The announcement of the LMEShield initiative arrives off the back of a number of other Asia focused developments for the LME. The LMEShield initiative takes the LME yet one step further towards its desire of having LME approved warehouses in Asia. However, questions must be asked about whether the LMEShield initiative is just a stop-gap measure into China or is it a diversification of the core LME business into non-LME metals?
Introduction When Hong Kong Exchanges and Clearing (HKEx) acquired the LME for £1.39 billion in 2012, market commentators had observed that, based on a multiple of its earnings in 2011, at that price "it would take 180 years for HKEx to recoup its investment"1. It was clear that HKEx felt it could justify that price based on its confidence in opening up China to the LME. Of course, HKEx had a more ambitious time horizon to recover its investment in the LME and therefore set into play a series of steps to increase the potential revenue streams for the LME.
Given that China represented roughly half of global demand for major base metals and yet only 20-25% of the LME's exchange traded business was generated from within China, the scope for increase in volumes traded was clearly there. But what else? The absence of an LME authorised warehouse (an 'LME warehouse') in the mainland was another gaping hole in the LME playbook. The regulatory and tax environment in China does not fully meet the LME's approval standards for new warehouses. Given that in 2016 there are still no LME warehouses in China, some of those key concerns remain.
Back in 2012, the market was told to expect some of the following developments from the new LME in its hope to further leverage the China opportunities. To name a few, these included clearing of renminbi (RMB) metals contracts, an LME clearing house in the Asian time zone, increased Chinese membership, RMB LME contracts, and new products specific to the Asian markets. With the recent announcement of the LMEShield initiative for warehouses storing off-LME metals in jurisdictions along China's 'Belt and Road' routes, this paper looks at the increased eastward focus of the LME and explores whether the LMEShield is a stop-gap measure to full LME warehouse approval in China, or if it is merely an opportunistic tool to expand the LME's influence over off-LME metals.
Recent developments looking to Asia Although the LME had an Asian LME reference price from 2011 for aluminium, copper and zinc, reform to the price discovery process was made in 2013 with an aim of enabling Asian market participants to get a more accurate reflection of the price of metals in the Asian time-zone. With a view to this, the reference price discovery window was shortened to 5 minutes from 15 and was set at a time more aligned with the closing of other Asian futures markets.
In 2013, China announced a pilot free trade zone (FTZ) in Shanghai with the idea that foreign exchanges will be permitted to establish local warehouse infrastructure notwithstanding a ban that otherwise exists outside the FTZ. Although this has led to a rush of existing warehouse operators to set up warehouses within the FTZ, the expected LME approvals for such warehouses have not yet arisen. Henry Bath & Sons (Henry Bath), an LME approved warehouse operator, was one of these operators who opened a new (non-LME) warehouse in the Shanghai FTZ in May 2015.
In September 2014, the LME launched its own clearing service (LMEClear) severing its previous arrangements with the London Clearing House. It was anticipated that the establishment of its own clearing service would help internalise a further £13 million in revenue and clear the pathway for an Asian LME clearing house. Of course, beside the time-zone advantage of clearing contracts at the end of the Asian working day, there needs to be more to justify the costs of setting up an Asian clearing house. For example, in September 2014, the Singapore Exchange (SGX) cleared 61.78 million tonnes of iron ore trades which, as a number, remains insignificant against the number of iron ore contracts traded on China's Dalian Exchange.2 The LME needs either to clear enough Chinese OTC contracts or provide sufficient volume of LME trades originated in Asia to therefore justify another clearing house.
One of the two developments that will clearly help facilitate that desired volume is to offer local Chinese market participants the ability to trade LME metals in RMB. As an incremental step towards this, the LME has launched three LME London mini contracts (Aluminium, Zinc and Copper) in October 2014 which are traded and settled in offshore RMB (i.e. CNH) but based on the CNH/US dollars conversion of the official settlement price for the metal as determined on the LME (i.e. in US dollars). Coinciding with this was the Bank of England's approval of LMEClear to accept CNH cash as collateral3.
