February 18, 2019
by Katherine Cooper

            On February 7, 2019, the International Organization of Securities Commissions (“IOSCO”) released its final report on Commodity Storage and Delivery Infrastructures: Good or Sound Practices (“Report”).[1] The Report, which builds upon the findings IOSCO made in its 2016 The Impact of Storage and Delivery Infrastructure on Derivatives Market Pricing report,[2] suggests that regulated bodies such as trading venues (“exchanges”) and central counterparties (“CCPs”), in conjunction with the storage facilities (“warehouses”) they use for the physical delivery of derivatives that the exchanges and CCPs trade and clear, adopt enhanced practices in the areas of oversight, transparency, fees and conflicts of interest.

Recent Storage and Delivery Challenges

            Beginning in 2013, questions began to be raised in the press regarding long wait times for the delivery of metal out of warehouses that were designated delivery points for the London Metals Exchange (“LME”).  In the aftermath of the financial crisis, several metals market participants bought warehouse operators to profit from the storage of metal surpluses they anticipated would build up as a result of reduced economic activity caused by the financial crisis.[3]  The long wait times for load-outs of metal – in some cases up to year, during which the owner of the metal would owe ongoing storage fees – worked to the advantage of the warehouses.  Some attributed the delay to the LME’s limit on the amount of metal that warehouses were required or permitted to load out each day.[4]  In any case, the long load-out delays appeared to have prevented the LME’s contracts and physical, cash market prices to converge.[5]  In response to these complaints, the LME issued a rule to require warehouses with delays over 50 days to deliver metal to delivery more metal out than they accept in.[6]

            Reports of long delivery delays re-emerged in 2018.[7]  The cash market premium, however, was reported to have dropped from $132 per ton to $103, down 7.5 percent.  With LME-designated warehouses charging more for storage than other warehouses, market observers have noted that holders are incentivized to move metal out of the LME warehouses making it less clear what the deliverable supply is.  In addition, some suspect that sellers of LME warehouse metal warrants do so to share in the premium storage fees charged by the LME warehouse that the buyer must pay until the buyer can move the metal out to a cheaper storage facility.[8]

            IOSCO Recommendations

            The recent challenges experienced in the metals markets provide a context for the IOSCO’s recommendations regarding enhancements to practices in the areas of oversight, transparency, fees and conflicts of interest in the storage and delivery processes.

            In terms of oversight, the Report focuses on the issues raised in the oversight of internationalized commodity markets, where physical delivery of the commodity being traded is, or can be, delivered in a different jurisdiction from the one in which the exchange or CCP is located.  The Report notes that without the warehouse

consenting through a legal, regulatory or contractual arrangement to the jurisdiction of the trading venue, there is lack of clarity over the application of the rules of the trading venue or CCP and, by extension . . .  the trading venue’s or CCP’s . . . financial regulator over extra-territorial [warehouses].[9]

To address such concerns, the Report suggests financial regulators make clear in their supervision of exchanges and CCPs that the financial regulator has an interest in the activity of all warehouses which serve as delivery points for derivatives contracts traded on the exchanges and cleared through CCPs subject to their jurisdiction, “even where the [warehouses] at which storage or delivery takes place are located in another jurisdiction.”[10]  In addition, the Report recommends that exchanges and CCPs have in place appropriate information sharing arrangements with their overseas counterparts.[11]

            Regarding transparency, the Report proposes that exchanges “regularly make public reports which may disclose, on an equal basis to all market participants, relevant data.”[12]  Also, the Report suggests that exchanges and CCPs conduct periodic audits of the warehouses to check that the warehouses are complying with exchange and CCP rules and that the data that the warehouse is providing to the exchange is valid.[13]  Another transparency best practice the Report recommends is that warehouses use best efforts to announce planned and unplanned maintenance that would impact the warehouse’s storage capacity and its ability to process deliveries, load-ins and load-outs.[14]  Finally, the Report proposes that warehouses and exchanges make available data concerning the warehouses’ operational capabilities.[15]

            In terms of fees and incentives, the Report suggests that exchanges establish fee structures for warehouses which incentivizes prompt load-outs, such as a daily fee for storage combined with a lump sum that is not due until the load-out is complete.[16]  Alternatively, the Report proposes that exchanges consider penalty structures under which the warehouse is fined for delays in load-outs on “a flat, pro rata or escalating scale.”[17]  Another possibility would be capping the storage fees that the warehouse can earn after the commodity remains in the warehouse so many days after the owner has requested that the commodity be loaded out.[18]

            Regarding conflicts of interest, the Report suggests that exchanges and CCPs have rules regulating the order of load-outs by warehouses and prohibiting preferential load-ins or load-outs.  Moreover, the Report recommends that exchanges and CCPs only use warehouses as delivery points for their contracts that have taken sufficient steps to identify conflicts of interest and disclose their conflicts of interest policy that they have identified.  In addition, the Report proposes that warehouses undertake external audits to check on whether the warehouse observes the prohibition on preferential treatment for a related market participant and use of confidential information regarding warehouse holdings to the warehouse’s or an affiliate’s commercial advantage.

 

[1] Final Report – Commodity Storage and Delivery Infrastructures: Good or Sound Practices (IOSCO Feb. 2019), available at:  https://www.iosco.org/library/pubdocs/pdf/IOSCOPD622.pdf  

[2][2] Final Report – The Impact of Storage and Delivery Infrastructure on Derivatives Market Pricing (IOSCO May 2016), available at: https://www.iosco.org/library/pubdocs/pdf/IOSCOPD530.pdf

[3] J. Farchy, LME takes aim at warehousing queues (Fin. Times July 1, 2013), available at: https://www.ft.com/content/5988476c-e235-11e2-a7fa-00144feabdc0.

[4] Id.

[5] Id. (aluminum trades in the cash market at a 10 to 15 percent premium to the LME contract price).

[6] N. Hume, J. Farchy & G. Meyer, LME cracks down on metals warehousing after queues complaints (Fin. Times Nov. 7, 2013), available at: https://www.ft.com/content/af4e3af4-4792-11e3-9398-00144feabdc0.

[7] A. Mason, LME warehouse queues return with over 100-day wait for aluminum at Port Klang (Fastmarkets May 10, 2018), available at: https://www.metalbulletin.com/Article/3806110/LME-warehouse-queues-return-with-over-100-day-wait-for-aluminium-in-Port-Klang.html.

[8] A. Home, LME storage not market dynamics driving aluminum stocks lower (CNBC Oct. 2, 2018), available at: https://www.cnbc.com/2018/10/02/reuters-america-rpt-column-lme-storage-not-market-dynamics-driving-aluminum-stocks-lower-andy-home.html.

[9] Report at 7.

[10] Id.

[11] Id.

[12] Id. at 8.

[13] Id.

[14] Id.

[15] Id. at 9.

[16] Id. at 11.

[17] Id.

[18] Id.

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