LONDON, June 9 (Reuters) – The London Metal Exchange’s (LME) nickel nightmare continues.

US hedge fund Elliott Management and trading house Jane Street are suing the stock exchange for $456 million and $15.3 million respectively over its handling of the nickel market crash in March. Read more

The LME suspended trading in its nickel contract at 8:15 a.m. UK local time on March 8 after the price exploded to $101,365 a tonne. It also canceled all trades between midnight and the market stop.

A legal reaction was to be expected from the aggrieved long position holders. The LME and its owner Hong Kong Exchanges and Clearing (HKEx) (0388.HK) rejected the claims and “will vigorously defend any judicial review proceedings.”

The legal action will consist of a legal stress test of the LME rulebook, in particular the definition of what constitutes an orderly market.

But it’s not just about money.

The cancellation of the agreed transactions violated a cardinal rule of the market for many in the investment community. The LME and UK regulators will have to persuade them it won’t happen again if they are to return.

LEGAL DEFENSES

The legal defenses of the LME are at first sight formidable.

Its rules grant the exchange broad powers to act in an “emergency”.

These powers are exercised through the “Special Committee”, a body created to eliminate any conflict of interest from interventions in the LME market.

Chaired by longtime former LME director Phillip Crowson, the ‘specials’ include LME chair Gay Huey Evans, who also sits on the UK Treasury Board, LME Clear board member Marco Strimer, the arbitration lawyer Barbara Dohmann QC and LME Independent Director Dr Herta Von Stiegel.

The Committee “may take such action as it deems necessary, in its sole discretion, to contain or rectify” any “undesirable” situation.

Additionally, in the event of “a significant price movement for a short period of time”, the LME may suspend trading and “may cancel, modify or correct any trade agreement or contract”.

As always, the legal devil will be in the details, for which we await the LME’s promised “medico-legal” report on what happened before the events of March 8th.

ORDER, DISORDER

“The LME has undermined confidence in its ability to monitor the markets by failing to meet its regulatory obligations to maintain an orderly market,” according to the Managed Funds Association, which represents more than 140 investment firms. Read more

The LME, for its part, says it was precisely because the nickel market had become “messy” that it acted.

“It became clear that prices in the early hours of trading (of March 8) did not reflect the underlying physical market and that the nickel market had become disorderly,” he said in a statement dated 10. march. As such, the trades were canceled to bring the price back to the last point at which the exchange “could be satisfied the market was behaving in an orderly fashion”.

However, it is now clear that the exchange also acted to avoid what it perceived to be a systemic threat resulting from participants’ failure to meet margin calls on the explosive movement in nickel prices.

The LME said it “has serious concerns” that the stress of margin calls “raises the material risk of multiple defaults”.

A cascade of defaults by less well-capitalized member firms would have risked repeating the stock market’s near-death experience during the 1985 tin crisis.

The messiest market of all is the one where half the players have just technically gone bankrupt.

CARDINAL SIN

Many fund managers, however, will take a long time to convince.

The LME’s decision to call off the trades was “totally, incomprehensibly wrong,” Ken Griffin, chief executive of investment firm Citadel, told Bloomberg TV.

Griffin, who “didn’t have a meaningful position on nickel at all,” warned that “when you interfere with the markets on an ex post basis, it’s incredibly destructive to the sense of the markets.”

Jane Street appears to agree, telling the Financial Times that the damages sought are “secondary”. Rather, it wants to send a message that it would take action against any “unreasonable” behavior by an exchange.

Retroactive cancellation of trade for such like-minded free marketers is a cardinal sin.

March 8 was “one of the worst days of my professional career in terms of monitoring an exchange’s behavior,” Griffin said.

FREE MARKETS

The irony is that the LME has always prided itself on being a free market bastion of light regulation, eschewing position limits, circuit breakers or fixed loan caps.

The 145-year-old stock exchange is the epitome of London’s traditional laissez-faire approach to professional wholesale venues.

The LME rulebook was written by Alan Whiting, who parachuted into the UK Treasury exchange to clean up the aftermath of the Sumitomo copper fiasco of the 1990s.

The danger of such a hands-off approach, however, is that a market can get so wild that regulators are left behind the curve trying to tame it.

Whiting himself admitted that one of the strongest arguments in favor of automatic intervention “is the difficulty of analyzing and evaluating the reasons and causes of backwardation or unusual price movements”. (“Market Aberrations – The Way Forward”, 1998)

Any discretionary intervention by an exchange “may inadvertently be wrong and inappropriate” and even “correct” will always be “challenged because there will always be parties who consider themselves financially disadvantaged.”

Premonitory words, but the LME decided at the time not to apply the automatic constraints of the market and the London trading community has resisted them ever since.

They are now in place on all LME physically deliverable contracts and maintaining them will be a minimum requirement for many funds.

The key, according to Citadel’s Griffin, is the “need for clarity on trading rules.”

The days of LME resistance to preemptive and automatic market intervention seem numbered. Indeed, they may already be finished.

What is beyond doubt is the urgency to fix the regulatory system that led to May’s chaos.

Griffin predicted a shift in liquidity to other venues and “you’ll see people leaving the markets.”

It is already happening.

LME nickel trading volumes fell 35% year-on-year in May, part of a broader 13% drop in trading activity last month.

And Britannia Global Markets has just announced its intention to drop its membership in LME clearing, citing “a clear reluctance by some participants to support the existing LME market structure”. Read more

It will continue to trade metals but on an over-the-counter basis, a warning sign that liquidity is already slipping away from the exchange.

The opinions expressed here are those of the author, columnist for Reuters

Editing by David Evans

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