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The 145-year-old London Metal Exchange (LME) came perilously close to imploding in March as its nickel contract turned wild.
The potential for multiple member defaults posed an “immediate and serious systemic risk to the market,” according to LME Chief Executive Matt Chamberlain.
The contagion risk extended way beyond nickel, creating what Adrian Farnham, head of LME Clear, described as potential “liquidity stress across the entire financial and real-world metals market.”
The first detailed account of what happened on the fateful day of March 8 has emerged from court filings as the LME contests a combined $472 million lawsuit from U.S. hedge funds Elliott Associates and Jane Street Global Trading over its cancellation of nickel trades.
The exchange argues that it had a regulatory duty to do so in a disorderly market that was causing a liquidity drain on its members.
Lawyers for both sides will contest the devilish legal detail. The rest of us get a thrilling account of the near collapse of the world’s foremost industrial metals exchange.
DEATH SPIRAL
Had the LME not suspended nickel trading and cancelled trades on the morning of March 8, it risked generating what Farnham described as a “death spiral”.
LME Clear is the exchange’s clearing house, acting as guarantor to every trade and levying margin payments to ensure it has enough collateral to do so.
As the nickel market exploded upwards, LME Clear required ever higher margins against open short positions.
When the three-month price CMNI3 rose 7.6% to $29,130 per tonne on Friday March 4, it generated an intraday margin call of $2.6 billion, 40% higher than the previous record.
Another price surge to $55,000 per tonne on Monday triggered a wave of nine intraday margin calls totalling $7.0 billion before LME Clear took the “extremely unusual” step of suspending further calls for fear of defaults.
Indeed, six members failed to meet their overnight margin payments, totalling around $2.0 billion, which raised the spectre of a mass default as the nickel price spiked to an early Tuesday high of $101,365 per tonne before plunging back to $81,000 when trading was suspended at 08:15 London time.
Basis a price of $80,000, the collective margin call would have been $19.75 billion. Had the price gone back up to the earlier spike, the call would have been another 25% higher.
The LME estimated five members would be forced to default but the true number is now known to have been seven.
Those members held around 11,248 lots of open nickel short positions, which would have had to be picked up by LME Clear at a cost of $2.6 billion.
That exceeded LME Clear’s default fund by $220m, which would have required a further call of at least $1.22 billion to cover the loss and restore the default fund to its required regulatory level.
The LME estimates another five members would have then defaulted, meaning the transfer to LME Clear of another 17,627 lots of nickel short positions with a loss value of $170m.
This would have required more collateral, a vicious circle that could only end when there were no more members left to pay.
CROUCHING BEAR, HIDDEN DRAGON
The LME found itself in a race against time with a nickel price that was running out of control.
The cause of the nickel market melt-up was a collision of events and a big hidden short position.
The LME knew that exchange stocks were low and was monitoring the market in the months leading up to March, according to the court filings.
“When Russia invaded Ukraine in late February 2022, the LME viewed this as giving rise to a particular risk of volatility in the nickel market since Russia is a major nickel producer”.
The market agreed, which is why the LME nickel price started rising as soon as Russia initiated its “special military operation” on Feb. 24.
When the LME Special Committee met on the afternoon of Monday March 7, nickel’s price rise, although extreme, was explicable by “geopolitical and macroeconomic” drivers, particularly the potential for sanctions on Russian nickel, the LME said.
Fundamentals, however, couldn’t explain the price doubling again in the early hours of Tuesday morning.
It was the big short positions lurking in the over-the-counter (OTC) shadows which played a major part in the market disorder.
The biggest, but by no means only, OTC short was China’s Tsingshan Group, one of the nickel industry’s biggest players with extensive operations in Indonesia.
The LME claims it had no knowledge of those positions at the time of the market blow-out. “The LME does not monitor OTC positions and, indeed, there are only limited circumstances in which the LME requests disclosure of information about Members’ (or their Clients’) OTC positions,” it said in the court filings.
It does now, though, after amending its rules in June to require members to report all OTC positions.
That should help to narrow the information gap that was undoubtedly a contributor to the March chaos.
CIRCLE OF CRISIS
The LME’s nickel crisis isn’t over.
The lawsuits will wind their way slowly through the British courts. The nickel contract itself is suffering from low liquidity and resultant volatility.
The current LME executives can at least take comfort from the knowledge the grand old dame of metal trading has been here before and survived.
The best historical comparison with this year’s events was The Tin Crisis of 1985, when a default by the International Tin Council’s buffer stock manager risked exactly the same domino effect of defaults among the exchange’s 27 ring-dealing members.
The risk was compounded by the lack of a clearing function in what was at the time a market of principals each liable for their own debts.
It took almost four years and multiple lawsuits before tin trading resumed in 1989. By which stage the LME had hooked up with LCH.Clearnet to provide a full clearing function to prevent the risk of mass default in the future.
That relationship ended in 2014, when the LME brought clearing in-house with LME Clear.
What was meant to be the ultimate safety net, however, almost turned into a potential death spiral that could have finished the LME.
Source: Reuters