Cancelled Nickel Trades on the LME
Early in the morning on Tuesday March 8th the Nickel market, which had been a bit wild for a while finally broke. And the problems were starting to spread to other industrial metals too like zinc. Nickel whose price typically moves a few hundred dollars per day had jumped almost $20,000 on Monday, and by 6AM in London it had more than doubled again, trading at $100,000. This was a 240% price rise in just over 24 hours. A huge, short-squeeze was under way. We should note that the price of nickel really matters to the global economy, it’s an important metal, mostly used in making stainless steel, but also used in alnico magnets and rechargeable batteries.
This is not a video game retailer whose day-to-day stock price is significantly less important. The huge, short squeeze triggered billions of dollars of losses for traders leading the London Metal Exchange to suspend trading for the first time in over thirty years. This was the first major market failure since Russia’s invasion of Ukraine and it showed how the removal of one of the worlds largest producers of an important commodity from the financial system could lead to chaos in global markets. But there was much more going on here than just that.
The London Metal Exchange made the essentially unheard-of decision to not just close the market, but to cancel all 5,000 nickel trades that had been executed that day. Trades worth nearly $4bn. It is estimated that the exchange wiped out $1.3bn of profit and loss on the deals, they did this claiming that the decision was “in the interests of the market as a whole”.
By wiping a whole days worth of trades from the record books, the exchange crossed a line with traders who rely on the exchange. Not only did the exchange fail to manage the risks in a reasonable manner, but it also chose winners and losers when its role is to stay neutral and simply provide a venue for trading. So, who were the winners that were chosen in this decision? Well, cancelling the days trading activity would have been most helpful to Tsingshan Holding Group, the worlds largest stainless-steel producer who is estimated to have lost $8bn on their short position.
Many traders who lost out because of this highly unusual decision by the exchange pointed out that the LME’s is owned by Hong Kong Exchanges and Clearing – a Chinese firm. The biggest known loss was a Chinese company, and that company’s biggest lender and broker, who would have been hit by the company’s failure is a Chinese state-owned bank. The CEO of the LME rushed to say that the decision to cancel trades was not motivated by the LME’s links to its Chinese parent. “I can unambiguously say that the nationality of the participant was not a relevant factor here,” he said. OK so we need to go back in time a bit to understand what led to this huge, short squeeze, and how could the LME have dealt better with the situation? So, let’s start with Xiang Guangda, the Chinese tycoon who owns Tsingshan Holding Group.
He started out his business making frames for car doors, in eastern China. He then went on to pioneer new methods for producing nickel and stainless steel that made his company the world’s largest producer of both metals. His nickname in the Chinese business community is “Big Shot”, and he has a reputation for betting big on his visions for the future.
So why would the worlds largest nickel producer be betting against the metal? Well, like a lot of commodities, nickel had rallied a lot post Covid as producers struggled to keep up with the surging demand. Xiang felt that the price had spiked a bit too much, but not just that, perhaps more importantly, Xiang was on both sides of the market, as both a producer of the metal and a trader. His company, already the largest nickel producer in the world, planned to increase production by 40% in 2022. Not many people believed he could ramp up production that much, but if he could – that much extra nickel hitting the market would likely push prices down. Now, not everyone agreed with his vision, some hedge funds betting on a boom in electric vehicles thought nickel prices would rise, but overall analysts generally agreed with Xiang that nickel production would likely outpace demand in the medium term. Everything changed when Russia invaded Ukraine.
Russia is the world’s third-largest producer of nickel, producing just over ten percent of the global nickel that is mined, and importantly, Russia produce refined nickel—the type that is deliverable on the LME. Xiang produces nickel matte – also known as nickel pig iron, a low-grade ferronickel mined in Indonesia. You can’t deliver this metal to settle short positions taken on the LME. It is worth clarifying that in commodity markets many producers and users take short positions to hedge against losses on the physical commodities they hold in inventories. Any price changes on the futures market should offset price changes in the value of the physical stock they hold—and this does work – and it does make sense, as long as the traders can meet their margin calls. It’s not clear to what extent Xiang saw his position as a hedge against prices falling or as a speculative bet.
There is also a long history of commodity producers losing fortunes on huge speculative bets, and when you look at the commodity trading desks of all of the big producers around the world, you will start to notice that they are headed up by people with backgrounds in trading at financial firms. It is not obvious that all of their trading is actually hedging – or risk reduction… on March 7, when nickel surged from $30,000 a ton to more than $50,000. LME brokers and their clients were hit with margin call after margin call. Some of the big brokers got margin calls of close to $1 billion each over the course of the day.
