Founded in 1972, systematic multi-strat manager, Campbell & Company, has been trading a selection of base metals (copper, aluminum, zinc and nickel) on the London Metal Exchange (LME) since April 1998, as a subset of a larger grouping of commodities. “We see a lot of opportunities in terms of moves in markets, how the models respond, and adjust accordingly,” says Campbell & Company’s Executive Director, Trading Lead, Cheryl Scungio, who was featured in The Hedge Fund Journal’s 2018 edition of ‘50 Leading Women in Hedge Funds’, in association with EY.
The LME currently has some female clerks, but no female traders and has historically had only two. The first came in the 1970s: Geraldine Bridgewater, whose autobiography, Ring of Truth, discusses the stresses and pressures of her career. The second was Bethan Wilde, who was a trader between 2007 and 2013, and now works at the LME as a relationship manager. There is a perception that the noisy, shouty ring trading environment may deter some women, though the bulk of LME trading volumes are now executed electronically or by telephone.
Over the course of Scungio’s 18-year career at Campbell, the LME has gone through a number of milestones, including: reforms to warehousing; the Hong Kong Exchange takeover; new fee structures; more electronic trading; clearing; EMIR; MiFID II, and the launch of new markets, with changes to margining expected over the next year.
The warehousing structure is one of the unique features of the LME. Warehouses are not owned by the LME but are a key part of its ecosystem. Though fewer than 1% of LME volumes are physically settled – and Campbell has, thankfully, never taken nor provided physical delivery – LME-approved warehouses are involved in settling LME contracts via delivery of a warrant. Inventory backed by warrants has met quality and other standards and can therefore be traded as a future.
For decades, the system operated without issues, but it became dysfunctional around and after the great financial crisis of 2008. After Lehman Brothers collapsed, the economic slowdown reduced industrial demand for base metals, which multiplied volumes of inventory. Aluminium was acutely hit as a collapse in demand for autos and airplanes interacted with persistently high supply, due to the high costs of mothballing production. Incentives to store metal with the warehouses exacerbated the glut. “For instance, the quantum flowing into the Detroit metropolitan warehouse mushroomed from 50,000 tonnes at the start of 2008 to 847,000 tonnes by the end of 2009,” recalls Scungio.
We see a lot of opportunities in terms of moves in markets, how the models respond, and adjust accordingly.
Cheryl Scungio, Executive Director and Trading Lead, Campbell & Company
This allowed the warehouse owners to earn more rental income, and made warehouses very attractive investments for banks such as JP Morgan and Goldman Sachs, which had bought Metro; and commodity traders such as Trafigura and Glencore, which had bought Pacorini.
But a disconnect existed between abundant inflows of inventory and strictly controlled outflows. “When owners of metal tried to withdraw their holdings, they ran into the minimum load-out rules – which warehouse owners commonly treated as maximums, ultimately creating huge queues of users paying rent while awaiting access to their physical metals. At one stage, the anticipated waiting time reached one or two years. Aluminium for instance went into super-contango, prompting banks to use the metal as collateral. The queues worsened as financiers tried to move their metal out of LME warehouses into less expensive storage facilities. The aluminium situation resulted in some degree of cross-contagion, as owners could not withdraw their copper or nickel either,” explains Scungio.
It was not actually a bad time for investors such as Campbell, who were able to follow the trending price higher. “The warehouse issues fed through to the price which in turn impacted our trading. As a systematic trading firm, the price or similar quantitative inputs are our main drivers,” says Scungio. This is perhaps a good example of how trend-following strategies can profit from extreme price action around real-world crises, bubbles and busts.
“But the warehouse issues meant merchants had total bargaining power over physical consumers, which distorted the pricing mechanism for the global aluminum market, whether sourced from LME or elsewhere,” says LME CEO, Matt Chamberlain. Hence, the LME, which is committed to serving physical users in addition to financial investors, had to take action to restore an orderly market. The LME Warehousing consultation began in July 2013, a few months after the LME was acquired by Hong Kong Exchange, whose Chief Executive, Charles Li Xiaojia, took decisive action in resolving the issue.
