A surge in nickel prices in March threatened to topple a London Metal Exchange entity designed to keep troubles in a single market from infecting the financial system, according to the fullest accounting to date of a crisis that has shaken confidence the 145-year-old venue.
LME’s clearing house faced a $2.6bn loss in early March when the price of nickel jumped more than 200 per cent in a single day, while a stability fund that provides a further layer of protection would have been nearly wiped out, legal filings published this week show. The disclosures shine light on why senior executives made the highly irregular decision to halt trading and cancel billions of dollars of deals in a fraught period on March 8.
The group’s filings came as it combats a $470mn legal challenge launched by US hedge fund Elliott Management and Jane Street. The LME, which is owned by Hong Kong Exchanges and Clearing, has been accused of failing to perform its regulatory duty when it cancelled the trades.
Prices for nickel, used in steelmaking and electric car batteries, surged 230 per cent in a day, leaving LME members potentially needing to kick in $20bn in margin payments, cash required for trading. That was 10 times higher than the previous record of March 4 and a level that threatened to tip it and its members into a “death spiral”. At the centre of the chaos was a huge bet on falling prices made by Chinese steel producer Tsingshan, which was upended by the big move higher in prices.
The LME said it was forced into its emergency measures as up to seven of its members could have defaulted on payments due to its clearing house if it had let eight hours’ worth of trades stand.
But the legal filing also underscored that the LME’s own clearing house, set up to protect the market against defaults, was also in severe danger, with the LME potentially unable to trade other metals and posing “a significant systemic risk to the wider financial system”, it said. The LME declined to comment further.
A clearing house stands between two parties in a trade and helps prevent a default from cascading through the market.
The LME had concerns about the market the day before the main incident on March 8. On March 7, surging prices forced it to make an unprecedented nine intraday calls for more margin, totalling $7bn.
An internal meeting at 1.45pm London time on March 7 decided the clearing house would not ask for any more margin calls, which it admitted was “extremely unusual and a departure from internal policy”. The market did not close until 7pm.
Adrian Farnham, then chief executive of the clearing house, stated that the measure was “no more than a temporary stop-gap and was not sustainable beyond the end of the day: LME Clear could not continue to be under-collateralised against member default”, the filing said.
UK rules mandate that clearing houses must measure their liquidity and credit exposures to their members on “a near to real-time basis”.
Matthew Chamberlain, LME chief executive, stated that at the end of the day, in his view, the market remained orderly as traders tried to reprice assets in the wake of Russia’s invasion of Ukraine and the imposition of sanctions.
Prices surged again on March 8, pushing up margin calls, with the LME later estimating that seven members could have defaulted. If that had happened the LME would have been forced to take on the short positions of the defaulting members, it said. The positions, if sold at prevailing market prices, would have resulted in a loss of $2.6bn for the exchange.
But the LME said the size of losses would have eaten up both the clearing house default fund that protects the market as a whole against a sudden collapse of one of its members, and the clearer’s own funds that are used as a backstop, and still left a shortfall of $220mn.
The clearing house would have needed to ask its members for at least $1.2bn as soon as possible, and to find fresh funds of its own. If more members defaulted on nickel trade payments it could have cost the LME an extra $170mn and required it to take on thousands of short positions in other metals markets.
The LME insisted in the court documents that its decision to cancel trades was based on the need to maintain an orderly market and its regulatory objectives, denying that it was influenced by LME Clear’s exposure.
Sarah Taylor, a partner at HFW, a law firm, said the severity of the potential ramifications for the metals market could favour LME’s defence that it was motivated to comply with the regulatory obligation for its clearing house to remain fully collateralised.
“This potentially does provide an answer to Jane Street’s claim,” she said. “If the LME can establish that its regulatory obligations would have been breached had it not cancelled the [March 8] trades, it will be difficult for the claimants to show that this was an unreasonable decision.”
The Financial Conduct Authority and the Bank of England, the LME’s main regulators, are conducting a review into the LME’s handling of the incident. Consultants Oliver Wyman are also leading an independent review into the circumstances leading up to the nickel market squeeze. The report is due by the end of the year.
Colin Hamilton, managing director of commodities research at BMO, said the detailed defence provided further details on how severe the crisis, sparked off by the niche nickel market of approximately 3mn tonnes per annum, could have been.
“The fact that a market so small could cause severe financial strain will undoubtedly catch the eye of the regulators,” he said.