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Markets be nickel-and-dimin’

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The LME cancels trades for a third time

It has been a bit since this space has been updated, but a lot has happened! Today is a little offering for posterity, as this event will most likely be swept up in the dust bin of history, and only available as a footnote in a book. But it is a rather important development, IMHO, for blockchain tech and DeFi. The long and short of it is that Russian invaded the Ukraine on February 24th 2022. This threw the commodities world upside down, resulting in the price of nickel spiking from approximately $25,825 per tonne on February 23rd to over $100,000 per tonne on March 9th. This wasn’t the only commodity to spike as a result of the uncertainty in the geopolitical landscape, however, this move broke the London Metal Exchange (LME).

The LME suspends nickel trading

On March 8th the LME suspends trading in its nickel market due to …‘unprecendented’ increases in the benchmark price, which surged above $100,000/t overnight. Trading was suspended as of 08:15 GMT today, and the exchange cancelled all nickel transactions that took place after 00:00 GMT.” article

This seems pretty bad given the description of what the LME facilitates from their website:

The Exchange provides producers and consumers of metal with a physical market of last resort and, most importantly of all, with the ability to hedge against the risk of rising and falling world metal prices.” LME

It doesn’t seem as though they are honoring their commitment to their customers, nor fulfilling their mission statement.

Why is this interesting to anyone

The London Metal Exchange (LME) was established in 1877 and supports a robust and regulated market where there is always a buyer and a seller, where there is always a price and where there is always the opportunity to transfer of take on risk - 24 hours a day.” Until there isn’t.

The LME traded 145 million lots totaling …$15.6 trillion…with a market open interest (MOI) high of 2.1 million lots.” LME

That’s a huge market to break! Those are aggregated notional values, but turning off a market, if you are a market maker, is a huge fail! The 2021 LME Primary Nickel volume was 16,774,630 lots. LME Report

Okay, that’s a lot of volume, and some would think that a market place with that kind of volume turning off one of its markets is a big deal. Annnnd, it is.

The LME had to suspend trading because a spike in price, of such significance, engaged margin calls on the exchange. Margin calls of the size demanded by this volatility would have bankrupted the exchange. In the best interest of the excahnge, the LME halted trading to give time for its participants to meet the margin calls.

The loss on the LME Nickel trade has been estimated at up to USD 12bn. The LME default fund (4.2 on its IOSCO CPMI disclosure) is given at USD 1bn. I don’t know if that number is entirely accurate, of if all of it can be applied to the nickel market, or is segregated by product. Clearly, there was a counterparty who could not make margin call, and if the rules had been followed, they should have been declared bankrupt, and the position sold, and any losses would be paid by LME, and then surviving members.” zerohedge

Again, why does anyone care

Well, this is a huge professional exchange handling trillions of dollars, and was subject to a once in a lifetime event. It halted trading, but then everything was okay, and all of their customers moved on. Except that isn’t what happened! On March 16th the LMEs nickel market blew up again:

The London Metal Exchange temporarily froze electronic trading in nickel after it restarted from a week-long suspension, as a glitch allowed prices to plunge past a new daily limit that was supposed to help restore order following last week’s historic short squeeze.

The market reopened for the second time at 2 p.m. London time, but without any trading. The forced halt is an embarrassing setback for the 145-year-old exchange, which is the world’s main venue for setting prices and trading some of the most important industrial metals.” mining.com

And then on March 23rd it blew up, wait for it, again! The exchange also cancelled all trades declaring a disrupted session” in a release entitled DISRUPTED EVENT - NICKEL OFFICAL PRICES.”

Notably, the chaos and rule-changes continue at the LME as it says that the second ring session (which traded limit-up) will be deemed”a disrupted session” and all agreed trades during this session will be null-and-void.” zerohedge

The reason why this is particularly important in the blockchain wolrd and DeFi is this point right here, the LME is purposfully halting trading, changing rules, and rolling back legitimate trades for self preservation, and the preservation of its large participants. It really doesn’t have a choice, but what is left in the wake of these decisions is a broken market for nickel, and a bunch of pissed off hedge funds, namely Clifford Asness, who are walking away from the LME.

These are participants that want to trade, and cannot, and will not.

Enter the DeFi option

This is a rare case where blockchain does fix this! All of these actions taken by the LME could be mitigated by a smart contract. Sure, but this is all hypothetical, no not at the date of this writing. A protocol like SmartPiggies is designed for exactly these purposes. This isn’t a shameless plug for SmartPiggies so much as it is a brilliant illustration of how DeFi fixes some of the ailing problems from traditional finance.

A very large participant on the LME was able to establish a short position that blew up the LME nickel market. This is an existential threat to the LME, and it is allowed. With a protocol like SmartPiggies, which are cash-settled bi-laterial risk transfer agreements which settle similar to traditional options, a market can be established when one doesn’t currently exist.

To be fair Shanghai Futures Exchange is still trading, but the participants of the LME can’t trade. A smart contract protocol for cash settle futures or options can step in to support these participants. Of course there are frictions to using a blockchain solution, but it is there. And it will to be there as these markets continue blow up due to mis-managed risk by their participants.

Wrap it up

A very, very, large market for a base metal that trades at high volumes broke, not once, but three times. The exchange managing the market halted trading, changed exchange rules, rolled back legitimate trades, and is still broken. For western participants, there is no market to hedge nickel. This can be reconciled with blockchain, smart contract, DeFi protocols. These protocols exist today, some used, some waiting for events such as these. If anything is clear, traditional finance will continue to explode onto itself, creating winners and losers in the process. Once benefit in blockchain solutions in response to these adventures, is that the rules cannot change during trading, nor ex post. And once these markets are turned on, if desired, they cannot be turned off. It is a matter of programming. In this specific case of LME nickel, a far superior market place would be a decentralized one, with equitable application of execution for agreed, legitimate trades. Things are looking up for DeFi, and that is rather exciting.

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disclaimer: these musings are offered, at best, as educational, and at worst for entertainment purposes. Do not take action on the descriptions above, as they contain risks, and are not intended as financial advice. Do not do anything above.

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