London’s new precious metals contracts analysed

Author: Amélie Labbé | Published: 18 Aug 2016
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The World Gold Council and the London Metal Exchange (LME) will introduce a series of spot, futures and options contracts for gold and silver in the first half of 2017, in a bid to bring the precious metals market into the 21st century.

According to CEO Garry Jones, LMEprecious will help optimise precious metals trading. The initiative has made some ripples in the London market, with a number of key market players not on board with the plan.

Old system

Traditionally, the existing bilateral over-the-counter (OTC) system, which was launched in the late 1910s sees the price of metal fixed privately twice a day – once in the morning and once in the afternoon – by a group of banks looking at bids and offers, and determining a price.

The LME’s new system aims to modernise the London market to ensure it is more accessible and transparent. “In theory, an exchange-traded contract should be more efficient,” said Claude Brown, partner at Reed Smith in London. “In practice, however, it may or may not work – contracts could be withdrawn because of the lack of liquidity.”

Some market players have grown weary of the bilateral system in part because of its inherent opacity. Rate-fixing scandals that previously affected the Libor and forex markets called the integrity of the financial markets into question, prompting tighter regulatory oversight, including in the gold trading market.

There is also an ongoing issue of lack of liquidity, as a lot of banks have divested bullion capability because of increasing regulatory and storage costs. In May this year, China’s ICBC Standard Bank acquired Barclays' London precious metals vault, which can hold up to 2,000 tonnes of gold, silver, platinum and palladium for a value of $90 billion.

It is said to handle around $5 trillion in gold transactions every year, the largest physical gold trading market globally.

KEY TAKEAWAYS
  • The LME’s new precious metal contracts system aims to modernise the London market to ensure it is more accessible and transparent;
  • Some market players have indeed grown weary of the OTC system in part because of its inherent opacity;
  • Competition and increasing investor demand from China could be key drivers of this modernisation drive;
  • According to the LME’s head of business development Matt Chamberlain, LMEprecious will work hand-in-hand with the existing OTC system; 
  • LMEprecious doesn’t have the buy-in of all market players, including of the LBMA and key bullion banks, which could be an issue.

New solutions

However, London is facing increasing competition from other commodities trading markets worldwide, which are increasing their market share. The Shanghai Futures Exchange launched a gold futures contract in 2008. COMEX in New York, part of the New York Mercantile Exchange, manages the world’s largest metals futures trading platform.

“Some would argue that if it’s not broken then there's no need to fix it,” said Brown. “But then you have increasing competition and investor appetite from China so you could argue that London doesn’t want to lose its status as capital of gold trading and is therefore being proactive.”

According to the LME’s head of business development Matt Chamberlain, LMEprecious will work hand-in-hand with the existing OTC system. All trading of new contracts will be cleared via LME Clear, the LME’s own clearing house, and will benefit from tighter on-exchange price discovery.


"Some would argue that if it’s not broken then there is no need to fix it"


OSTC, a UK trading house, and investors including Goldman Sachs, ICBC Standard Bank, Morgan Stanley, Natixis and Société Générale will co-own the LMEprecious platform, and will act as liquidity providers.

This should help bring more efficiency to the bilateral system. The London Bullion Market Association (LBMA), which manages the OTC trade for gold and silver under supervision from the Bank of England, is also working separately to build its own trading platform. It consulted last year with the market on ways to “enhance transparency, improve efficiency and expand the technology requirements in the market” to address specific concerns including the Net Stable Funding Ratio as defined under BASEL III, and post-trade reporting.

“I don’t see the introduction of a new system such as the LME's as wanting to change the market,” said Raj Karia, partner and head of corporate, M&A and securities - Europe, Middle East and Asia at Norton Rose Fulbright. “I suspect that a few other new systems will emerge and compete with the existing ones, and we will be able to see which one works best or is more widely adopted.”

Problems?

The LME’s plan has been met with varying degrees of suspicion and scepticism, notably because it doesn’t have the buy-in (yet) of some of the market’s key players. This includes the LBMA. HSBC and JP Morgan, which the Financial Times calls “London’s two largest bullion banks,” are said to want to maintain the OTC status quo – albeit with a few improvements.

There are also conflicting trends within the gold market itself, with retails investors calling for more transparency. This may be not be to everyone's taste.

“On the non-investor level, you have the interbank market and the sovereigns,” explained Brown. “The problem is: the latter category may want more privacy when carrying out their trades so a more transparent system may not necessarily work for them.”

Gold
Gold trading in London is due a revamp

One of the main criticisms directed towards the introduction of a new gold futures structure is the LME’s lack of presence in the gold market. The ICE Benchmark Administration oversees the gold price setting for the LBMA. The LME, which was acquired by Hong Kong Exchanges and Clearing in 2012, has not been involved in precious metals trading for over 20 years. Its last initiative in that area, London Gold Futures Market, survived three years and shut down in 1985 due to lack of investor interest.

“The current system will change, but I believe there will not be an immediate change,” said Karia. “The London gold market hasn’t changed significantly for a significant amount of time so it may take time for it to evolve.”

As such, it remains to be seen how successful LME’s new proposed system will ultimately be.

See also

ISDAFix scandal: guilty as charged

VGBT structure could liberalise gold investments