In March, a close friend wanted to know whether the sky-high prices of nickel would persist. He cited the difficulties faced by his friend who runs an SME that using nickel to produce stainless steel tools. Worried about nickel prices, which went up by 500 per cent between March 4-8, he had decided to postpone his procurement on expectations that the prices would fall.
He was wondering if he would end up with a breach of supply contract. Trends in the international markets suggested he should hold on as the markets were recovering from a ‘short squeeze’. He waited a few days to see the prices sliding back, but never to the expected levels. The choice for him was either renegotiate the supply contract or breach. If the squeeze were to persist, it would have eliminated many users from the real economy till prices got corrected.
The very same happened with the crude oil prices, which fell into the ‘negative’ territory. From about $2 per barrel, it went down to (-) $37, i.e., a fall of $40 in 40 minutes. Negative price means that one pays to sell a commodity. The event proved that it could happen in the real world as well if businesses do not manage supply and demand in an efficient and planned manner.
Signals from derivative markets
If the upward or downward movement of prices of the same magnitude had happened in physical (spot) markets, it would have utterly damaged the commodity ecosystem. However, the above-cited movements were exclusive to the derivative markets. One may think that it does not have any relevance to the real economy. However, in the absence of a transparent and well-oiled spot market, commodity market stakeholders pick signals from the derivative market to anchor their forward transactions. The nickel spot markets also witnessed higher prices, though not high as the futures. In the oil world, spot prices of US gasoline also plunged to $1.5 per gallon, picking up signals from derivatives.
The irony is that the crude price was anticipated to turn negative, and the market was informed in advance by the New York Mercantile Exchange (NYMEX). And the nickel episode has been happening on the London Metal Exchange (LME) for the last few months, with nickel reaching a high of $20,000/tonne. Nickel’s run continued until it touched a historical peak of $100,000/tonne, waking up the LME due to the alarm set off by significant margin shortfall of a sizeable shorting trader.
Crude prices went into negative zone for fear of storage space availability to facilitate deliveries. One may wonder, despite prior estimation of such an occurrence evidenced by NYMEX’s notification, why has there not been regulatory efforts to proactively manage markets when they are pushed to the ‘irrational’ zone.
It makes one wonder why exchanges have not proactively managed the marketplace despite the availability of surveillance inputs. Or is it the prior warning by the exchange that encouraged participants such as in oil derivatives to deliberatively steer markets into the anticipated direction to squeeze the profits, knowing well that markets are in a tight corner on the April-20 contract at expiry.
All fingers point to the ‘Trade At Settlement’ (TAS) contract of NYMEX and its extensive use by a group called ‘Vega’ on the expiry day. While the regulators are reported to be enquiring into it and may disgorge unfair profits if the allegations are proven, those who have lost in expectation of markets’ return to rationality would never have got compensated, for they must have lost their trust in the rationality of the markets.
Similarly, it is reported that the ‘Nickel squeeze’ was caused by funds and banks with large LME positions so that they may move their benchmark for the nickel over the counter (OTC) contracts that they entered into with Tsingshan — which shorted the market (both on LME and in OTC). Tsingshan says it trusted on markets’ prudence and prices coming down to reflect the fundamentals. Opaque OTC positions of Tsingshan against the rising prices allowed its counterparts to gain billions on the exchange and move their prices in their favour. They were on the other side of Tsingshan on both the OTC and exchange-traded markets encouraging the participants to squeeze the markets with historic peak prices of nickel due to fear of potential economic sanctions against major Russian nickel producers.
As the origin of the squeeze emerged from the possible interests of those who held large OTC positions, one may wonder why LME has not mandated OTC reporting so that it could have a holistic picture while regulating markets. Why LME did not have access to reported OTC data so that timely and efficient regulatory action could have been taken. Learning its lesson, LME has mandated all its traders to report OTC positions, hope such price runs/squeezes may remain a thing of the past with proactive regulatory decision-making. Sensing an opportunity, the CME across the Atlantic launched Nickel derivative instruments.
Loss of confidence
What’s lost is the confidence of market participants who had decided to keep away from the exchange-traded derivative markets. London’s loss may be Chicago’s gain, but it seemed to have brought the Indian nickel derivative markets almost to a standstill. With it, the opportunity for India’s nickel users to hedge their rupee-denominated nickel price exposures in India is lost.
Negative prices of crude oil had similarly impacted the trust of the market participants for fear of another episode of negative crude oil prices on settlement, making some participants lose confidence in the crude derivative markets. It had a similar impact on the Indian markets too, in terms of reduced participation and a volley of litigations.
The Financial Stability Board (G-20) Chairman said recently they are diving deep into commodity market volatility episodes, and hope they bring out regulatory lessons that were missing in the recently released IOSCO report. The lesson is that markets in global assets will have a global impact, and regulating such markets must be jointly debated, agreed upon, implemented, and monitored.
In this context, India must play a stellar role in various global regulatory bodies such as IOSCO, BIS, FSB, G-20, and other multilateral forums associated with financial markets to globalise regulation of markets trading global assets. In loosely regulated markets, trading global asset classes can cause higher potential harm to the global economy. It is time that emerging market stakeholders push the agenda of streamlined functioning of markets through global financial markets policy-making bodies.
The writer is with the National Institute of Securities Markets. Views are personal
July 15, 2022