The London Metal Exchange has been fined £9.2m ($11.91m) after a widely-publicised incident in March 2022 led to an eight-day suspension of the nickel market and the cancellation of all trades that took place on March 8, 2022.

The fine has been imposed for a failure to ensure the implementation of adequate systems and controls to deal with severe market stress. It sets a precedent as it is the first time the FCA has taken enforcement action against a UK recognized investment exchange.

We covered the events surrounding the LME’s suspension of trading, as well as the consequences, in 2022. Commentators called it “an example of extreme concentration risk” linked to short positions held by a Chinese tycoon that were not visible to the exchange.

The FCA final notice describes, in very readable detail, the events at the exchange itself that led to the issuing of the final notice and fine.

These events took place in March 2022 with unprecedented volatility in metal markets as a backdrop. Here is a succinct summary:

As mentioned above, at the heart of these events was extreme volatility triggered by very large nickel positions held mainly on the OTC market.

Such volatility and the resulting risk of market disorderliness was not unanticipated and was intended to be managed by way of automated controls and a process of escalation to LME senior management.

But there was a “lack of training or instruction” that would have allowed the trading operations team “to recognise signs of situations when volatility caused by intentional, non-erroneous, trades may have to be managed, and trading potentially constrained.”

The TO team “did not receive specific training on the nature of a disorderly market or how to recognise it” nor were they “trained to recognise that disorderliness could arise in a market that was, from the technical standpoint, functioning properly.”

The FCA held that this meant that the exchange’s processes for escalating unusual or hazardous market conditions were inadequate and that the additional risks stemming from overnight trading were “insufficiently managed.”

And it was the price bands which ultimately proved to be a real weak link at the exchange.

MiFID II

These types of automated controls were mandated under MiFID II in order to ensure that volatility was managed by trading being “halted or constrained if there was significant price movement in a financial instrument.”

But they “went almost unmentioned” in the LME’s “key internal operational manuals despite an explicit regulatory obligation on LME to set out and publish policies and arrangements relating to its volatility control mechanisms.”

A third-party review undertaken in August 2020 had found this to be an area of weakness at the exchange and a possible breach of regulatory requirements. However, senior management at the exchange challenged the findings because the third party “was unaware of the existence or purpose of the static price bands.” Something that the FCA felt “would not have been surprising” given the lack of references to them in internal LME documentation.

Crucially, the LME treated price bands “as a control measure” against error trades and orders and “failed to articulate to staff responsible for operating the price bands” that these “formed part of its controls more broadly to ensure orderly trading under conditions of severe market stress”.

Directly as a result of this lack of documentation and training on both price bands and the escalation procedures the decision to suspend both dynamic and static price bands was made by junior staff and the LME’s key decision makers remained unaware of it on the morning of March 8. They only became aware of the suspension on or around the 9 March.

“This is a warning to exchanges and platforms that they need to review systems and controls appropriately to provide reasonable oversight.”

Rob Mason, director of regulatory intelligence, Global Relay

And even during the FCA’s investigation of the events, detail around the suspension of the price bands was made available to the regulator only after a “protracted correspondence.” The LME admitted that “historic data on price band settings was not routinely captured in a durable format” and that a table provided to the FCA “detailing the alterations and suspension of the price bands in chronological order had been pieced together retrospectively” and “could not be relied on as an exact record  of the events.”

The FCA is careful to say that it “does not consider that the LME set out deliberately to misinform” the regulator. But its interpretation of its difficulties in obtaining the necessary detail from the LME is, if anything, more scathing of the shortcomings at the exchange. The report concludes that the series of misunderstandings during the investigation “could only have arisen because the operation of the price bands was not widely or well understood within the LME outside of the Trading Operations staff directly involved in manipulating and maintaining the system.”

This is the FCA’s first enforcement action against a UK recognized investment exchange and so is precedent setting. Steve Smart, the FCA’s joint executive director of enforcement and market oversight, pointed out that “London’s metal markets are of vital importance to the UK and global economy” and that the FCA expected “controls that match their significance.” He contended that “the LME should have been better prepared to address the serious risks posed by extreme volatility.”

The LME “accepted the findings” by the FCA and will have to pay a financial penalty of £9,245,900.

Commenting on the case, Rob Mason, director of regulatory intelligence at Global Relay, pointed out the “material size of the fine” – as well as the fact that it was the first against a regulated exchange – was noteworthy. He also said that it was the suspension of the “price bands”, which was a critical moment in this case and “is a warning to exchanges and platforms that they need to review systems and controls appropriately to provide reasonable oversight and ensure that these are communicated to all relevant staff.”

GRIP Comment

This is a fascinating case and one that roiled a crucial market and deeply perturbed its participants.

The lessons for firms are clear. Adequate training, processes, governance and, dare I say it, good recordkeeping, are not “nice to haves”. They are the foundations on which a resilient operation depends. If they are in place a firm is far more likely to be able to deal with the inevitable unexpected event or market crisis.

And the difference between a close call and a debacle is a person manning the desk at 4AM in the morning who has the knowledge, experience and the mettle to pick up the phone.

On that final note a striking thing about this case is the human element in the story. The team members in Hong Kong inundated with alerts and angry emails and phone calls from traders; the conscientious LME Board member waking up at 5:30AM to check on the overnight nickel price movements; the panicked calls from LME members facing potential disaster as a result of margin calls that it would be impossible to meet. All these offer fascinating insight into what we really mean when we speak about financial markets.