“The reforms made in 2013 and 2014 reduced the ability of warehouses to pay the large incentives that contributed to the queues problem,” says Chamberlain. “The LME warehouse system provides market confidence in terms of quality control, and the new load-in, load-out rules, suspending fees for those in queues, seem to have resolved the problems,” concurs Scungio.
“Overall, inventories are now lower, partly due to the health of the global economy, but not as low as they were in 2005 or 2006,” reflects Chamberlain. The composition of inventories has changed, with a higher proportion now held off-warrant. “I watch the shift between on- and off-warrant storage (released daily) because any large irregularities will move prices. I feel the warrant system and network of warehouses is an LME strength,” says Scungio.
Indeed, even on-warrant storage is not without its risks. In China and Singapore, there have been a number of scandals where duplicated certificates were used to get multiple loans over the same lot of metal. Conversely, the LME has never had a warehouse fraud scandal.
After 136 years of mutual ownership by its members, the LME was taken over by HKEX in December 2012. LME was formerly run in the interests of members and kept fees low. “When HKEX took over, it had to invest a lot, among other things, in building a clearing house,” points out Chamberlain. HKEX initially hiked fees sharply, which stimulated OTC trading activity, and former LME CEO, Martin Abbott, even floated the idea of building a rival exchange. Fees later came down somewhat and are thought to be competitive in relation to contract sizes. The LME also sought to reduce the difference between OTC and on-exchange trading costs by imposing a surcharge on OTC activity, which still uses LME infrastructure to some degree. Fees now work out at $2.70 for exchange trading versus $1.90 for OTC trading, per contract. “It took a few years to find the right balance between exchange and users,” says Chamberlain.
1972
Campbell & Company founded
“Of the potential acquirers, which included CME Group and ICE, the HKEX respected the existing market structure most,” says Chamberlain. Today, around 10% of business goes through the ring (split between ring trades and basis trades), 40% is on the LMEselect electronic platform, and 50% goes through the interoffice telephone voice-broker market, before being booked onto the exchange. “The interoffice market is in effect an OTC cleared market,” says Chamberlain.
The ring and LMEselect are lit venues. “The interoffice market is a dark venue, but differs from equity dark pools in that it is bilaterally negotiated with no interaction between different orders, and has no crossing algorithm so requires users to search out trade volume,” says Chamberlain.
Judging by the ICE acquisition of IPE – which ended open outcry – some possible buyers might indeed have effected more profound change than HKEX did. The LME is Europe’s only open outcry market partly because this is perceived to help price discovery in the complex curve of calendar spreads. “Unlike a traditional, monthly futures market, the LME is the only on-exchange market with a daily date structure with many combinations of dates and carries sought after by traditional physical users who are the DNA of LME,” claims Chamberlain. Nonetheless, HKEX has accelerated the move towards electronic trading, which members had previously been very slow to embrace. And for the first time in 143 years, from March 18, 2019, there is a three-month trial of electronic, screen based, price discovery for nickel closing prices. “The ring is great theatre and marketing, but we must challenge ourselves, and the question is whether it is the best place for price discovery,” says Chamberlain.
The LME’s consultation revealed that hedge funds generally have a preference for electronic price discovery based on a VWAP (Volume Weighted Average Price) mechanism similar to other markets to determine closing prices. Says Scungio, “the LME’s trial period for testing an electronic close is a testament to the exchange’s commitment to listen to market participant feedback. Although the ring close was always transparent, an electronic close will bring the LME in line with other exchanges. More participants will actively determine the close as opposed to only ring members. We will monitor the trial period but have no current plans to alter the method in which we trade.”
Some 98% of Campbell’s metal trading is now on the LMEselect electronic platform. Campbell trades with the LME via brokers who are members of it. Some of them are ‘Category 1’ members who have access to the infamous ring.