The second development, although very much outside the control of the LME, is nonetheless significant towards achieving its desire to offer LME cleared contracts traded in RMB. This was the November 2015 acceptance by the International Monetary Fund (the 'IMF') of RMB as a qualifying currency for its special drawing rights (SDR) basket from 1 October 2016 and its determination of the RMB as "freely usable"4 from the same date. This signals the removal of a key barrier to the internationalisation of RMB and therefore the LME's ability to offer RMB denominated LME contracts.
In terms of new LME products with an eye towards Asia, the LME London-mini contracts and arguably, the attempt to launch a cash settled steel rebar and scrap contacts in 2015, are more focused on China than on Europe (as historically, European steel producers have shown reluctance to hedge market price risk). The liquidity for other European and U.S. steel derivatives (e.g. LCH.Clearnet's and CME's equivalent contracts) is broadly similar. As such, pursuing this only makes sense with a view towards a Chinese market segment but only where this becomes a product cleared in Asia.
The LMEShield and the Belt and Road initiative The March 2016 announcement by the LME of its strategic alliance with Henry Bath5, CMSTD and Mercuria Energy Trading to list warehouses for the LME's new LMEShield repository in regions along the Maritime Silk Road, which runs through China and Southeast Asia, follows from its earlier October 2015 memorandum of understanding with a number of parties to support the initiative launched by the Chinese government in 2013 known as the 'Silk Road Economic Belt and the 21st century Maritime Silk Road' initiative. This initiative has triggered infrastructure projects along those routes leading to a demand for base and ferrous metals.
The announcement advertises the recognition of one of Henry Bath's warehouses as qualifying for the issuance of receipts (note, not 'warrants') within LMEShield. Significantly, LMEShield facilitates issuance, electronic transfer, pledging and administration for receipts for those warehouses where the metal in question is not LME warranted metal (i.e. 'off-warrant metal'). Therefore, in contrast to 'warranted metal' held in LME approved warehouses issued via the LME's LMESword repository, the electronic receipt for the off-warrant metal will be issued via the LMEShield repository. However, ostensibly, upon application, existing LME warehouses are automatically approved for offering LMEshield receipts with the proviso of the warehouse's information systems being compatible to link with LMEShield.
Seven banks have agreed to support the financing of stocks held at such LMEShield warehouses and metal will be deposited by market participants, such as Mercuria. LMEShield will facilitate banks in the provision of finance by providing clarity regarding the metal's status as being subject to finance with "clearly identified liability for rent".
The LMEShield central electronic register technology, provided by Kynetix, works in a manner similar to LMESword in that:
- Only warehouses that are approved by the LME can issue LMEShield receipts for off-warrant metal. These warehouses are subject to discretionary inspection by the LME.
- Such approved warehouses will create the first LMEShield paper receipt that will be printed at and immobilised within deposited with an LME approved depository.
- LMEShield will issue an electronic receipt off the back of the confirmation by thefollowing the immobilisation of the paper receipt by the LMEShield depository. of receipt of the paper receipt. Transfer of electronic receipts may occur between LMEShield account holders with LMEShield effecting the movement between accounts with a commensurate notification to the depository of the change in receipt holder.
- When delivery of the metal is to occur, the account holder notifies LMEShield who then creates an encrypted electronic code and provides this to the warehouse and the depository. The depository will then cancel the paper receipt and the warehouse will release the metal to the encrypted code holder.
Why LMEShield? Clearly this is not the same as the LME providing LME approved warehouses in China. On its face, it is no more than the LME facilitating the enhanced financing of off-warrant metal by creating a LMESword-lite system for metal 'receipts' to address some of the fraud and transparency concerns arising out of the events in Qingdao and Penglai during the summer of 2014. However, given the LME's LMESword system and its warehouse infrastructure was primarily created to support its physically settled exchange traded contracts, it begs the question, what contracts is the LMEShield system designed to support? Will these contracts be exchange traded or OTC? If OTC will they be in RMB and if so, will the LME then provide the clearing service to clear these? Although this system may exist just to support its physical storage, repo financing business, that is not where the main metal business for the LME sits.
