Keeping one step ahead of regulators, traders are again putting the squeeze on metals markets.
Some have found new ways of employing the time-honoured technique of forcing prices higher by building up stockpiles of metals to make a killing in distorted markets.
Regulators at the London Metal Exchange had tried to stop the practice after Mr Copper, a trader with Sumitomo Corp, was found in 1996 to have been controlling five percent of the world's yearly supply of the red metal for a decade.
They have since fine-tuned rules to deny “dominant holders” - defined as those controlling over half of stocks in any metal and cash positions - from profiting from that position. They are instead forced to give their metal away at scant profit.
But now some traders are suspected of shifting millions of tonnes of stocks around the world and taking some tonnages off warrant at the LME to ensure their positions, or holdings, meet regulators' requirements while cornering the market. Often they own the warehouses storing the metal which helps the operation.
“It's a fine line. Increasingly operators are a lot more sophisticated in how they keep on the right side (of market abuse regulations),” said analyst Robin Bhar at Societe Generale in London.
But as bidders circle around the LME - due to accept binding takeover offers by May 7 - the exchange may have to tackle questions over its rules to guard against market abuse and its transparency of market data.
Traders say the market for copper - a metal widely used in power generation, construction and the auto sector - is being squeezed. Copper prices flipped into backwardation in early March, making prices for the metal now more expensive than those for future delivery, indicating a severe supply shortage.
Many of those interviewed say commodity house Glencore has amassed a dominant position on the LME in copper. Glencore declined to comment.
Some LME users are calling for a deep look at the interaction between long delays in accessing metal in warehouses, financing deals, warehouse ownership and dominant positions.
“The LME and maybe the market as a whole needs to revisit this ... It's not a perfect system and it's come in for a lot of criticism and anger. It's worth opening it up for some intelligent responses,” said Bhar.
Others say that the building blocks of potentially severe squeezes are now being put into place.
“It's potentially very, very interesting and the ramifications in a year or two could be quite extraordinary when demand really kicks in,” said analyst Wiktor Bielski at VTB Capital.
GAMES WITH INVENTORIES
While LME rules put a lid on profits that can be earned on expiring cash positions, traders have several ways of spinning profits from holding major positions.
One strategy is to keep prices and premiums buoyant for spot business executed outside the exchange.
“Even though we didn't make any money from (LME requirements on) lending, we more than made up for it from our physicals business,” said a trader whose firm held a dominant position last year.
Trade houses such as Glencore have long had an advantage in the metals markets due to their extensive intelligence about physical markets and big banks have mimicked that model, expanding operations in physical metals trading and warehouses.
The link between inventories and large positions is now in focus in the copper market, where cash premiums over three-month futures jumped in recent weeks to the highest levels in 3-1/2 years and the nearby “tom/next” spread also surged.
In this case, the tight conditions are localised on the LME due to a global imbalance in stocks, the perfect environment for traders to apply pressure points.
LME stocks have fallen by almost half since last October to the lowest levels in over three years, while stocks at bonded warehouses in Shanghai are estimated to have more than doubled to as much as 650,000 tonnes.
At the same time, over a third of LME copper stocks, more than half at US warehouses, are waiting to be removed and are not available to the market, sparking fears that some of the moves are tactics to squeeze the market.
“The drawdown in LME stocks in the US may partly represent large traders moving metal off warrant to exacerbate the tightness and prepare the ground for a major squeeze later in the year, when Chinese buying is likely to accelerate again,” Bielski said. Warrants are ownership documents for LME stocks.
LME data showed one party had control of over half of the combined LME stocks and cash positions, giving it a dominant position. The position at one point soared to over 90 percent.
The exchange did not reveal the identity of the holder, but traders said it was Glencore, the world's biggest listed commodities trader.
Glencore, which declined to comment on whether it is a dominant holder, routinely shies away from discussing positions in metals markets or details of its warehousing activities.
Later a second dominant holder emerged, which traders said was another trade house or a major bank.
Big traders and banks often need to hold big positions to source metal for clients. The LME argues its rules aim to allow legitimate trading, but caps profits when large positions distort prices and hold consumers to ransom.
LME Chief Executive Martin Abbott told Reuters earlier this year: “We say go ahead, build up as big a position as you want. But if you bring it to settlement we'll make you give it away, and that's exactly what we do, and that seems to work well.”
WEB OF OPERATIONS
Glencore has extensive operations in the metals sector. It owns mines as well as acting as a middleman to sell other producers' ore.
When Glencore floated last year, it said it had significant market shares in the global traded markets of several metals: 60 percent in zinc, 50 percent in copper and 45 percent in lead.
The Swiss-based trader also owns Pacorini, which operates a chain of metals warehouses, a sector that has seen business flood in since the global financial crisis in 2008 which triggered a series of interest rates cuts to close to zero.
Commodity traders Trafigura and Noble as well as banks Goldman Sachs and JP Morgan all own warehousing units while Barclays owns a stake in one.
Last year, traders said Barclays held dominant positions on the LME in nickel and lead. The bank declined to comment at the time.
The LME says it insists on strict “Chinese walls” between warehouse units and units of the same parent that trade on the exchange, but complaints have persisted about long queues to access metal in warehouses stuffed full with material gathering dust in financing deals.
Under the financing deals, which are widespread in aluminium and zinc, a bank buys metal for nearby delivery and immediately sells it forward at a profit, making money from the price spread and from striking a deal to store it cheaply.
At many warehouses, the minimum amount of metal the warehouses are allowed to deliver out each day under LME rules is small compared to the metal waiting to leave, leading to backlogs of months and lucrative rents for warehouse firms.
Some traders and analysts say the queues are helping create squeezes because metal sent to a warehouse with long backlogs will be stuck there and contribute to tight conditions.
The LME took limited action recently, forbidding warehouses in Vlissingen, the Netherlands, from accepting more copper from late July, in what traders said was an attempt to stop the metal from getting caught up in queues of up to a year for aluminium.
Glencore unit Pacorini owns 29 of 31 LME approved warehouses in the Dutch port, according to LME data.
The LME also took action to increase the minimum amounts of tin and nickel that must be delivered from warehouses because “there is concern that deliveries of tin and nickel are being caught in queues which is having an impact on the availability”.
While these moves may address specific bottlenecks, a more comprehensive policy is needed, traders and analysts say.
There are also questions about whether the exchange's definition of a dominant position is in some cases less relevant now due to the inventory financing deals.
A key component of a dominant position is based on “live” warehouse inventories a party controls. But in many metals, the effective free float of inventories available to consumers is well below what the data indicates due to financing deals, and only the LME compliance department knows the free-float total.
Aside from stocks, parties with major positions can be very shrewd so their holdings dip just below the 50 percent threshold for LME regulations to kick into force, traders say.
“Guess what they do?” one trader asked. “Make sure it (the large position) doesn't get there (to the prompt date) and just squeeze the other parts of the curve. It's not hard, it's blindingly easy.” - Reuters