London Metal Exchange

What is the London Metal Exchange?

The London Metal Exchange (LME) is the world's premier non-ferrous metals market. The LME offers futures and options contracts for six primary metals: aluminum, copper, nickel, tin, zinc, and lead. It also offers contracts for two regional aluminum alloy contracts. In 2005, the Exchange launched the world's first futures contracts for plastics. This is really important, because it could create much more growth for the LME. The plastics included are polypropylene and linear low density polyethylene. The LME also planned to introduce regional plastics contracts in 2007, although information on whether or not this occurred is not yet available. The LME also offers LMEminis, smaller contracts for copper, aluminum and zinc, and LMEX, an index contract. LMEminis are traded via the LME select trading platform by members. Clients of members can trade through a member's order routing system by phone. The index contract (LMEX) is based on the six primary metals traded on the exchange. The index is used to provide investors access to futures and options contracts without the physical delivery, storage and transaction costs associated with the underlying commodity contracts.

Functions

One of the most important functions of the LME is to discover what the price of materials will be months and years ahead. This assists the physical industry to plan forward for severe and rapid price movements. These discovered prices are relied upon by the industry throughout the world and are used to create futures contracts.

The second function of the London Metal Exchange is to provide hedging against fluctuations in metal prices. Hedging is an investment that is made in order to reduce risk for another investment. For example if a manufacturer believes the price of copper will rise he/she can buy a future contract for the copper they will need instead of paying a higher spot price when the copper is actually needed.

Thirdly, while the LME never deals directly with the metals, they do facilitate delivery. Once a contact is agreed upon the metals must be transfered into a LME approved warehouse until the time of the final transaction. This assures all parties of the safety of the contract and the materials.

Who can trade?

The only organizations allowed to trade on the London Metal Exchange are member firms. The members provide the physical industry with access to the market. Membership is on a corporate basis and through elections by the LME's board of directors. Two types of members exist: broker members and trade members. Broker members are those companies allowed to issue LME contracts (buying or selling on behalf of their customers) and trade members are industrial or financial companies who take out an LME membership primarily in order to be kept informed of the strategic development of the exchange. There are 80 major firms involved in the LME.

How does trading take place?

The LME trades futures and traded options contracts. A futures exchange is where people can make contracts to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. An option is a contract which gives the buyer the right, but not the obligation, to buy or sell metal or the index at a specific price for a specified time. For this right, the buyer pays a premium. The buyer of LME-traded options has three choices of activity: declare the option, abandon the option or trade the option. If the buyer declares or exercises the option, they will receive a futures contract as specified in the option contract. If the buyer chooses to abandon the option, nothing happens except they lose their premium. If the buyer trades the option by selling it back to the market, they reclaim some or all of their premium and may even make a profit. Trading in the LME takes place across 3 trading platforms:

There are twelve companies who have exclusive rights to trade in the Ring and around 100 companies involved in the LME in total.

1. Open outcry trading in the 'ring': Each of the eight metals are traded in two blocks, once in the morning and once in the afternoon. The morning session occurs between 11:40 and 13:15 and the afternoon session last from 15:10 until 16:35. Each of the eight metals are traded in five minute sessions. Using the open outcry method, a trader cries out that he wants to sell at a certain price and then another trader yells out that he will buy at that same price. This method is the oldest and most popular way of trading on the Exchange and was the original way trading occured before the LME was officially established. This type of trading is central to the process of price discovery, which is one of the LME's most important tasks. The official settlement price, on which contracts are settled, is determined by the last offer price before the bell is sounded to mark the end of the official ring. 2. Inter-office telephone market: Occurs 24 hours a day and is simply a inter-office telephone market between LME members 3. LME select: an electronic trading platform from 1pm-7pm. The LME select is the official Exchange-operated electronic trading platform. LME member firms are connected to the LME select system which allows accredited traders to execute trades electronically. It allows for straight- through processing in which LME select trades are automatically sent to the matching and clearing systems. The system also enables LME members to connect their clients directly to the LME select trading system via third party applications a process known as 'order-routing.'