Commentators are already saying that the test of the LMEShield system will be the confidence financiers place in the LMEShield receipt. The practical issue that arose in Qingdao and Penglai involved the lack of transparency of stocks of off-warranted (i.e. non-LME) metal, with multiple warrants issued for the same metal, and allegations of lack of inventory checks to ensure the paper was backed by the stocks in question. By providing an electronic environment for receipt issuance and centralising it in a single registry, it should reduce the risk of duplication of the underlying receipt. However, we consider that it will remain important to exercise care and, for example:
- Conduct due diligence on the warehouse and its ownership
- Investigate formalities for evidencing title in the relevant jurisdiction
- Analyse the storage terms
- Conduct regular inventory checks
- Ensure that finance documents properly allocate responsibility for the metal
- Conduct stress testing for various scenarios to consider, for example, what happens if the storage company becomes bankrupt or if there is a shortage in inventory
Notwithstanding the above, the effectiveness of the LMESheild system will ultimately hang on the integrity of the warehouse which, in turn, will depend on the robustness of the LME approval process and LME supervision.
In the warranted metal context, this first warrant issuance is outsourced by the warehouse to the London Agent and the LME is under a regulatory obligation to supervise the activities of its warehouses. As a business segment (i.e. off-warrant metal), the LMEShield warehouses do not fall within the LME's regulated ambit as an exchange. Therefore, unless there are commercial incentives it wishes to protect (e.g. percentages of rent receipts, licence fees for use of the LMEShield software, and service charges from account holders for receipt transfers etc.) or just to protect its reputation, there is no obvious pressure on the LME to actively police the stocks on behalf of any off-warrant metal financiers. In particular, its most likely weapon will be limited to revocation of the warehouse's status as an LMEShield warehouse which can only happen when it may be too late from the perspective of any financier.
Irrespective of whether the LME wishes to use the term 'receipt' rather than 'warrant' (perhaps to avoid confusion with its warranted metal product) the likelihood is that the same reasons that prevent the LME from approving the warehouse in China as an LME warehouse apply to the warehouse it is approving as capable of issuing LMEShield receipts. On the presumption that it will require stock reporting from its authorised LMEShield warehouses, this will however, give the LME visibility over the stock of off-LME metals. If those LMEShield warehouses become fully approved LME warehouses in the future (once any legal and regulatory hurdles have been removed), then the LME will have visibility over both warranted metal and off-warrant metal stocks. This is something it currently does not have.
Given that the LMEShield system is also being offered to existing LME approved warehouses that are outside the China 'Belt and Road' routes, perhaps the LME is merely seeking the ability to better perform its regulatory oversight with regards to warranted metals. Certainly, if the LME is finally able to approve LME warehouses in China, how it will be able to discharge this obligation effectively must be of concern to the LME. Having visibility across both the off-warrant metal and warranted metal must make that easier for them. LMEShield certainly helps in that.
1 FT, June 17, 2012 "China key to HKEx London Metal bid", Jack Farchy.
2 During the same period, Dalian traded 2,211,344,000 tonnes.
3 Some limits exist with CNH collateral, for example, (a) it is currently subject to a 9.04% haircut (triple the haircut for USD/JPY), (b) payments by LMEClear in respect of CNH collateral will only be made by transfer to a renminbi bank account maintained in Hong Kong (and not any other offshore renminbi centre) and certainly not to an account in China.
4 Please note, that "freely usable" is not the same as "freely tradable" which applies to the other currencies in the IMF's SDR basket.
5 Now 51% owned by the China Materials Storage and Transportation Development Company (CMSTD) following its purchase in January 2016 from Mercuria. CMSTD has been charged by the Chinese government with building a network of commodity houses outside China.
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