME has restricted its response to the proposals set out in Section 5 (Measures Specific to Commodity Derivatives Markets), Section 6 (Transaction Reporting) and Section 9 (Reinforcement of Supervisory Powers in Key Areas). These are the proposals that will have an affect on the LME s operations and concern issues where the LME has direct experience. Section 5 - Measures Specific to Commodity Derivative Markets 5 The LME has experience in collecting position information from users of its metal markets and in publishing information based on that position information. The LME receives position reports every morning that identify all positions held by all users of its metal markets. Each LME broker is obliged to report to the LME (a) all of the broker s proprietary positions for each metal across each delivery date, and (b) all of its clients positions for each metal across each delivery date. Most clients have accounts with more than one broker, which requires the LME to be able to aggregate a client s positions held across two or more brokers. The LME receives these reports by 8.30am London time and is able to process that information before 9.00am so that the LME compliance department has a total picture of all broker and client positions as at close of business the previous day. 6 When establishing this reporting system the LME tried to do so as efficiently as possible. The LME was also aware of the need to balance between the benefit to those receiving the reports and burden of those making the reports. For that reason the LME did not impose client identification codes on the brokers. Before a new client starts trading, an LME broker must notify the LME of (a) the identity of that client and (b) the client identification code that will be used by the broker. The LME broker is therefore able to use its own client identification code when making position reports to the LME. The LME s compliance support system (CSS) is able to identify that different client identification codes used by different LME brokers relate to the same client and, therefore, is able to aggregate client positions across more than one broker. 7 This approach to reporting allows for great flexibility. Brokers can have a different number of letters and digits for their client identification codes. A single broker can also use different sub-account identification codes for the same client. 8 The LME uses this position information to monitor its markets and to detect market abuse. The LME also uses position information to publish daily anonymised reports that show the number of market participants with:- (a) concentrations of LME warrants in five bands: 30-40%, 40-50%, 50-80%, 80-90% and over 90%, 2

3 (b) (c) concentrations of trading positions for the nearby delivery dates in five bands: 30-40%, 40-50%, 50-80%, 80-90% and over 90%, and concentrations of both long and short positions for prompt dates one month, two months and three months further forward in five bands: 5-10%, 10-20%, 20-30%, 30-40% and over 40%. 9 The LME also publishes daily open interest figures for each delivery date. These open interest figures are compiled from open interest reports made to the LME by its broker members. Open interest information gives transparency on the depth of liquidity for each available delivery date. 10 These banding reports and open interest reports do not break down the information with reference to the type of entity holding positions. It has been suggested that position reports should indicate whether positions are for the purposes of hedging or speculating. The LME has resisted suggestions to do so because it believes that such classifications would not accurately identify either the motivation for those identified positions or the status of the position holder. Hedging on the LME is a process by which those with economic risk to metal prices sell that risk. In order for those who wish to sell their risk to be able to do so the market needs participants who are prepared to buy risk. It is these buyers of the risk that would fall within the definition of speculator or investor. The range of participants who use the LME is such that the same participant may in one transaction be selling risk and in another transaction buying risk. No system for categorising position or open interest information has yet been devised which would enable reports to separately identify within a participant s net position if different proportions of the position arose from buying or selling risk. All current systems rely on a categorisation of the participant and an assumption that all of that participant s transactions are for the same purpose. It is openly acknowledged that these systems are crude and inaccurate. Questions 60 & The LME would recommend that if any system were being mandated for the collection of position information that it ought to be flexible enough that those required to provide that information are not obliged to use centralised client identification codes. The imposition of centralised client identification codes is, from the LME s experience, inflexible and an unreasonable burden to place on those who provide the information. The obligation ought to be on the body collecting the information to be able to reinterpret client identification codes which have been provided to it by those making the reports. 12 If the Commission is minded to recommend that position information must be reported in a way that categorises the position holder, such categories should be formulated in such a way that it is clear to those making the reports that the same customer would be categorised by each of them in the same way. Clients who use the LME use more than one LME broker and therefore as more than one LME broker 3

