Dislocations in derivatives markets: The causes and consequences of disorderly futures markets in the light of recent episodes in nickel and crude oil

1. Introduction

The prices in the market for derivatives based on an underlying are usually related to those in the market for the underlying itself. Occasionally, however, the prices in these two markets disconnect from each other. Exchanges and clearing houses have wide-ranging powers to manage such situations. Market stress can create large losses for parties who have relied on the usual relationships between prices holding, either due to movements in the prices themselves or as a result of the use of these powers. Therefore, it is important to understand the main types of connection between derivatives markets and their related underlying (‘physical’ or ‘cash’) markets, the different ways in which these connections can fail to keep prices in the derivatives and cash markets aligned, the tools available to market infrastructure providers to intervene when this happens, and the requirements around the proper use of those tools.

Two episodes will be used to illustrate market dislocations. The first is the tumult in nickel futures traded on the London Metal Exchange (LME) in early March 2022. Here, prices climbed dramatically without a corresponding rise in the price of the underlying commodity. In response to this dislocation, the LME declared that the market was no longer orderly and suspended futures trading at 8.15 a.m. on 8 March. The exchange subsequently cancelled nickel futures trades made after midnight on 7 March until the point of suspension. Further, it used the nickel futures closing prices on 7 March rather than later, higher prices, as the basis for margin calls. These actions were unusual and economically significant. As a result, two market participants, Elliott Associates and Jane Street Global Trading, brought judicial review proceedings and a damages claim under the Human Rights Act against the LME.¹ The claimants sought to overthrow the trade cancellations on the basis that the LME’s actions were ultra vires for an improper purpose and conducted in a procedurally unfair manner.

The recent dismissal of this case, Elliott, is important for several reasons. It confirms that the actions of regulated exchanges and clearing houses are subject to public law standards of review.² It emphasizes that market participants trading in a derivatives market should be aware of the mechanisms that connect it to the underlying cash market, the circumstances under which prices in the two markets can diverge and the actions that can follow if this divergence is deemed to be disorderly. The private law contractual context, notably the decision-making powers that exchanges and clearing houses have available under their rulebooks, and to which members voluntarily assent as a pre-condition of trading, is also important.

The picture that emerges from this episode is one of a public/private law hybrid. The LME is a private body, with no overriding duty to act in the public interest. The Bank of England, as financial market infrastructure regulator, for instance, requires clearing houses to ‘give adequate regard to the interests of system participants and the financial system as a whole’. In other words, systemic risk management is an important consideration but not necessarily always a determinative one.³ Exchanges and clearing houses are, in some regards, clearly tools of public policy. They are subject to certain public law duties and are sometimes both bound by and shielded by regulation.

The nature of financial market infrastructures as public/private hybrids comes into particular focus in stress, where a response is needed, and any effective action will create losses for some stakeholder or group of stakeholders. It suggests that the governance problem for modern financial market infrastructures is delicate and emphasizes the importance of clarity concerning the relevant public law obligations so that private actors can contract with certainty.⁴

In the LME nickel episode, prices rose very quickly. In our second example of a dislocation, in contrast, the price of a globally significant futures contract referencing crude oil fell, not just to zero, but to a negative level. This future was the benchmark West Texas Intermediate (WTI) future traded on the New York Mercantile Exchange (NYMEX): the closing price for this contract was negative on 20 April 2020. The WTI stress will be insightful because it reveals important features of the mechanism connecting cash and derivatives markets. It suggests that there is always a risk that a derivatives market will dislocate from the cash market, and hence, that the aspiration that financial market benchmarks always faithfully represent the economic reality they are thought to portray cannot be met with certainty.

The remainder of the article is structured as follows. In Section 2, a key background on cash and derivatives markets is set out. This section discusses financial market benchmarks, the physical settlement of derivatives and the market liquidity considerations that shape the design of instruments in derivatives markets. Section 3 then turns to the events of the March 2022 nickel futures dislocation and the motivations of market participants. Section 4 considers why prices in cash and derivatives markets usually follow predictable relationships and how these regularities are exploited. Using this context, the analysis continues in Section 5 with an account of the April 2020 WTI market stress, illustrating how issues in physical delivery can create dislocations, and discussing related problems with the representativeness of financial market benchmarks. Section 6 considers the declaration by an exchange that a market, such as those in nickel or WTI futures, is no longer ‘orderly’. It discusses the tools available to exchanges and their associated clearing houses to address such situations. Section 7 concludes with recommendations for market participants and regulators in light of this analysis.

