The Unprecedented Events of March: The Oliver Wyman Report

Thankfully, futures clearinghouses do not fail often; it’s happened three times in history, most recently in 1987.  But last year, in the first week of March, the clearinghouse of the London Metal Exchange, LME Clear, had an uncomfortably close brush with a near-death experience.  The fallout of the measures LME Clear took to avert that outcome is continuing, and some key stakeholders – including the Bank of England, the Financial Conduct Authority and the LME itself in its regulatory capacity – have yet to speak publicly on the events of March, presumably as ongoing investigation continues. But, last month the Oliver Wyman Group released an Independent Review of the events. Commissioned by the LME, the report provides valuable and detailed context for those looking to understand the events, and makes thoughtful recommendations to the LME.  The report does not venture an opinion on whether LME Clear was “right” to suspend trading on March 8, 2022; but for those interested in that question, the report is essential reading. 

The report’s synopsis of what happened is a model of concision: “The analysis of events shows nickel underwent a short squeeze: there were large, exposed short positions; a lack of willingness to provide liquidity; a price spiral and resultant margin calls; and consequent rapid risk reduction by participants exposed to those large short positions.”  Notably, there’s no indication in the report, one way or the other, that the short squeeze did or did not result from manipulative activity.  What is clear from the report is that the LME was facing a price surge the speed and scale of which was without precedent in modern times (including the three cases in the 20th century when futures clearinghouses actually failed: the Hong Kong Futures Guarantee Corporation in 1987, the Kuala Lumpur Commodity Clearing House in 1983 and the Merchandise Liquidation Fund in 1974).  Over the course of three trading days between March 4 and March 8, when trading in the LME’s core nickel futures contract was suspended, the price of nickel on the LME increased by over 270% (including a two-fold increase in the space of six hours on March 8, falling back some 20 percent from that level just before the suspension).

The report identifies several factors that contributed to the events.  

• Short positions were highly concentrated but highly fragmented at the same time between on-exchange and OTC trades, involving a relatively large number of counterparties and clearing members.  At the time, the LME had limited transparency into OTC positions (a regulatory gap the exchange has since closed, having adopted a regulation in June of last year requiring members to report all OTC positions in core metals contracts, on a weekly basis).  This limited the LME's visibility into the build-up of market risk.      
• Regulatory tools – position limits, accountability levels, price volatility controls – did not prevent market participants from establishing dangerously large positions, and failed effectively to arrest the run-up in prices.
• There was a perception among market participants – fueled by market rumors and real-time media reports – that a member had defaulted or was about to default, as a result of client defaults to the member.  The report is cagey about whether the problem was primarily one of substance or perception: members had met USD 16 billion in margin calls in the run-up to the March 8 suspension, but almost $20 billion in mark-to-market losses from the run-up in prices during the morning of March 8 was never called.

When the LME suspended trading on March 8, it voided all trades filled on the exchange from market open at midnight to the time of suspension at 8:15 a.m. in London.  Trading remained suspended until March 16.  As noted, its actions remain subject to regulatory investigation; civil litigation by parties on the winning side of those voided trades is also pending. 

The Oliver Wyman report is available here.  The LME release on mandatory reporting of OTC trades is available here.  And an examination of the failure of the Merchandise Liquidation Fund in 1974 is available here.