New Metals Exchange

Why the World Needs a New Metals Exchange

Mining companies sell much of their production by offtake agreements. For the sales price, these contracts usually reference some external benchmark price. That makes miners pure pricetakers.

That small statement might easily be glossed over, but it is in fact a lynchpin around which much of the world turns.

Not only do producers rely on those benchmarks for their revenues, but they use them to make investment decisions. Those prices therefore govern the amount of money put into projects, and correspondingly, the amount of metal taken out of the ground. If those pricing signals are distorted, capital gets misallocated. If capital gets misallocated, resources get misutilized. If resources get misutilized, that permanently alters the inheritance we pass along to every generation to come. Mineral extraction cannot be undone. If we don’t have accurate prices, we’re stealing from the future.

Flawed futures

Only a few futures exchanges publish prices which are used as global benchmarks. While each of these has its own rulebooks that govern trading behavior, they all share the same basic underlying structure. It has two noteworthy features.

The first is that only approved banks can act as market makers. The reason this matters is that market makers are the only ones endowed with the ability to create new futures contracts. If only banks can be market makers, then only banks can create contracts.

The second feature is that futures contracts can be settled by cash instead of physical metal. Since sellers do not need to deliver the physical product at maturity, they do not need a physical product to create a contract. Removing that constraint effectively eliminates the upper limit on the number of contracts that can be created.

These are not accidental byproducts of uninformed decisions. They are implemented by design in order to increase the size of the market and facilitate trading activity. If futures contracts were restricted to the physical availability of metal, and if every seller were required to deliver a physical product at maturity, then liquidity would dry up and the market would grind to a halt.

But these features come with significant downsides. In a matter of seconds, banks can manufacture a tranche of contracts large enough to move the price significantly. That is not a speculative statement about whether price manipulation has or has not taken place, by whom, or for how long. It is an observation about market structure. On an exchange where any number of contracts can be created at will, and where the ability to create those contracts resides with a single class of participant, the potential to supplant the basic economics of supply and demand by the fiat decrees of institutional powers will always loom.

Because the number of cash settled transactions dwarfs those that are settled physically, financial participants are now the driving force behind the benchmark. That is the same benchmark being used to price all the metal being delivered into the market by producers every day under their long-term offtake agreements. That is the same benchmark being used to value all mineral reserves still sitting in the ground the world over. That is the same benchmark being used to inform sovereign monetary policies, alter the composition of national currency reserves, determine tax revenues on imports and exports, and shape foreign trade relations. The power in the hands of market makers is vast.

Centralizing risk

However, there is another hallmark of futures exchanges which ought to incite perhaps even greater caution as these markets grow larger.

Whenever two parties agree to a transaction that settles in the future, there is risk that one side might not hold up their end of the deal. To handle that risk, a futures exchange routes trades through a clearinghouse. This entity is operated by the exchange itself and acts as a counterparty to every transaction—sellers in the marketplace sell to the clearinghouse and the clearinghouse sells to buyers.

Ostensibly, using a central counterparty (CCP) creates a more efficient market. Two parties who do not know each other can agree to a trade without direct concern for the other defaulting since they are actually dealing with the CCP, not the other party. But that risk does not disappear. Since the clearinghouse guarantees the performance of every contract, the risk of nonpayment is concentrated onto the shoulders of the CCP.

This creates a problem. The probability of one party defaulting might be high or it might be low, but in either case, it is only one party. By utilizing a CCP, the sum of all risk of defaulting from every market participant is accumulated into a single mass.

In an attempt to redistribute some of that risk, the exchange requires its members to contribute funds to a pool that can be used to cover losses. The issue is that liabilities are a product of the magnitude of contracts outstanding, the direction of a price movement, and the velocity of that price movement. If liabilities grow faster than the exchange’s ability to collect, the exchange operator will be left with a financial obligation that it cannot fulfill. In short, it faces collapse.

Central clearing therefore puts the exchange operator in conflict. On one hand, it has the motive to facilitate increased activity on its platform. It therefore implements cash settlement and endows market makers with the ability to swell trading to the size of their desire.

On the other hand, every additional trade is a potential liability that it—the exchange—must bear.

The result is a set of forces which stand irreconcilably opposed to one another. More trading, more revenues from fees. But with that comes greater instability, and greater potential fallout should a credit event occur.

The point being illustrated is that the issues that plague today’s markets cannot be resolved by changing rules, pleading with courts, or laying them at the feet of regulatory bodies because these aren’t problems of governance. They’re problems of market structure. Stricter oversight may help, but it does not reroute plumbing.

If we want a fair market, we have to design a market that is fair—a new exchange built from the ground up, a fresh start from a clean sheet of paper. It must be an entire rethinking and radically new approach to the way a market can—and should—work.

The author of this report is not a registered analyst or advisor with any financial exchange or any other regulative body. In accordance with the U.S. Investment Advisers Act of 1940 the information contained within this report is for illustration and discussion purposes only and is not a recommendation, an offer to sell, or a solicitation of any offer to buy, an interest in any affiliated entity or fund, nor should it be construed or used as investment, tax, ERISA, accounting, or legal advice.

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