The reason why the London Metals Exchange "blew up in March"

 

There's an old saying that if you owe the bank $1 million, you have a problem.  However, if you owe the bank $100 million, the bank has a problem.  That appears to have been behind the London Metal Exchange's unprecedented actions during March this year, when they effectively defrauded dozens, perhaps hundreds of independent traders in favor of one very large client who couldn't cover his short positions.  Matt Levine reports:

Xiang shorted something like 150,000 tons of nickel somewhere in the $20,000s, and when nickel prices went up to $100,000 he said “no thank you”:

After nickel started spiking on March 7, Tsingshan struggled to meet its margin calls. … The LME had eventually intervened to halt trading a couple of hours after nickel hit $100,000. It also canceled billions of dollars of transactions, bringing the price back to $48,078, where it closed the previous day, in what amounted to a lifeline for Xiang and Tsingshan.

And then the LME said “well, okay, $48,000?” and Xiang again said “no thank you”:

To reopen the market, the LME proposed a solution: Xiang should strike a deal with holders of long positions to close out his trade. But a price of around $50,000 would be more than twice the level at which he had entered his short position, and would mean accepting billions of dollars in losses. ...

Xiang told the assembled bankers he had no intention of closing the position anywhere near $50,000. A few hours later he was delivering the same message to Matthew Chamberlain, chief executive of the LME. Tsingshan was a strong company, he said, and it had the support of the Chinese government. There would be no backing down.

And so his banks said “well okay what price would be acceptable” and he said “$30,000” and they said “fine”:

On March 14, a week after the chaos that engulfed the nickel market, Tsingshan announced a deal with its banks under which they agreed not to pursue the company for the billions it owed for a period of time. In exchange, Xiang agreed a series of price levels at which he would reduce his nickel position once prices dropped below about $30,000. 

Eventually nickel got below $30,000 and he got out of the position at about a $1 billion loss. “The loss has been roughly offset by the profits of his nickel operations over the same period.”

The article also describes the scene at Xiang’s office on the evening of March 8:

Within hours, more than 50 bankers had arrived at his office wanting to hear how he planned to respond to the crisis. He told them simply: “I’m confident that we will overcome this.”

If FIFTY BANKERS ever arrive at your office all at once, (1) you have done something terrible but (2) it is absolutely their problem, not yours.

With unprecedented chaos rippling through the industry, Xiang — still facing his bankers in the early hours of March 9 — had a key advantage. They were more terrified than he was.

If he refused to pay, they would have to chase him in courts in Indonesia and China. What’s more, he had executed his nickel trade through a variety of corporate entities – such as the Hong Kong branch of battery unit Ruipu Energy Co. – and it wasn’t clear the banks would even have the right to seize Tsingshan’s most valuable assets.

The bankers understood that if things went wrong, their careers would be over, one person who was in the room remembered.

Incredible stuff. When the LME declared that the price of nickel wasn’t actually $100,000 (as the market said) but $48,000, it broke a bunch of trades and cost some financial traders hundreds of millions of dollars. They were really mad, understandably; several have sued the LME. I was pretty sympathetic to those lawsuits before reading this story, but now, oh man! The LME canceled trades and shut down the market not for some good neutral reason, but because it was bullied by a giant trader who decided that he preferred not to follow the rules, and the LME couldn’t risk the chaos of trying to hold him to the rules. So it put his losses on other people instead, people who did follow the rules and could meet their margin requirements.

There's more at the link.

That's the Golden Rule in operation - the financial Golden Rule, not the altruistic one.  The financial one says, "He who has the gold, makes the rules".  Xiang and his company had literally billions of dollars in short exposures, but the banks and the LME couldn't force him to cover them.  In other words, it became their exposure as much as - if not more than - his.  If he didn't cover it, they would go to the wall before he did.

As for all the other clients of LME, well, sucks to be them, I guess.  Many of them were effectively defrauded of millions, even hundreds of millions, of dollars in perfectly legitimate trades that the LME canceled in order to cover Xiang as best it could.  I hope they win their lawsuits . . . but whether they'll ever recover from the financial damage they've suffered is a dubious proposition.  Some will probably end up in bankruptcy court.

It just goes to show.  If you don't know who's really calling the shots in a business deal, it's not you.  If you don't know who has the most influence on a market, it's not you.  If you believe that any major bank, or any major exchange, actually cares about you, and is offering you services and loans so that you can grow richer, you're living in cloud cuckoo land.  They're in it for themselves;  and if it's in their best interests to favor one investor over another, they'll be all over that like white on rice, and you can go sing for your supper in the street outside.

It's not for nothing that the term "bankster" was invented.  I thought Jon Corzine was about the most egregious example of one I was likely to hear about, but Xiang looks set fair to fill his shoes, and then some.

Peter