The London Metal Exchange needs to overhaul how it oversees live trading to prevent another market collapse after it was forced to cancel $4 billion in nickel trades, a report into the fiasco says.
The exchange needs to improve its risk and control functions and upgrade its volatility controls, according to consultants Oliver Wyman, who were commissioned by the LME to review what caused the March 2022 crisis in the nickel market.
The exchange cancelled $4 billion in trades on March 8 after a short squeeze stemming from a position held by Chinese steel manufacturer Tsingshan sent nickel prices soaring by more than 240%.
The move erased an estimated $1.3 billion of gains for long position holders. In the aftermath of the incident, nickel trading was suspended for more than a week.
Oliver Wyman investigated the events that led up to the breakdown, including the growing threat of sanctions on Russian nickel producers and low nickel warehouse stocks. Following the invasion of Ukraine on Feb. 24, nickel prices rose in line with other metals, and bid-ask spreads remained at typical historical levels, it found.
But “large short positions had been built-up by a number of participants long before concerns over the invasion of Ukraine surfaced,” the report said. “Two positions, both with significant [over the counter] components, were particularly large in relation to the financial resources of their owners.”
Between March 3 and 7, prices across all metals rose, increasing margin requirements for traders, while order books declined relative to historical norms.
“Smaller physical nickel producers and traders began to cover short positions held in LME and OTC contracts, with 10 physical participants accounting for almost 50% of risk-reducing trades on 4 March. This led the nickel price to dislocate from other metals and appears to have been the start of the significant short squeeze that followed,” Oliver Wyman’s report said.
The review, which has seven recommendations for the LME, said the exchange needs to introduce to clear risk controls over how it manages the exchange, such as extending its risk and control functions to “explicitly cover identification and prevention of market distortions.”
The consultancy also called on the LME to tighten enforcement to “prevent risks of market distortions” and to monitor “significant risks” in the OTC market.
Volatility controls also need an upgrade, the report said, “to slow down extreme price moves.”
The LME also fell short on its “operational readiness” to manage “extreme events”.
Oliver Wyman said the LME should “draft and formalise LME and LME Clear playbooks for each broad type of extreme event, recognising the need for flexibility and discretion given the wide variety of scenarios and inherent unknowns”.
The LME should set out the expected roles of the LME and LME Clear under each scenario, alongside those of market participants and other stakeholders.
The LME should also improve communication with members “to better understand how they manage client defaults on OTC and centrally cleared positions, and assess how the risks of such default scenarios can impact the LME.”
To improve confidence, Oliver Wyman also suggested developing a “clear vision” for how the LME will respond to events and rebuild liquidity in future.
LME chief executive Matthew Chamberlain said: “[The recommendations] are understandably wide-ranging and multi-layered, and as such the LME Group intends to consider them carefully to ensure that the full market impact, and any potential unintended consequences of specific measures, are assessed carefully before moving into the implementation-planning phase.
“The LME Group has already taken proactive steps to reduce the likelihood of a similar event happening in future (including, for example, the introduction of specific tools such as daily price limits and periodic OTC reporting.)”
The LME is still awaiting the outcome of a regulatory probe by Financial Conduct Authority and Bank of England into the nickel market meltdown.