Tsingshan’s margin calls were even larger, coming to around $3 billion, according to Bloomberg. The company paid some of its margin calls early on Monday, but there was a problem. While they had access to nickel – being the worlds largest nickel producer, it was the wrong grade of nickel, they couldn’t deliver this against the contracts they had signed. And while their stores of nickel would have been growing in value offsetting their financial losses, they did have a valuable asset, but doesn’t mean they had the cash to meet their margin requirement. As the price rose more and more, Tsingshan started struggling to pay, there was blood in the water, and the LME would have known this, and this was probably the right time to halt trading.
It is very reasonable to halt trading at a point like this if your goal is to maintain an orderly market, as this would give Xiang, and other big traders who had not been prepared for this level of volatility time to arrange loans with their banks. Banks would most likely be happy to lend money against the valuable nickel that Xiang owned, but they only move so quickly. Additionally a break in trading would have also given him time to exchange his nickel pig iron for high grade nickel which could be delivered to the LME’s warehouses to close out his position.
When an exchange demands margin from a client, their broker often puts up the margin first and then asks their customer for the funds. Xiangs brokers had put up margin with the exchange while receiving no margin from their client – they were now exposed to market risk. Some started buying nickel contracts to hedge this risk, pushing the price of nickel ever higher. It was a classic short squeeze, as the pain for Tsingshan, its brokers, and other shorts created a self-reinforcing cycle. The LME held a special committee meeting that Monday morning to discuss the issue and decided to let the market keep trading.
When the price took off on Tuesday, Tsingshan was no longer the only nickel company that was struggling—they were just the biggest. Many producers, traders, and users of nickel with short positions on the LME were now facing margin calls many times larger than they were prepared for. With nickel at $100,000, the brokers themselves wouldn’t be able to meet their margin calls. Four or five LME member firms would have failed, possibly devastating the global metals industry. The LME then made the near-unprecedented decision to cancel all of the trades that took place on Tuesday morning—$3.9 billion of them. Exchanges sometimes cancel trades when technology glitches or “fat fingers” cause one-off mistakes – most traders find even that controversial.
But it’s unheard of for an exchange to cancel an entire day’s trading after the event. Doing this reset the nickel market to the moment when it closed on Monday at $48,078. Even at that price, half a billion dollars of margin calls went unpaid by clients according to Bloomberg. Tsingshan accounted for about half that amount. And that was just for the portion of their short position held directly on the exchange—about 30,000 tons.
The company had a further 120,000 tons or more in short positions off the exchange, in over-the-counter deals with banks like JPMorgan and Standard Chartered. The fallout of the LME’s decision to cancel trades was immediate, aggrieved traders contacted their lawyers to take legal action against the exchange. They were furious, I spoke to one trader who saw twenty five million dollars in profits vanish due to the cancelled trades. Executives from Goldman Sachs Group voiced their displeasure to the management of the LME and other firms put their exchange memberships under review. Hedge fund manager Cliff Assness took to twitter to ask the LME to explain why people should keep trading with them, if this was the way they handled things. An LME broker I spoke with told me how he had spent years convincing commodity producers that they should hedge their production on the exchange and convincing hedge funds that it was a reasonable place to speculate.
After this event many of these clients have entirely lost faith in the exchange as a reasonable place to do business. The LME does have a competitive advantage above other exchanges around the world. It has a vast network of warehouses where the physical commodities being traded can be stored and delivered.
But producers and buyers of metals don’t actually need to deal with an exchange. Producers can simply lock in prices with their customers for years into the future, negotiating prices and credit terms. There are only so many big producers and users. This may be a less liquid market, but it will do the job.
A modern commodities exchange is not just a venue for hedging though, even if they claim that is the purpose of the exchange. They invite speculators in too who want to bet on prices and not just hedge production or consumption. Adding speculators into the mix increases liquidity and reduces transaction costs and should improve market efficiency. Anyhow, once the nickel market was shut, Xiang had time to sort out some of his problems. According to Bloomberg J.P. Morgan and China Construction Bank extended some credit to
him and Chinese authorities directed Tsingshan’s domestic banks to offer even more credit lines to the firm with the majority to be used for margin calls on existing positions on the LME. A few people I spoke to in the industry questioned whether JP Morgan would extend such a large loan to Tsingshan – or at least to the corporate entity within China, as if you wire 8 billion dollars into China – a country with capital controls, you might not be able to get that money back out. Only certain Chinese companies – generally state-owned ones can send money out of the country.
