MetalMiner welcomes back guest contributor Spencer O. Johnson, who has worked at INTL-FCStone as the primary risk management associate for steel since December 2009. Johnson co-authored this post with his partner on LME swaps, Dr. Mo Ahmadzadeh, who has over 30 years of LME trading experience.
For more than 125 years, the LME has insisted that physical delivery is the necessary mechanism to validate price discovery for metals traded on the exchange. Recently the LME announced that in January it will clear trades of cash-settled swaps for copper, aluminum and other non-ferrous metals.
A swap is best understood as exchanging a floating price in the future for a fixed price. By way of example: a manufacturer knows they will need 100 metric tons of aluminum for every month in 2012 — they can exchange the floating price of that aluminum for a fixed price by purchasing a swap for each month for the same amount of tons (in this case, 25-ton aluminum lots on the LME would mean the hedger would buy four swaps for each month in the calendar).
In this way, at the end of each of these months, if the average LME price is higher than the swap purchase price, the hedger’s gain on the long swaps will offset the higher price paid for the physical aluminum. Trades in LME swaps will reference the underlying LME metal prices traded on the exchange which, because of the tried and true physical settlement process, gives hedgers confidence that their average price swap will be a reflection of the physical market.
The move to list average priced swaps on the London Metal Exchange begs the questions: why list these swaps now and who is the intended audience for this product? The answer to both of these questions may largely be tied to the collapse of MF Global.
Clearing LME swaps has been the subject of discussion between the LME and the London Clearing House (where LME members’ trades are cleared) for years. Systems and economics appear to have been the main stumbling blocks for an agreement between the two parties, despite a strong lobby of practitioner proponents within the exchange. However, this discussion accelerated after the dramatic demise of MF Global and with the scale of stranded OTC swap contracts that ensued, counter-parties were left scrambling for clearing solutions.
This scramble appears to have concentrated the minds of all parties, and perhaps with a persuasive push from the regulator, the LME has announced its decision to launch swap contracts on the LCH in January — this coming ahead of the LME’s recently stated objective to establish its own clearing system in the future.
To be continued later today in Part Two.
–Spencer Johnson and Dr. Mo Ahmadzadeh