By Andy Home
LONDON - Four big short position-holders and one financial player on the long side were at the core of the London Metal Exchange's (LME) nickel meltdown last March.
The clash of positioning is revealed in a report by independent consultancy Oliver Wyman, hired to review the events in the nickel market leading up to the LME's decision to suspend trading and cancel trades on March 8.
Oliver Wyman's report delivers a wide range of recommendations such as improving regulatory oversight of the over-the-counter (OTC) market, enhancing volatility controls and extending the LME's risk management mandate to include preventing "market distortions".
The LME said it is "committed to taking all the necessary steps to rebuild the confidence of the metals market" and will publish an implementation plan by the end of the first quarter.
However, it also pointedly noted that "nothing in the report should be taken to either acknowledge or exclude the possibility of abusive or other behaviour having also contributed to events in the nickel market".
The exchange "has been considering, and will continue to consider, what further steps may be appropriate in terms of its investigatory and/or disciplinary powers," it added.
What might have raised the LME's regulatory suspicions?
Is it something to do with the four shorts and the long?
SHORT SQUEEZE SPIRAL
The report does not identify the players in the nickel game, but so far only China's Tsingshan Holding Group has been widely reported to have been running large short positions from the end of 2021.
However, it turns out there was not one but four big short position holders in the market coming into February, when Russia's invasion of Ukraine sent the price of all metals, including nickel, higher.
The four each held a sizeable short position of between 13,000 and 24,000 lots, equivalent to 78,000 to 144,000 tonnes.
LME warehouses held just 80,088 tonnes of nickel stocks when Russia invaded Ukraine on Feb. 24. Over half of that total was awaiting physical load-out, leaving live stocks at just 39,342 tonnes.
Some of the big shorts were cleared through the LME system, but others were placed entirely in the OTC shadows and "most" were spread across multiple LME members as counterparties, Oliver Wyman's report found.
"Two positions in particular, both with significant OTC components, were large in relation to the financial resources of their owners," the report said.
By early March, when the LME three-month nickel price was approaching $25,000 per tonne, notional losses for "more than one beneficial owner" would already have been "significant relative to their reported equity".
The mix of producer hedging and speculative overlay in the short position landscape is impossible to know with any precision. It's worth remembering that Tsingshan is itself a huge nickel producer, albeit not in a form that can be delivered against an LME short position.
What is all too clear is that these big shorts, as well as plenty of smaller ones, were caught in a ferocious squeeze as they tried to cover positions in a market that was spiralling ever higher.
Huge margin calls added to the urgency of reducing exposure.
There were two risk-reduction buyers chasing the price up to $100,000 per tonne on the morning of March 8, Oliver Wyman said. Only when they simultaneously backed off did nickel top out at $101,365 per tonne and plunge back to $80,010 in the space of seven minutes.
Collapsing liquidity meant that shorts managed to cover only 1,400 lots (8,400 tonnes) of exposure by the time trading was suspended at 0815 local time, compared with 11,500 lots the preceding day.
LATE ARRIVAL
The shorts were not helped by the rapid build-up of a long position on March 7 which the report links to "one financial client with no material existing nickel position".
By the end of the day, the long stood at 2,000 lots (12,000 tonnes), representing 13% of the day's net buying activity.
The impact was magnified by a drying-up of liquidity from March 4 onwards.
By the morning of March 7, according to the report, the bid-ask spread for nickel was averaging $150 and "the depth of resting sell orders at competitive prices had become almost non-existent." When the market blew up the following day, buy trades were moving the price by an average $250 per lot.
The long got a lot of bang for its bucks in a market where ready sellers all but vanished.
SHADOW PLAYERS
The report throws light on the positional tensions in the market ahead of the price surge to above $100,000 per tonne, even if the players remain anonymous.
The LME will wish that it could have seen a little more of the nickel landscape before it was sucked into what Adrian Farnham, then head of LME Clear, called a potential "death spiral".
However, the report makes clear that one of the root causes of the blow-up was the fragmentation of positions across counterparties and between exchange and OTC markets.
"In terms of venues used, two of the largest 10 short positions were exclusively on-exchange, five had both OTC and on-exchange components (with on average 52% being OTC), and three were exclusively OTC," it notes. All but one position was with multiple brokers. One had as many as 12 member counterparties.
The LME may have had good regulatory visibility on exchange trades but not on the many jigsaw pieces lying in the OTC shadows. Any coherent picture of the overall landscape was always going to be elusive.
Indeed, LME "management stated that when risks around specific large positions were evaluated, the presence of a large on-exchange component created an impression that it constituted the entirety of that beneficial owner's position when in fact there was a larger position held OTC," the report adds.
The exchange has already brought in OTC reporting rules but Oliver Wyman calls for better risk assessment of potential disruption in the OTC market, new notification requirements for OTC events and the development of analytics tools to see the bigger picture.
Whether the LME should have already had those tools, or used better the tools it did have, is not a subject covered by Oliver Wyman.
For answers we'll have to wait for the regulatory reviews by the Bank of England and the Financial Conduct Authority into the governance and decision-making process around the nickel mayhem.
More may be revealed.
The opinions expressed here are those of the author, a columnist for Reuters.