4 will be making reports about the same client, it musty be clear to each LME broker which category the client belongs to. Question 63 (Contract Design) 13 The first part of question 63 raises the issue of contract design. MiFID requires regulated markets to design derivative contracts that either correlate with the value of the underlying or disclose the value of the underlying 1. Properly interpreted for commodity derivatives this requirement already encompasses a need to take account of price convergence in contract design. Generally speaking a derivative is a financial instrument that derives its value from changes in the value of an underlying investment. However, in the commodities markets the word derivatives is used as a lazy shorthand for futures and options. This leads to a confusingly mixed use of the same terminology to describe different things. LME metal futures contracts are not derivative contracts that rely on prices for metals produced by the underlying physical markets. The LME metal futures markets are the primary markets that discover metal prices that the physical markets use to price their metal sale and purchase contracts. Physical delivery commodity futures markets, like the LME, were developed in the 19th century as the best available tool to discover the value of traded commodities. Trading on the LME discovers prices for its metals from one business day forward ( Tom ), two business days forward ( Cash ) and every subsequent business day forward out to three months 2. The spot price could either be the Tom price or the Cash price. Both of these prices are produced by the LME. The LME Cash price is most commonly used by those in the physical industry to settle their physical metal transactions. Current practice is to use the average of the LME Cash prices published during the month in which the metal is delivered to the buyer. 14 Any regulation that creates an explicit requirement to ensure convergence between futures prices and spot prices must take into account that many commodity markets generate the spot prices for those commodities. In those circumstances there is no other spot price that convergence can be measured against because the exchange s spot price is used both:- (a) (b) by the exchange in settling exchange contracts; and by the physical trade and industry as a reference price for settling physical contracts. Question 63 (Trade Halts) 15 The second part of question 63 raises the issue of trade halts as a method of restricting price moves within given timeframes. Trade halts are introduced by 1 Articled 37 of Commission Regulations (EC) No 1287/ Beyond three months the settlement dates are: every Wednesday out to six months; every third Wednesday in the month out to 123 months (for aluminium and copper), out to 63 months (lead, nickel and zinc), out to 27 months (both aluminium alloys) or 15 months (tin and steel billet). 4

5 exchange where the exchange deems that the maintenance of an orderly market requires a pause after certain price moves. This is done reluctantly because trade halts introduce uncertainty while trading is halted and can in them selves cause disorder. They are a specific response to a specific problem. It would be wrong to impose trade halts on exchanges that do not consider them necessary for their markets. All exchanges have an overriding obligation to maintain order in their markets and have the intervention powers to take whatever action they consider necessary. For example, the LME s rules give it wide powers to intervene in its markets for the purpose of maintaining either order in its markets or the integrity of its markets. These powers include the power to suspend trading. Section 6 - Transaction Reporting For All Commodity Derivatives Question Transaction reporting is a tool used in the securities markets for detecting market abuse. The equivalent tool in commodity derivatives markets is position reporting. The imposition of a transaction reporting obligation for commodity derivatives in MiFID was a mistake. The obligation should have been to report positions. It would be wrong to compound that mistake by extending the transaction reporting obligation to all commodity derivatives. Section 9 - Reinforcement of Supervisory Powers in Key Areas 17 The Commission is correct to recognise that position management and position limits are equivalent tools for preventing settlement squeezes in physicallysettled commodity futures markets. Position limits are primarily a tool for preventing settlement squeezes in physically-settled commodity futures markets with monthly or less frequent settlement dates. They may appear to some to be simple in their application. However, all current position limit regimes require detailed and complicated rules to ensure that the limits do not interfere with the hedging requirements of the physical users of those markets. The current position management regimes of European exchanges have been developed over a number of years both to deal with settlement squeezes and to cater for the hedging requirements of physical users of their markets. The LME s tool for preventing settlement squeezes is the Lending Guidance 3 which is specifically tailored to the LME s daily settlement requirements. The LME is the only major commodity futures exchange in the world that has daily contract settlement rather than monthly or less frequent contract settlement. 3 The effect of a settlement squeeze on the LME is seen in the price that a party due to deliver an LME metal warrant (the short ) has to pay to postpone delivery for a day. In the absence of any regulation there is no upper limit to the price that the short would have to pay if the control of warrants were concentrated in the hands of one party (the dominant long ). The Lending Guidance obliges the dominant long to trade with the short at pre-determined prices that reduce as the degree of control by the dominant long increases. The Lending Guidance prevents a dominant long from taking advantage of his dominance. 5

