LME Front Month Spreads Rule Change
Last Friday the LME shook up spread trading on base metals.
Some history: In October 2021 after cash-3's copper spreads traded to a backwardation of over $1000, the LME introduced rules that capped the level of backwardations for tom-next trading. These caps were put in place to prevent/disincentivize traders from amassing dominant long positions and forcing the market into backwardations, which they would then lend into, making sizeable profits. The caps: 50% dominant position = 0.5% of the cash price; 80% = 0.25% of cash; and above 90% traders would have to lend at level.
However, at that point in time, they did not do anything to limit the month over month spreads. These backwardations were still (in theory) limitless. And hence were still susceptible to traders building long positions and holding them to expiry in the hopes backwardations would occur.
Now, after some recent large positions were built in the aluminium and copper front month markets, the LME has introduced new lending rules for the front month positions.
If a trader is holding more length than the total available LME stock for that metal, they will be obliged to lend that excess from the front month (M1) to the following month (M2) at level, i.e. $0/mt.
Their M1 position is cumulative for any length sitting from 'cash' to the nearest 3rd Wednesday. For example, if it was the 1st of July 2025, the total length would include any positions sitting between the 3rd of July and the 16th of July (3rd Wednesday). Once we reach the 15th of July, so the 3rd Wednesday became 'tom', the M1 cumulative position would include the 17th of July up until the 3rd Wednesday of August. The trader must reduce any excess positions by 1.30PM London.
Now, there is one major caveat to the position reduction requirement. It is not applicable if available stock levels fall below certain thresholds: Al: 6,400 lots; Cu: 3,200 lots; Pb: 2,400 lots; Ni: 1,600 lots; Sn: 200 lots; Zn: 2,400 lots. Given that on Copper we are already below that threshold of 80,000MT, it remains to be seen if this will prevent the current back increasing.
This is a tricky issue for the LME to navigate. For one, they have always been a lender of last resort for physical product. So if a trader has a book of a certain size, why shouldn't they be allowed to amass length that they could in theory let expire and be delivered physical warrants for their sales.
Backwardations also play a key part in incentivizing new warrants to enter the LME warehouse system. When backwardations get large, traders can deliver material in and capitalize on this. Typically this diffuses the backwardation and increases warehouse stocks.
But it is also incumbent upon the LME to prevent the market becoming disorderly, particularly if there are actions taking place that may be within the rules, but not in the spirit of fair trading. A simple way to limit this is to change the rules, which is what the LME has done.
