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Conflicts of Interest

It is a measure, if any were needed, of how far the London Metal Exchange has departed from its purpose of running a free market, that in a week when more than 1Mt of aluminium sits in an LME-registered warehouse in Vlissingen, creating a queue of 666 days to deliver out, and 5.1Mt of aluminium (about 14% of world consumption) is generally on warrant, that the LMEs main concern is that of its own sale.

It seems a bit like a case history of the decline and fall of the City of London: from the home of financial fair play to a breeding ground for conflicts of interest.

What we are talking about, in regard to the LME, is the devilishly clever mechanism by which our Victorian forefathers devised a method to hedge; enabling the forward sale of base metals departing from far off parts of the world, and the establishment of fixed forward purchases for the once-giants of British industry.

To the outsider its arcane systems, its open outcry, the idiosyncracies of dates, borrows, lends, backwardations and contangoes might be complicated but its outcome of price was simple. People believed the prices that the LME published. Its values reflected the true world supply and demand for base metals. During the Cold War, as a mark of the respect in which the LME was held, both Stalinist Russia and Mao’s China implemented their state-controlled purchases and hedge sales through the exchange.

Most of the ills of the LME, can be laid at the door marked ‘conflict(s) of interest’. The big one is the fact that Category 1 ring-dealers, such as JP Morgan, were allowed to own not only a seat on the inner ring of the exchange but also a large proportion of LME-approved warehouses. In other words, those with an interest in prices via their managed funds and proprietary trading appear also to have an interest in one of the fundamental drivers of price. JP Morgan’s action was copied by other banks and large trading houses – Goldman Sachs bought Metro warehouse in Detroit, Trafigura bought Nems, Glencore bought Pacorini, Noble bought DNS, Barclays bought Erus and CWT, the Singapore warehousing group, backed into Marc Rich Investment.

The problem for LME users (of the diminishing old-fashioned physical metal trade variety) is a psychological one. Who would enter into a hedge purchase or hedge sale knowing that the stock of the LME is so well held by banks or traders? What physical metal merchant would feel confident of their actions when price movements have departed from the fundamentals of supply and demand? This is the cumulative effect of the absence of stewardship i.e. the lax controls which have allowed banks and large trading houses to use the LME as their toy.

The first issue a new owner of the LME needs to address is to ensure that any party with an interest in prices is made to divest their interests in warehouses.

Mining Journal, February 24th 2012