6 18 There is a long-standing debate about the effectiveness of position limits in controlling excessive speculation in commodity markets. It is accepted by those with detailed understanding of commodity derivatives markets that it is an unrealistic or misguided expectation that position limits will control prices in commodity derivatives markets. In the US, Federal position limits have been in place for exchange-traded agricultural commodities for many years. Those who propose that US Federal position limits would have controlled price movements in the exchange-traded oil and gas markets have not been able to reconcile that contention with their simultaneous contention that the exchange-traded agricultural markets were subject to the same uncontrolled price movements. CESR, in its responses to questions 1 to 14 and 19 of the Commission s Request for Additional Information in Relation to the Review of MiFID (CESR/ ) commented that:- There is little evidence so far to suggest that markets where position limits are operated for the life of the derivative contract have been any less volatile than those which have not. Nor is there sufficient evidence so far that position limits can systematically be used to limit the impact significant positions may have on the prices and market generally. 19 The LME would encourage the Commission to view position limits as one of a number of tools for preventing settlement squeezes in physically settled commodity derivatives markets and in no way superior to position management or the LME s Lending Guidance. The Commission should encourage current best practice by supporting those tools for preventing settlement squeezes that have been developed over a number of years by European commodity derivatives exchanges because those tools are tailored to the characteristics of those exchanges and the commodities that they trade. 20 If there is anything in this letter that you would like to be further expanded or explained please let me know. Yours faithfully Diarmuid O Hegarty 6

7 APPENDIX THE ROLE OF THE LONDON METAL EXCHANGE IN THE INTERNATIONAL BASE METALS TRADE AND INDUSTRY 1 The London Metal Exchange is the world's premier base metals market. The LME is a highly liquid market and in 2010 achieved traded volumes of million lots, equivalent in value to US$11.6 trillion annually and US$46 billion on an average business day. Based in London the LME is a global market with an international membership and with more than 95% of its business coming from outside the UK. More than 450 brands of metal from over 60 countries are approved as good delivery against LME contracts. There are over 500 LME approved warehouses in 39 locations covering Europe, Asia and North America. 2 The LME operates futures and options markets in ten industrial base metals. Seven of these, aluminium, copper, zinc, lead, nickel, tin and aluminium alloy, are mature markets where the daily LME official prices have become the accepted reference prices for the world trade in those metals. The LME launched steel billet futures contracts in 2008 and cobalt futures and molybdenum futures contracts in These newer contracts have not yet matured into the accepted reference prices for their industries but the steel billet futures contract is approaching that stage. 3 Base metals are amongst the few commodities that lend themselves to a globally traded reference price and it is for this reason that the LME has become the world centre for the trading of that price risk. Base metals lend them selves to global reference prices more so than other commodities because the relative cost of shipping metal around the world is low compared to the value of the metal. This low relative cost of shipping limits the size of regional variations. The LME provides a global reference price because LME listed warehouses are in the three regions of Europe, Asia and North America. 4 Copper and tin have been traded on the LME since Lead was introduced in 1903, zinc in 1915, primary aluminium in 1978 and nickel in The two grades of aluminium alloy are recycled primary aluminium and were introduced as contracts in 1992 and All LME metals have different characteristics but the price discovery process for each of them is the same. The LME listed delivery locations in Europe, Asia and North America are in areas of net consumption or transhipment ports that are conduits to areas of net consumption. LME listed brands represent a significant proportion of the physically traded metal. For example, LME listed grade A copper brands represented 60% of world production capacity for grade A cathodes in The LME is an on-exchange forwards market. Each LME futures contract is an obligation to deliver metal against payment on the settlement date. On a trading date, the available settlement dates are every business day out to three months, 7

8 every Wednesday out to six months and every third Wednesday in the month out to ten years. LME contracts are based on physical settlement by the transfer of ownership of metal stored in licensed warehouses; this guarantees price convergence as the far futures settlement dates converge on the cash settlement date (i.e. two days from the trade date). The ability to make or take delivery of metal against an LME futures contract on the settlement date prevents any divergence between the LME settlement price and the physical metal price. 7 Settlement of LME futures contracts is first by offset and then by delivery of the balancing position by means of LME warrants. This takes place on the settlement date so that ownership of metal changes hands on the day: there is no settlement window. Offset allows those who trade on the LME to reduce the number of LME warrants necessary to settle their obligations on a settlement day to the net exposure. For example a producer who hedges his risk to a drop in metal prices will sell for delivery on a future date on the LME. He will close out his hedge by buying back an equal amount of metal for delivery on the same date on the LME. The metal delivery obligations will offset exactly and result in no LME warrants changing hands but the price differences will produce a net cash payment on that date. 8 An LME warrant is a bearer warehouse receipt that represents the ownership of a specific number of tonnes of an identified producer brand, stored in an identified shed operated by an LME approved warehouse company. The LME devotes a great deal of effort to maintaining the metal brand listing and warehouse approval systems because the reliability of metal stored in LME approved warehouses underpins the integrity of trading and price discovery. 8