The London Metal Exchange’s metastasising warehouse problem must be solved once and for all by prohibiting warehouse companies from issuing more warrants at affected locations until load-out delays have been reduced to an acceptable level.
The delivery problem has grown and morphed, affecting every aspect of the way metals are traded and supplied. But rather than adopt a bold solution, the exchange continues to tinker with the existing, broken system, layering on more complexity and creating more opportunities to game the system.
Any review of warehousing must start by recognising that warrant holders own the metal — not the warehouse, not the exchange and not the broker. Warrants are titles of ownership, they are not trading “chips”. It is the responsibility of the warehouse operator, regulated by the exchange, to ensure the owner can get access to his or her metal without undue delay.
Preventing warehouses issuing new warrants until queues are brought down to acceptable levels would recognise LME-registered warehouses provide a service, for which they receive a premium rent, and a vitally important part of this service is timely access to the customer’s metal.
For the second time in less than four years, the LME has been forced to launch a consultation about how to cut the long queues affecting customers trying to obtain their metal from LME-registered warehouses.
Announcing the results of the last consultation in May 2011, LME Chief Executive Martin Abbott insisted the problem “is specific to aluminium and to one location; the LME does not have a systemic issue with its warehousing network.”
The exchange responded by increasing the minimum load-out rates based on a sliding scale depending on how much metal a company is storing on warrant at a given location.
Despite the reforms, the problem has spread to other locations across North America, Europe and Asia, and affects almost all the LME’s main metals contracts, as my colleague Andy Home has carefully chronicled over the last two years. In October 2012, Charles Li, chief executive of the Hong Kong Exchange, which bought the LME last year, caused a stir when he threatened to aim a “bazooka” at the warehousing problem.
The rhetoric has subsequently moderated. Li wrote in a recent blog that the problem “can’t be solved with either a bazooka or a surgical operation. Instead, a modest approach, such as Chinese medicine, might be the cure.”
On July 1, therefore, the LME launched a new consultation on a proposal to “cut existing queues and prevent new queues from forming.” According to the exchange’s press notice: “If there is a queue of more than 100 calendar days, the affected warehouse would be expected to deliver out additional metal based on a formula.”
Warehouse operators are private businesses, not owned or controlled by the exchange. But their right to issue special warehouse receipts (LME warrants) for metal in their custody which can be offered as good delivery to satisfy futures contracts has always been subject to regulation.
Warehouses are free to store any metal they like off-warrant. But if they want to store metal on warrant they must comply with requirements set by the exchange.
The LME already regulates many aspects of warehouse “terms of service” to provide assurance to exchange users. Rules cover location, transport links, weight and quality checks, security and even minimum load-out rates.
The exchange currently prescribes minimum acceptable load-out rates related to the amount of metal the operator is storing on-warrant at a particular location. The problem is that the relationship is not close enough.
Following the last round of reforms, the LME introduced a sliding scale. For a warehouse company storing up to 300,000 tonnes at a particular location, it must be able to load out a minimum of 1,500 tonnes per day, rising to 3,000 tonnes per day for operators with more than 900,000 tonnes of stock.
There are two problems with this system. The first is that minimum load-out rates rise much more slowly than the amount of metal in storage. An operator with 900,000 tonnes has three times as much on-warrant as one with only 300,000, but the minimum load-out rate is only twice as high.
The second is that the load-out scale takes no account of new metal coming into the warehouse so stocks (and delays) can continue to worsen even if the warehouse operator meets its minimum load-out requirements.
In many instances, the minimum required load-out rate has become a maximum. Warehouse companies (most of which are now owned by brokers and banks that are members of the exchange) benefit from queues because they can continue collecting rent on metal during the lengthy waits for it to be delivered out.
Warehouses maximise their earnings by taking delivery of metal and putting it onto warrant as quickly as possible while delivering it out as slowly as the rules allow. The cynical observer might conclude warehousing companies have no incentive to resolve the delivery problem.
Warehousing companies have responded to demands for even higher load-out rates by noting that load-out is subject to physical constraints such as the width of warehouse doors. But that has left customers incensed when they see operators continuing to deliver new metal into the warehouse and put it onto warrant while protesting they cannot get any more metal out.
The LME’s latest set of proposals attempt to tackle this problem of distorted incentives. Minimum load-out rates would be linked to the average delay over the previous three months.
Warehouses with a queue of more than 100 days would be required to load-out more than they load in, which should eventually shrink the amount of stock in the warehouse and cut delays.
The LME believes the proposal will shrink existing queues in the medium term and prevent sustained long queues from forming in future. But it admits that “implementation is complex” and 100-day queues may come to be seen as acceptable. In the same way minimum load-out rates became maximum ones, the 100-day threshold could become a minimum waiting time for metal.
There is a simpler solution. The exchange could simply prohibit warehouses from issuing new warrants (or refuse to register them in its SWORD recording system) until delays have been brought down below a minimum acceptable level.
The acceptable threshold could be set at 100 days, or lower as 100 days is still a very long time for an owner to wait to obtain their metal.
Forbidding warehouses from issuing new warrants until they can assure timely delivery on existing ones is within the exchange’s powers. It would recognise that timely delivery is an important aspect of the quality of service warehouses provide to the owners of the metal — something the exchange can and should regulate.
It promotes maximum flexibility for warehouse operators.
Rather than cap the amount of metal an operator can store, or impose a complex formula linking load-in and load-out rates, warehouse operators would be free to receive and store any amount of metal — provided they can continue to guarantee a minimum service quality level by providing timely load-out within a maximum number of days (averaged over three months to maintain operational flexibility).
If a warehouse cannot cope with demands for delivery, it should not be accepting new metal.
And if the operator cannot meet acceptable service standards, it should not be allowed to issue more warrants until it resolves the problem, either by allowing the volume of metal to fall, or upgrading its facilities to permit faster load-out.