Says Scungio, “now that electronic trading volumes have increased throughout the entire trading window, the opening of the ring – noon UK time or 7am US time – does not dictate the start of my trading day. I tend to start trading metals as early as 3am US time or 8am UK time.”
The geographic location of the ring has changed several times as the LME has moved around London offices, but its rules of conduct have remained constant. Traders can be fined for standing up, wearing an open neck shirt, having no tie or chewing gum, as part of a code of conduct that also includes restrictions on pointing – because hand signals can be binding ways to trade. Brokers may also cover their mouths when on the phone to prevent lip-reading.
Most liquidity resides in the three-month rolling prompt date and the origin of this dates back to the first copper contracts in 1877, when the voyage to London from Chile took three months. Campbell trades some financial contracts up to one year ahead, but mainly trades base metals at quarterly 3rd Wednesday maturities, and does not reach out into the longer dated contracts of up to ten years that are on offer at LME.
Both speculative and physical traders are active in the three-month rolling prompt, but it adds a level of complexity that deters some market participants who prefer more standardised contract tenors.
“Physical players are permitted to hedge to any date, which eliminates basis risk, while financial users typically reference the third Wednesday. Both cases require two trade legs to adjust to the desired maturity, resulting in higher brokerage contracts. Additionally, standardising to the third Wednesday still cannot be done electronically – it still involves calling a broker to make the necessary adjustment trade to coordinate with standard IMM dates. Brokers earn a profit from charging across two spreads,” says Scungio.
“The LME is aware that funds do not always like the rolling three-month dates, as they can become progressively less liquid as they approach maturity. To cater for financial participants, the LME is seeking to increase user choice via an implied pricing model for electronic trading in its matching engine. The engine adds together the three month carry and outright prices, to produce a netted price that has become more liquid, with tighter bid/offer spreads,” says Chamberlain.
It seems that this was a step in the right direction for hedge funds. Says Scungio: “the new model for trading on the implied price is an exciting and attractive prospect. However, we continue to trade on the three-month basis and adjust because the available range of implied dates is not expansive enough to accommodate our strategies. We continue to work with the exchange on recommending modifications that would make the new implied model workable for us.”
“A third Wednesday prompt traded directly on platforms would be helpful for some participants but not others. This can, perhaps, attract new clients and the LME may run into trade-offs in doing so,” observes Scungio.
These and other changes were partly the upshot of the formal, public consultation that in 2017 had invited members of the metal-trading community to comment on various evolving topics at the LME. Scungio was one of those in the CTA world who participated.
“The strategic review was prompted by a desire to validate the model and justify its differentiators including: the daily date structure, open outcry ring, and large non-lit telephone market,” says Chamberlain.
The strategic review was prompted by a desire to validate the model and justify its differentiators including: the daily date structure, open outcry ring, and large non-lit telephone market.
Matt Chamberlain, CEO, LME
If liquidity has deteriorated in some financial markets, Scungio has noticed an improvement in LME liquidity as participants have got used to the three-month roll.
Liquidity on the LME comes in roughly equal measure from physical users, medium term investors and intraday traders. The LME’s Commitments of Traders report was introduced as part of the warehouse reforms and is broadly comparable to those published by other exchanges, but the nomenclature is different. As per the 2017 Discussion Paper on Market Structure, the LME label for “systematic financial traders” does not fit the usual definition and focuses instead on intraday traders. Campbell comes under the umbrella of “fundamental financial traders”, which includes those trading over periods beyond one day. They may actually be discretionary and fundamental traders, or systematic and technical players, or those combining various approaches.
Indeed, the “fundamental financial traders” category is not a homogenous group. For a start, some of them are long-only, while others, like Campbell, take both long and short positions. The behaviour of long-only commodity index operators can throw up opportunities for more active traders. “The long-only indices roll like clockwork between the 5th and 9th business day of the month and in their consistency they do provide opportunities. It is possible to take advantage of knowing that information. We get broker research on anticipated index moves and can strategically plan around them,” says Scungio.
