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Lord Michael Farmer, guest speaker at the annual LME dinner in the Grosvenor House Hotel, London, called on the exchange to remain competitive to its users. He welcomed the recent decision by the LME to cut fees but warned that exchange trading market share was up for grabs.
“There are many exchange competitors and even some here in London, who are waiting in the wings and would be very happy to take over the mantle of the LME. If costs of trading on the exchange are prohibitive, it will drive customers away and the golden goose will die of malnutrition,” he told the audience.
“Many users will still find the cost of trading to be high and I would strongly recommend the LME to consider further reductions to attract liquidity back,” he added.
Average daily volumes on the LME have been declining through 2016, most recently dropping by 11.4% year-on-year in September.
The LME attributes the decline to various factors including a downturn in China and the physical market that underlies the exchange’s trading contracts. Members, however, point to a rise in fees on short-dated carries, critical also to industrial clients who roll positions daily.
The exchange responded by cutting fees on the member leg of short-dated carries by 44%, bringing the cost down to match the client fee of $0.50 per side, inclusive of trading and clearing.
Lord Farmer, who has attended over 50 LME dinners during his career in metals, said that it is of the “upmost importance” to maintain the trust and goodwill of the exchange’s users in a rapidly changing world.
“Markets are living organisms – they are made up of people and their opinions and their actions,” he noted.
“The whole area of trust and integrity of functions is vital to a successful market place. An exchange, whose first priority is to serve the needs of its users rather than its own needs, will find that by so doing, it will be serving well its own needs too,” he added.
He also spoke fondly in support of the merchant trader, of which he has been one for much of his career.
“I have found over the years we [merchant traders] often get the blame for a lot of price movements and goodness knows what else,” he said.
Lord Farmer co-founded metals-focused hedge fund Red Kite and started trading in January 2005. When it launched, it was the first hedge fund active in China’s physical market.
Nicknamed ‘Mr Copper’ by the trading community because of his expertise in the metal, Lord Farmer started as a difference account clerk for LME ring trader AJ Strauss. He has worked at various companies with some of the industry’s legendary trading figures, including Manfred Kopelman at Anglo Chemical and Dieter Boettcher at Philip Brothers.
HFTs Lord Farmer likened the activity of some high frequency traders (HFTs) to front-running, which is now illegal and puts many other market users at a serious trading disadvantage.
He said that the LME runs the risk of – through its own rules and regulations – giving some market users an unfair advantage over others, “particularly in the brave new world of electronic platform trading”.
“In this regard, I would highlight the area of HFTs, who appear to me due to their advantage of co-location platforms, to have a nano-second advantage over other users and can jump in front of incoming orders in the market,” he said.
Lord Farmer said that in most cases, this ensures the orders behind HFTs buy at higher prices or sell at lower prices than would have otherwise been the case if the HFTs’ server had not been co-located with the metal exchange.
“This does appear to me to be an unfair advantage and could be described as front running, an age-old practice where you placed your own personal order in front of your incoming customers order. Sums then extracted from clients were considerable and enriched many brokers of long ago, but this is now illegal,” he noted.
“Today it appears that users who are not co-located could likewise, in the long run, be at a considerable disadvantage. This will without doubt reduce liquidity and volumes on the LME,” he added.
According to Lord Farmer, high frequency trading appears to have “no other purpose than to make money from the trading of other participants by jumping ahead of them”.
This results in additional cost and inefficiency of execution for liquidity providers, and so “it should not be a surprise if the consequence is that liquidity reduces and our marketplace is damaged,” he told the audience.
“In fact, this may be part of the explanation why volumes are falling at the present time. There needs to be a level playing field for all users of the exchange,” he said.
Regulation During his speech, Lord Farmer also highlighted the danger of excessive government intervention in the market place, either as principals themselves or through regulatory authorities.
Farmer cited the scandal of the International Tin Council, which defaulted on its metal exchange contractual obligations in 1985.
The International Tin Council which was made up of 22 sovereign governments, including the UK and Switzerland, set up the buffer pool to control the tin price. Having underestimated the global surplus, the buffer pool manager entered into far more purchase contracts of tin than it had funds for and in 1985 walked away from obligations worth $1.4 billion.
“It was a salutary lesson to all involved, that governments are not only human in not knowing how future markets will develop, but also you could say, not as blue chip as they claim to be and do need to have proper credit assessments like the rest of us,” Lord Farmer said.
He meanwhile noted that it is not only governments that control prices, citing for example a Zambian copper producer cartel whose influence on the market price was only broken by demand from China.
“The law of supply and demand wins eventually and great is the fall thereof of whoever is trying to either hold prices up or keep prices down against these natural market pressures,” he said.
“Bunker Hunt in the silver market in the 1970s and Sumitomo in the copper market in the 1990s are further examples which warn of the danger of thinking one’s self bigger than the market,” he added.
Lord Farmer also noted the controlling creep of regulatory and compliance requirements, originating ultimately from government departments, “which can smother free trade and easily extract the oxygen of liquidity from the market place.”
“Ideas such as banning short-selling and limiting position sizes, for example. The ‘free’ part of free market capitalism is to be fiercely defended from interference and intervention,” he said.
“A new wave of state intervention seems to be at hand, the legitimacy of political control riding on the back of the fashion to disparage city workers and markets of all stripes. The financial services industry has become a political football which has to be resisted,” he told the audience.
“We need to remember and remind people that the LME operated smoothly and without disruption during the financial crisis of 2008,” he added. Reiterating that he is, always has been and will continue to be a great supporter of the metal exchange, Lord Farmer highlighted the LME’s governance, rules and regulations, arbitration system, warehouse delivery and supply systems, and quality of registered brands. He said that these factors, along with a political and legally stable backdrop and expertise of its members and users, have all helped the LME to thrive.
Super-cycle Farmer – who said that he may be approaching “some sort of conclusion” to his trading career on the metal exchange – is a base metals “super cyclist”.
“I believe the 21st century could be the century of commodities in spite of the current poor patch,” he noted.
Metals, such as zinc and copper, have a finite life, he said, and this – in conjunction with the world’s demographic trends and growing prosperity – will help produce volatile markets and rising prices as demand over the years outpaces supply.
“This is even taking into account human ingenuity in devising substitutions, when prices get too high,” he said.
“So a well-run and trusted market serving its users will be of paramount importance during this century and liquidity is key,” he added.