It is likely that Tsingshan has an offshore entity that it uses for trading on the LME, but such entities are not generally very well capitalized, and banks wouldn’t typically lend to them, as they would only want to lend to the legal entity that holds significant assets as collateral. But anyhow, Tsingshan was able to borrow the money they needed, simply because Tsingshan produces lots of nickel, and as the price of nickel goes up (and it loses money on its short) the value of its assets goes up too. So, that is one problem solved, and next we learned from China's Securities Daily that Tsingshan had managed to gather enough plate nickel – which is deliverable on the LME - to settle their trades. Industry insiders were a bit skeptical about this, saying that it would have been almost impossible to collect that much plate nickel in such a short length of time as China is not a large producer of high grade nickel. One of the people I spoke to said that it is possible that the nickel that was sourced could be Russian nickel, which is not actually sanctioned, so legally they could deliver it, but he told me that none of the western banks that are significant players in the nickel markets would be comfortable taking delivery of that, so if that is what happened, it could cause problems in the future, as it sits in a warehouse at the clearinghouse unclaimed. Most of the large financial institutions would look on an asset like this as being a bit like a blood diamond.
Even though Russian nickel is not actually sanctioned, people are treating it as if it is. OK, so at this point a lot of the problems were sorted out, and on Wednesday this week, the LME reopened nickel for trading, but this time with 5% price limits - meaning that it would only allow the price to move up or down by 5% - but surprisingly the starting price they chose was the price it had closed at on the Monday. That close was not necessarily an obvious price to pick, as it was part of the way through the squeeze, but also ignored the cancelled trades that had happened on the Tuesday. Arguably the point of taking a week off trading was to let investors line up the appropriate financing, and come back to move nickel to a reasonable market price that was representative of the supply demand dynamics of the industry.
There is no reason to think that last Monday’s closing price was the “right” price, the LME could have possibly decided now that no one is forced to buy or sell due to margin calls, we can just let the market open and move back to the real price, no matter what that is, but that is not what happened. On top of this the LME announced that they would stop reporting an “Official Price” for nickel for some time. A key element of the day’s trading on the LME is to generate the Official Prices, which are used by the industrial metals community around the world. The LME said that they will only start publishing Nickel Official Prices once these are discovered without a daily price limit being engaged during the relevant Ring trading session. I guess what is happening is that the LME want the price to move to a reasonable value, but they are in no rush for that to happen, so for now they plan on opening it at the wrong price every day for a few days, closing it instantly, and they wont report that as an official price – as they recognize that this makes absolutely no sense The LME reopened referencing the price on Mondays close with a rule that the market would close if the price moved up or down more than 5%, and when it re opened, the reasons for the short squeeze had disappeared so the market opened down 5% a few trades occurred outside of the price band – which shouldn’t have happened and so the LME went and canceled them.
Oh no… So now the price was just too high. The LME had basically come to a situation where they were going to let the price fall back to whatever fair value was, but slowly. I’m not sure how this makes sense. The next day they did it again, but to speed things up, widened the bands to 8%. The start of the second day of trading was delayed to 8:45 a.m. after a series of problems
hit the LME’s electronic system, a few trades managed to go through before the market was officially started, these were then cancelled, and when the market finally opened, futures dropped by the daily limit of 8%, but only two trades occurred. For today, the limits were set even wider at 12% and the market went limit downright away at the open again. Matthew Chamberlain, CEO of the LME told CNBC the exchange had “deliberately prioritized stability” by setting a relatively narrow range of daily trading limits, but these could soon be widened if the exchange observed a “more orderly market.” This mess just piles further embarrassment on the LME The exchange is allegedly in discussions with its regulator, the FCA, and with the PRA, which monitors its clearing house, and the regulators have made no comments to the press on the matter.
I guess I should finish up by pointing out that metal trading has been such a fiasco this week, that the mining industry has possibly become a meme. Adam Aron, the CEO of AMC announced a few days ago that he was buying a gold mining company. He described it on twitter as a bold diversification move. I suppose that is probably true… It is a gold mine that does not appear to actually be mining gold at the moment, but it did go public via a SPAC in 2020 – which is important for meme stocks, and I guess in many ways gold is possibly history’s oldest meme investment, so I’m sure that will go well. The stock did actually rally on the news.
Anyhow, that is it for now, if you missed my video on the economic effects of Russias invasion of Ukraine, you can click here to watch it. Have a great day, and see you again soon. Bye.
2022-03-21 02:15
