Understanding the Nickel Fiasco

So there's been a big blow-up surrounding the nickel market and I want to understand what exactly has gone on.

Very quickly, on the eighth of march nickel prices rose 250% within a day from 30k to a peak of a 100k. Then, the London Metal Exchange actually cancelled trades that have already been made. Why? And how?

To start, Nickel is traded on a commodities exchange, which is just like any other financial market, except focused on the commodity itself.

Ostensibly, how a commodities market would work is to stabilise prices for actual producers and consumers of nickel. Right, so this means they deal with futures and other forward looking contracts. For example, a nickel producer wants to lock in his selling price for the next year. He finds a consumer and agrees with them on a price. Then they both sign a contract and the price is set.

And if this happens en masse a market can form around these negotiations. First, many different parties negotiate for the price, credit terms, and durations. Overall this creates a larger market price that moves up and down.

But, in reality there are a whole lot more derivatives and abstract trading going on. Instead of just nickel producers and consumers, there are also 3rd parties like traders. These 3rd parties can bet on the direction of prices with derivatives. And these derivatives can be like standardised contracts that are easily traded - with differences being settled with equivalent cash transfers rather than being about delivery of cargo itself.

The reason this is tolerated is for liquidity to enter the market. And liquidity is just the flow of money which leads to the easy conversion of assets to cash - via the markets. Actual industrial producers also benefit by being able to hedge their positions - which means they can take up some calculated bets to protect themselves if the market goes crazy. For example if they're afraid that future prices will be lower than normal.

Looking at the price hike, it occurred because a Chinese nickel tycoon, Xiàng GuāngDá, bet hugely against nickel. With the Russian invasion of Ukraine, prices shot up. This triggered margin calls for his short positions, leading to a short squeeze. (which is fundamentally the same mechanism as with GameStop last year) So after they got margin called, short sellers were forced to cover their positions by providing cash - or else by buying up nickel futures to return.

The company that GuāngDá heads is Tsingshan Holding Group, and their bankers also had to cover their own short positions which were now exposed. Which just leads to even more of a price spike.

At this point, with prices approaching a 100k, many producers and traders were facing ruinous margin calls. LME then decided to cancel all the trades that happened the morning of March 8th. Parties wouldn't need to pay margin calls on an 80k price, and prices were rewound back to 48k.

This leads to a question of what is right to do. Is the market there for practical purposes to prop up the underlying nickel industry? Or is the exchange bound to provide a market with solid rules, and nothing more.

LME says that their obligations are to support the industry. If a disaster arises from the market structure, maybe it is the market structure that is flawed. This makes sense if you think the exchange is just a fiction of convenience to help real world trading.

But again this isn't fully convincing. People who profited from now cancelled trades are furious. The nature of derivatives are already abstract and you could say that being aligned with physical reality is not an ironclad requirement. After all, the whole basis of the exchange is to enforce an environment that attracts 3rd parties who produce no nickel at all to trade.

Now we're left with figuring out what the rules are made for. The Chinese tycoon is probably fine since he could source loans backed by his real world nickel.

Personal Opinion

For stability's sake, it probably is right to cancel such trades, but any complaints would be valid. Either future traders will have to be formally given a disclaimer that these sort of things could happen. This increased risk could lead to a permanent discount, and so a gap between the exchange and real world prices - which reduces its efficacy. Or, we should continue to let firms blow up - because how protected should big players really be?

If I had to say, I'd bet that any future instabilities will be guarded against in the same way. So you'd need to factor the risk of being cancelled on if you take a short position and prove to be very very right.

This incident is a reminder that many rules we have are just made up. It's not like they don't matter, but that they are not always ironclad. At the end of they day, rules are enforced by those with power - who can decide what they will. This is exactly like the international justice system: where their courts are only as powerful as the individual nations that back them are.

An actionable insight would be then to not assume that markets are always binding. Instead, the focus should be on the real players that take part in and manage the market. Markets may just be an abstract plane of existence, which are underpinned by vested interests and whose rules are enforced by fickle people.