Metals have historically had a few market manipulation scandals such as the Hunt brothers ramping silver in 1980 (which was not traded on the LME then, but is now via LMEprecious), and the Sumitomo case for copper in 1996. The LME has no position limits per se, but those above a certain threshold are forced to lend out their inventory, in effect selling calendar spreads at a certain price.
Manipulation apart, “all markets have attempts at low-level abuse. We have surveillance systems
designed to detect spoofing, layering, momentum ignition, ramping and so on,” says Chamberlain. Some of these market conduct issues can be associated with High Frequency Trading. “High Frequency Trading is controversial in most financial market exchanges. To guard against any malign side effects of HFT, the LME has adopted market conduct rules similar to those of other exchanges,” says Scungio.
“Our systems are not particularly low latency, so there are limited benefits from super high frequency trading. We distinguish between unhelpful forms of algorithmic trading – such as jumping in front – and helpful forms, that can add liquidity,” says Chamberlain.
“Algorithmic trading can be extremely important to maintain the implied curve structure and add price discovery. It also helps to arbitrage between CME Group’s Comex and LME prices, where there is a latency element,” he goes on.
Campbell uses algorithms for electronic execution, and is not involved in HFT. As part of best execution analysis, Scungio carries out transaction cost analysis, and compares the performance of various algorithms. She has found “transaction costs to be uniform across all brokers we use”.
Since clearing is not mandatory for commodities, it is possible to do OTC trades referencing LME prices, on an uncleared basis. Hedge fund managers have been very much in the vanguard of voluntary clearing however, and Campbell clears all of its LME base metal trades through LME Clear, which is the only clearing house (bar the parent HKEX, one in Russia and one in India) licensed to use LME prices, and operates exclusively for LME.
Building LME Clear was a big project. “LME Clear was the first EMIR-compliant clearing house to go live,” says Chamberlain.
EMIR also marked changes in terms of segregating client and broker assets. “A consequence of the EMIR regulation segregating client and house accounts, is that an extra transaction has to be done to shift trades from broker to client accounts, which made trading costlier for brokers and clients alike,” says Scungio.
“The drive to comply with EMIR and MiFID rules was a huge effort, since they assume electronic trading and do not envisage open outcry. Rules such as minimum matching times had to be adapted to the ring,” recalls Chamberlain. “The telephone market does not have pre-trade transparency throwing up offers on the screen; a consultation on this topic is ongoing,” he adds. “MiFID II impacted the timing of rolls,” reflects Scungio.
ESMA rules help to determine margin rates. The LME is in the process of moving from CME Span margining, to a VaR based approach, which is expected to apply to all users by early 2020. Scungio welcomes this. “CME Span margining dates back from the 1980s, when not much computer power was used,” she says. “VaR tends to be more accurate and efficient. “The move to VaR from Span should make the margining more accurate although it will be more variable,” she adds.
Campbell’s four chosen base metals are selected partly based on liquidity: copper and aluminium are most liquid, followed by zinc and nickel. Campbell researched the lead market but concluded it might be easy to get into but less liquid to exit. Campbell also trades copper (and precious metals) on Comex.
The regional variations between physical prices and the LME global price relate partly to the transport and storage costs but are not really relevant to a macro trader such as Campbell, which focuses on the global market price. Additionally, Campbell has not traded, and has no plans to trade, LME options.
On 11 March 2019 the LME launched seven new cash-settled futures: two hot-rolled coil, two aluminium premiums, alumina, cobalt and molybdenum. Cash-settled contracts are one new departure for LME, which has historically offered physically-settled ones. Campbell has not taken the plunge into these inaugural contracts. “But we continually evaluate new trading opportunities across all markets and liquidity is a key component that guides decisions,” says Scungio.
Just as cobalt is important for batteries and electric vehicles, so too, is lithium, which is in the pipeline of the LME’s planned product roll outs. It just happens to be rather abundant in Chile, from where the exchange started sourcing copper back in the nineteenth century.
Investors searching for new sources of diversification should watch this space.