The LME debacle raises serious questions for the City of London

A decade ago, Paul Tucker, then deputy governor of the Bank of England, issued an impassioned appeal to financiers and his fellow regulators. He wanted them to wake up to the dangers around the clearing houses that underpin exchanges.

After all, he noted, three clearing institutions had failed in living memory: two, in 1974 and 1983, because of gyrations in commodity prices; and one, in 1987, when equity prices caused a Hong Kong clearing house to fail, with “devastating” market impacts.

“This [Hong Kong] episode warrants more study than it has received,” Tucker noted, lamenting the complacency of the financial sector. “Had it been London, Chicago or New York, it would have entered the folklore of policy memory.”

Today, Tucker’s warning seems depressingly prophetic, given that the London Metal Exchange’s concerns about default risks have left it facing potentially ruinous lawsuits, including from the hedge fund Elliott Associates.

Every large clearing house should know this financial history — especially one that is owned by Hong Kong Exchanges & Clearing.

But this week’s lawsuits were triggered by a decision that the LME took on March 8 to cancel $4bn-odd in trades, following a 250 per cent rise in the nickel price in two days.

The LME says it did this because the market had become “disorderly”, without explaining what this meant. It is to be hoped that a forthcoming report from the Bank of England and the UK Financial Conduct Authority will provide details.

This saga makes everybody involved look bad — LME management (who were seemingly complacent about default risks), regulators (who were asleep at the wheel) and the exchange’s own members (who blocked badly needed trading reforms last year).

How did the City of London get to this sorry state? The bare facts are these: a year ago, I am told, Elliott traders started placing bets that nickel prices would surge due to global supply chain tensions. When Russia invaded Ukraine, that happened. Then nickel prices spiked dramatically higher when the tycoon behind Tsingshan Holding Group, China’s leading stainless steel group, had to buy contracts to offset massive short positions in the over-the-counter market.

By the morning of March 8, market prices and tensions were so extreme that players on the winning side of the moves had amassed around $1.3bn paper profits in a mere two days (over half of which supposedly accrued to Elliott). But the losers were small traders and Tsingshan’s founder Xiang Guangda, who had big loans to Chinese banks and JPMorgan.

Big margin calls loomed, and had there been a string of defaults, LME Clear only had a laughably small $1bn-odd reserve fund to dip into. But on March 8 the LME suspended trading and later cancelled that day’s trades. That saved LME Clear, the Chinese tycoon (and his lenders) and small exchange members — but it also wiped out the hedge fund’s putative profits.

The LME is now trying to offset the damage. It has introduced daily price move limits, doubled the size of LME Clear’s default fund and is demanding more transparency from banks around over-the-counter positions.

These reforms are sensible, albeit hopelessly belated. But they may not be enough to rebuild confidence. After all, as Elliott’s suit points out, the LME’s actions in March look so capricious that, at best, they reek of panic and, at worst, of naked favouritism. Which, of course, undermines the City’s claim to uphold the rule of law and a level playing field.

This argument does not mean that Elliott and the funds will necessarily triumph in court. They face a big challenge since the LME’s founding charter appears to give it the right to cancel deals, and English law offers exchanges some protection against tort claims (which is why the litigants are using a judicial review mechanism, instead).

Moreover, Elliott is unlikely to win much sympathy in the court of British public opinion. The hedge fund is famously aggressive and profit-hungry.

What is more, many non-bankers are apt to feel uneasy about the fact that commodity markets have become so prone to “financialisation” in recent years, shaped by speculators rather than players in the real economy.

Ironically, the LME leaders themselves have also agonised about this trend, as has the Chinese government (which is another story).

But even if the hedge fund loses its compensation claim, this will not remove the need for urgent answers to some crucial questions. Does the City of London still believe in a level playing field? Can its regulators and financial leaders manage risks sensibly around clearing houses, or anything else? Does anyone even read history books?

And if Elliott actually wins its case, the questions will only mount. Will the LME collapse under compensation claims? Will litigants then seize control of the LME? Or will the deep-pocketed HKEX bail it out? What could Beijing do? Financial history might be about to take an intriguing, and alarming, turn.

gillian.tett@ft.com