LME puts its foot on the high-speed pedal to attract volume

In the global race among bourses to attract trading volume, metals exchanges are increasingly dealing with a counterparty that has become controversial in equity markets: the “black box”, or computer-driven, trading programme.

The London Metal Exchange wants to broaden access to its electronic trading platform, and recently outlined plans to make it easier for non-UK based traders to access the system. To encourage participants to trade in greater volumes, the exchange is offering fee rebates.

Trading on the 136-year-old exchange is still done via telephone and face to face in the “ring”, the last bastion of open outcry commodity trading in London. Introducing more algorithmic electronic traders, or algos, is an attempt by the LME to increase business.

As the world’s largest banks have withdrawn from commodities trading during the past few years, the number of entities willing to take the other side of trades has reduced. At the same time a growing number of computer-driven funds, which often follow models and technical signals to trade, have entered the field.

Lightning-fast automated trading has been accused of exaggerating price moves in several markets, both by accident and design. So-called high-frequency traders first came to the public’s attention after the 2010 flash crash, when the Dow Jones Industrial Average plunged more than 600 points in minutes.

“Where they add liquidity we want them in the market,” says Matthew Chamberlain, head of business development at LME. “We absolutely don’t see algo traders as creating volatility.”

Bought by Hong Kong Stock Exchange in 2012 for $2.2bn, the LME faces growing competition from US futures exchange operator CME Group for a slice of this speculative trade. Easing access to its electronic trading system and simplifying futures contracts could increase its attractiveness.

The LME has traditionally catered for physical producers and consumers of industrial metals, from Alcoa to Coca-Cola, allowing hedging on specific dates to match company risks.

But when the LME lifted a trade ratio volume restriction this year on its most liquid contracts, several algo funds hooked up to the exchange, according to Mr Chamberlain.

“It’s a pure liquidity-adding algo — it’s a win-win for the market,” he says.

In 2012 the LME allowed clients to place their systems in data centres closer to the exchange’s matching engine, which puts buy orders together with sell orders, through the Equinix data centre in Slough.

High-speed and computer model-based funds have come to make up most of the trading activity in metals markets since the departure of many banks after the financial crisis.

“All of the liquidity is going to the screen,” says one trader. “The normal liquidity providers aren’t stepping in and taking any risk at the moment — that’s part of the problem with the market.”

Also driving the LME’s strategy is China, where a growing amount of capital is available for investing in overseas commodities markets. More than 100 state-owned companies were given the green light to trade in overseas futures this year, adding to the 31 that were already allowed. In addition, a growing number of Chinese hedge funds want to trade foreign commodity futures contracts electronically.

Copper trading volumes and open interest on the Shanghai Futures Exchange has almost caught up with the LME thanks to speculative market participants, according to Bank of America Merrill Lynch. The Shanghai exchange introduced a nickel contract this year, so it has all the same metals as the LME. In April CME launched a zinc futures contract.

The arbitrage between China and overseas metals contracts is an increasingly watched metric, especially as electronic trading is open on the LME, Comex in New York and SHFE during the same hours. A dramatic fall in the price of copper in January started in the middle of the night London time, driven by Chinese selling.

“If I was setting up a hedge fund today, the arb is the best place to express fundamental views,” one market participant says.

But others say more speculative, computer-driven trading is causing sharp moves in prices because all models tend to trade in the same direction. Aluminium sharply reversed in price last September as algo funds sold on a strengthening US dollar.

“It has increased intraday volatility but that doesn’t necessarily increase overall volatility,” Duncan Letchford, CEO of Galena Asset Management, a unit of Trafigura, says. “It’s pushing markets through previous technical levels on an intraday basis but they have a tendency to mean revert.”

“There are times when it is extremely frustrating as a major user of the LME to see a computer program jump in front of you — it happens enough you have to address how you submit your orders,” Mr. Letchford says. “I think you have to adjust your trading style.”

But increased profits from trading strategies that benefit from volatility are drawing in investors. Funds that profit from price moves in commodity markets returned 15.67 per cent last year, according to the Newedge CTA index, which tracks the 20 largest managed futures funds by assets under management.

“The LME is a mature market,” says one market veteran. “You’re not going to double volumes by convincing more miners and smelters to hedge on the LME, because they already are. Where can they increase volumes? It has got to be speculatively.”