The London Metal Exchange (LME) is the world’s premier futures market for non-ferrous metals. The LME Copper Settlement price is effectively the world copper price. It should thus accurately represent the balance between supply and demand in a world market, whose turnover in 1995 was nearly $34 billion. In 1996, however, it emerged that this price had been systematically manipulated by a Sumitomo trader over a period of six years, causing the LME price to depart substantially from its fundamental values, particularly in late-1995 and early-1996. These revelations prompted the Securities and Investment Board (SIB), which oversees regulation of all London financial markets, to undertake a major review of the functioning of the LME.

On 11 December 1996, on the eve of publication of the SIB’s report, Christopher Gilbert (Queen Mary and Westfield College, London and CEPR), one of the UK’s leading academic experts on commodity futures markets, gave a briefing on the issues involved at a meeting organized by CEPR and funded by the ESRC Global Economic Institutions (GEI) Research Programme. Gilbert had recently completed the first independent academic study of the regulatory position in the United Kingdom with regard to manipulation of futures.

Futures manipulation is the activity of cornering or squeezing a futures market. This involves exploiting certain features of the futures market, in particular the delivery provisions, to create an element of monopoly power which allows the manipulator to raise prices to his advantage. Because manipulation distorts market prices away from their fundamental values, and because it reduces the value of the futures markets in hedging, such activity is at best regarded as ‘antisocial’, and is generally illegal.

In reviewing the existing regulatory arrangements, Gilbert argued that the 1986 Financial Services Act (FSA), under which the SIB regulates UK financial markets, failed to give explicit consideration to futures manipulation. The SIB deemed such manipulation illegal under section 47 of the FSA, but this section appeared too narrowly directed to sustain the claim. In the United States, in contrast, manipulation was explicitly prohibited under the Commodity Exchange Act (CEA). The implication was that the FSA should be amended to outlaw any exercise of monopoly power in futures markets which has the effect of generating artificial ‘off-exchange’ prices.

US experience nevertheless indicated that it was very difficult to bring successful prosecutions against futures manipulations. The emphasis should therefore be on prevention rather than prosecution. The key element in prevention is client-position reporting, which currently existed only on a voluntary basis on the LME. This should be put onto a statutory basis, extended to include metal in LME warehouses, and extended also to other London futures markets.

Gilbert further argued that the best deterrent to manipulation is increased transparency. Publication of aggregated position information can act as a significant impediment to manipulation, since market participants can act early to close out positions when they see evidence of a potentially manipulative situation emerging. Consequently, the SIB should introduce the CFTC’s (the US Commodities Futures Trading Commission) Commitments of Traders in Futures reporting system to London markets. Reporting should cover both futures and options positions, augmented by summary statistics showing concentration of open interest. It should also cover stocks in LME warehouses.

The LME, however, differed in a number of respects from standard futures markets. The differences arose fromthe LME’s traditionally very close links with the metals industry, which are a significant source of strength for the exchange. Perpetuation of some of the differences – in particular, non-cash clearing and the use of historic-price carriers – was unwise and imposed additional risks on LME members, but did not raise regulatory concerns.

Another important difference between the LME and standard futures markets, which did raise regulatory concerns, was the LME’s use of day-of-delivery rather than month-of-delivery market contracts. Typically, if manipulation takes place in a regular month-of-delivery market, this affects only the delivery contract, and not the ‘nearbys’, which are used as a pricing basis for ‘off-exchange’ contracts. The effects are therefore limited largely to the ‘consenting adults’ who participate in the ‘delivery end-game’. By contrast, manipulation on the LME distorted the cash price which provided the basis for the entire world copper industry. The consequence was that, although manipulation was more difficult on the LME than on standard futures markets, its effects were more serious. This reinforced the importance of both the LME and the regulator acting urgently to ensure that manipulation became much more difficult in the future.

The Sumitomo events had also focused attention on the question of self-regulation, which formed the basis of financial-market regulation in the United Kingdom. Gilbert argued that there is a general public interest in ensuring that prices reflect market fundamentals – an interest which goes beyond the narrower interests of exchange members alone. This might suggest that exchanges should be even more vigilant in their suppression of manipulation than would be implied by the direct interest of their members. Although there was no basis for any charge that the LME had lacked diligence in attempting to identify and control manipulation, both it and other London futures markets would benefit from a significant strengthening of the regulatory framework.