Fideres's two cents on the copper fix


Key Findings

§  The London Metal Exchange (“LME”) Official Price for copper is an important benchmark for transactions involving copper and related derivatives: annual trading volume for futures contracts that reference this benchmark is approximately USD 2 trillion

§  Fideres has identified sharp and consistent declines in the copper price in the 30-minute window before the Official Price is fixed, in an analysis of intraday pricing data covering the period 2005 to 2015

§  Similar pricing anomalies have been observed in other precious metals (such as gold) markets that have since been the subject of regulatory enforcement actions and class action litigation in the United States

§  We further find that between 2012 and 2015, all major dealers downgraded their membership category on the LME, allowing them to escape more onerous scrutiny and compliance requirements.


Background

LME is the world’s major trading place for industrial metals, including copper. Copper is traded on all of LME’s three trading platforms:

§  Telephone market which is open for trading 24 hours a day;

§  LMEselect, the LME’s electronic trading platform, which is also open for trading 24 hours a day; and

§  The Ring which is an open outcry platform, and in which each metal is traded in distinct five-minute windows. Only LME category 1 members (“Ring Members”) participate in these ring trading sessions.

The daily Ring trading windows for copper are as follows:

Ring Session

London Time (pm)

First ring session

12:00 – 12:05

Second ring session (official price fixing)

12:30 – 12:35

Third ring session

15:10 – 15:15

Fourth ring session

15:50 – 15:55

Source: LME, Fideres

For each metal, including copper, the LME publishes various official prices:

§  Official Prices, both bid and offer, for cash and various forward delivery tenors up to ten years. The Official Prices are based on the last bids and offers quoted during the second ring session; and

§  Official Settlement Price, which is the last cash offer price during the second ring session.

For purposes of this memo and our analysis, we will refer to the various LME Official Prices and the LME Official Settlement Price together as the Official Price. 

Market Size and Trading Volume

The Official Price is an important benchmark for transactions involving physical copper and copper derivatives including exchange traded futures. The following chart shows annual trading volume of CME copper futures, which has increased significantly since 2000 and reached almost USD 2 trillion in 2017.

Source: Bloomberg, Fideres

In terms of CME futures, the copper market is as large as the silver market and approx. one fourth of the gold market.

Source: Bloomberg, Fideres

Products Affected by the Official Price

Copper market participants include producers, fabricators, consumers, financial institutions, hedge funds and individual traders. Most of the products traded by these market participants are either directly or indirectly affected by the Official Price.

Contracts directly linked to the Official Price

§  Physical Copper – most physical copper trades are done by reference to either the LME Official Price or the LME Official Settlement Price;

§  LMEminis Copper: – LMEminis futures are cash-settled based on the LME Official Settlement Price;

§  Copper Monthly Average Futures: – the settlement price is the Monthly Average Settlement Price (MASP) which is the average of the daily LME Official Cash Settlement Prices over the relevant number of business days;

§  Traded Average Price Options (TAPOs): – settlement is based on the average of the daily LME Official Settlement Prices for the relevant month (MASP); and

§  Exotic derivatives and structured notes – copper derivatives may be structured with reference to either the LME Official Price or the LME Official Settlement Price.

 

 Contracts indirectly linked to the Official Price

§  Exchange-traded copper futures, i.e. futures traded on the LME, the Chicago Mercantile Exchange (“CME”) and the Shanghai Futures Exchange (“SFE”);

§  Exchange-traded and OTC copper options; and

§  Exotic derivatives with indirect linkage to copper prices, incl. structured notes.

Ring Members

The list of LME ring members (also called “category 1” members) has changed frequently over time. In addition to various specialized brokers, the following dealers were ring members for at least part of the Analysis Period: Barclays (Feb 2005 - Nov 2011), Credit Agricole, (Feb 2005 - Oct 2007), J.P. Morgan (Aug 10 - Sep 2015), Jefferies (Aug 2012 - Nov 2013), Natixis (Feb 2005 to Jul 2012), RBS (Feb 2005 to Jun 2010), and Societe Generale (Feb 2005 to Nov 2017).

 

Source: LME, Fideres

Some of these brokers have ceased being a ring member or are now category 2-5 members which lowers their compliance burden. Category 2-5 members are not allowed to trade in the Ring by open outcry and instead route their orders through one of the category 1 ring members.

We note that some of the world’s largest commodity traders, such BHP Billiton and Glencore, are category 5 members which are not regulated.

Pricing Analysis

Overview

Fideres investigated the average intraday price movements of CME copper futures and found that copper prices have on average decreased sharply during the 30-minute window leading up to the close of the second Ring session.

As shown in the chart below, this sharp average downward movement is unique to the second Ring session, at the end of which the Official Price is determined.

Source: LME, Fideres 

The chart below shows that, during the five minutes prior to the determination of the Official Price (i.e. between 12.30pm and 12.35pm), copper prices decrease more days during the Analysis Period than outside of the Analysis Period.

Source: CME, LME, Fideres

This is also confirmed if we look at the percentage of days with positive and negative movement by year.

Source: CME, LME, Fideres

Forecasting Error

The chart below exhibits the 30 minutes Squared Error of the Average for the Analysis Period and Post Analysis Period. As it is possible to see, the pattern is different between the two periods.

 

Source: CME, LME

 The spike of the squared error of the average during the Analysis Period concurrently to the LME Official Price fix is bigger in magnitude than Post Analysis Period.

UK Fines and Litigation

A recent UK lawsuit revealed how Barclays has managed to manipulate the LME Closing Price in order to increase the Futures margin paid by their client. Specifically, it is alleged that Barclays sought to manipulate the LME Closing Price by repeatedly bidding large sums for copper positions right before close of trading.

The results shown in the previous sections are potentially a sign of banks conducting similar unlawful practice in order to manipulate the LME Official Price. In fact, the LME Official Price is more vulnerable to manipulation due to the fact that it is based on the last bid and offer made in the second morning Ring trading session.

Fideres has identified 27 LME fines related to manipulative copper trading in the Ring. Despite these fines, LME has failed to take decisive action to prevent the market from being distorted by manipulative trades.