The contracts of the LME are traded and quoted in US dollars, therefore LME trading is hardly affected by the Euro. However, contracts can be cleared in other currencies as well (mostly the Euro, Japanese Yen and Pounds).

The use of hand signals is very prominent in open outcry trading. Here is how some basic operations of trading are performed.

Buying or Selling: Gesture with your hands out, palms facing in, and move your hands toward yourself. Gesture as though you are pulling something in. Selling is the exact opposite; gesture pushing outward as if you are pushing something away. Price at which to buy or sell: Shown in numbers by the number of fingers the trader is holding up with the palm facing inward. Quantity to buy or sell: Shown in numbers by touching the face with that number displayed in fingers.

This information about hand signals was taken from http://everything2.com/index.pl?node_id=1844043 and http://www.oxfordfutures.com/docs /Handsignals.pdf. The actual hand signals that the London Metal Exchange uses may differ. Very specific signals are used in each financial trade setting to keep amateurs out and to ensure that a professional is doing the trading.

History

The London Metal Exchange was established in 1877 and celebrated its 130th anniversary in 2007. It was originally known as the Royal Exchange. The Royal Exchange got started in 1571 during the reign of Queen Elizabeth I. It was in the 1570's that traders who wanted to trade metals and other commodities began to meet at a regular basis. Unlike today, traders back then dealt in physical metals for the domestic market instead of electronically for the international market. With so many commodity traders, ship charterers, and financiers joining the Royal Exchange, it became impossible to get any business done. Ergo, individual groups of traders set up shop in coffee houses. It was in the coffee houses that the tradition of the "Ring" was born. When a trader have a metal to trade, he would draw a circle in the dust and those who want to trade can stand around the circle and bid.

In the early 19th century, the United Kingdom was generally self-sufficient in copper and tin. Originally, only copper was traded then lead and zinc were added, but only gained official trading status in 1920. Other metals now traded include aluminum, nickel, and aluminium alloy. The exchange also started trading plastics in 2005. The quoted prices for these metals was generally fixed for long periods. After the Industrial Revolution, the United Kingdom became more advanced in technology and began to import large quantities of metals from abroad. The importation of metals from other countries as far away as Chile created a problem for the traders. The time between ordering the metals and delivery of the metals could be anywhere from three months to a couple of years. Consumers needed to know the price of the metals before they arrived so they could properly budget. The problem of not knowing when the metals would arrive and what the prices are going to be when it actually arrives caused some stress among traders and consumers.

The answer to the problem came in the form of the telegraph. The telegraph helped improve communication between countries so arrival dates became more predictable. The change from sails to steam ships helped decrease delivery time and so did the opening of the Suez Canal in 1869. The faster delivery time led to the rise of the London Metal Exchange's unique system of daily trading dates for up to three months forward. This system is still in play today.

When the London Metal Exchange formed in 1877, the groups of traders temporarily set up shop in coffee houses. When more and more traders joined the Exchange, the meeting place was moved to an office in Lombard Court. As the number of members gradually increased, the Exchange decided to move to a purpose built Exchange in Whittington Ave. They stayed at Whittington Ave for 98 years. Afterwards, they moved to another location for 14 years before finally settling down at its current location in Leadenhall Street in 1994.

The picture shows the main entrance to the London Metal Exchange at 56 Leadenhall Street. If you wish to visit the LME, it is open to the general public Monday through Friday through advance booking. More information on visiting can be found at http://www.lme.com/visit_lme.asp

Affecting London and the UK economy London as a financial center is served by the LME in a number of ways. Attracting skilled workers and international business are two major things. The LME is the world's premiere metal market so those wishing to be in the field must work through this exchange. London's central location and the LME's ability to clear contracts in currencies other than the US dollar are also very helpful. Finally the LME is a highly efficient market.

The United Kingdom economy is helped by the LME in a number of ways. The LME clears billions of pounds a day and this increases the country's GDP. Also it gives UK manufactures easy access to foreign metals. The UK has few natural metals so most must be shipped into the country. Set prices help UK and international companies to anticipate future costs, reducing risk and lowering the final products cost. Also all of this international business encourages trade, a benefit in any economy.