2. Some features of cash and derivatives markets

It will be helpful for our analysis to set out some of the key features of derivatives markets and their relationship to underlying cash markets. This section begins this discussion by introducing a pair of cash and futures commodity markets, those for crude oil and WTI futures. This will also prepare the ground for consideration of the dislocation between these two markets in Section 5.

Cash markets

The crude oil market makes for a good introduction to the complexity of cash markets in general and those for physical commodities in particular. This is one of the largest and most economically significant markets in the world. It covers products with a wide range of properties: as Dunn and Holloway⁵ put it, ‘crude oil varies in colour from nearly colourless to tar black, and in viscosity from close to that of water to almost solid’. There are hundreds of different grades of crude oil produced globally, with different chemical compositions and, as a result, different properties and different prices.

Two of the most economically important properties of crude oil are density and sulphur content. These matter because crude has few direct uses: most applications use refined oil products and lighter, lower-sulphur⁶ oils can be refined to yield products of a higher value than heavier, higher-sulphur ones. It is also less complex and less costly to refine lighter, lower-sulphur crude oil.

If the properties of a particular batch of crude oil matter for its value, so too do its location and the amount concerned. Issues of size—and hence which type of tanker or how much pipeline capacity is required—insurance, shipping costs and the location of suitable refineries with free capacity on the right timescale, are all important.

It is clear from this discussion that we cannot meaningfully speak of the global price of physical crude: rather there are many prices at a given moment depending on chemical composition, size of transaction and cost of transportation to the buyer, among others. Each transaction in physical crude oil has hundreds of features that are relevant to its price.

Derivatives markets

A derivatives market is a market for financial instruments that condense the details of a cash market as well as provide additional transaction types. One key feature of successful markets here is relative simplicity compared to the underlying cash market: the derivative abstracts away from some of the details of the cash market, providing standardized instruments that many market participants find useful. In order for this to work, legal and market infrastructure are needed.⁷ A common setting for the provision of these features is an organized market.⁸ Such a market also often provides other supportive features, too, such as membership criteria and rules of conduct, market surveillance, pre- and post-trade transparency and counterparty credit risk mitigation through margining (and, often, central clearing). Many or all of these features may be absent in the cash market. Thus, better legal and market infrastructure is one of the factors supporting the growth of derivatives market activity.

However, all of this is not enough to guarantee a successful market. In addition, there must be both eager buyers and eager sellers. Simplification and standardization help here, because standardized instruments pool liquidity. They facilitate (the perhaps tacit) agreement that market participants will trade the same thing despite their somewhat differing needs. In order to illustrate some of the issues that arise, we now return to the WTI futures market.

The example of WTI futures

The most important crude oil futures market in the USA is that for a grade of crude known as WTI. These futures trade on the NYMEX exchange⁹ and are based on crude oil with properties within specified bounds deliverable in Cushing, Oklahoma.¹⁰

WTI abstracts away from the complexity of the crude oil market by defining a (in this case, large) range of crude oil production as a valid deliverable, given that many oil fields in the USA produce crude with properties within the specified range and which can be transported to Cushing with relative ease.

A wide range of related financial market instruments are based on WTI: futures, options and swaps are all commonly traded. This demonstrates that the abstraction from the various grades of crude oil in different locations to WTI at Cushing has been highly successful. Indeed, the price of the ‘front month’ (usually, shortest maturity) WTI crude oil futures contract is a global benchmark for both energy and financial markets.

Financial market benchmarks

This discussion highlights the role of benchmarks in derivatives markets. As commonly used, this term refers to either:

• The settlement price of a financial instrument that is used as an indicator of the broad state of a market, and which is preferentially used to price other instruments. Practically, this is often the price of a highly liquid active-month¹¹ futures contract. The other instruments based on the benchmark futures contract often include options on the future and Over the Counter (‘OTC’) derivatives. Or,

• An index, reference rate or other published price or level that fulfils the same reference function. This is typically derived from cash market transactions or, less commonly, surveys of cash market participants.¹²

Benchmarks abstract away from the details of the cash market…

We have noted that successful financial market benchmarks often isolate a set of potential transactions that is big enough that the level of the benchmark can be reliably determined, but small enough that all the transactions in the group are reasonably similar. WTI permits a range of different sulphur levels, for instance, but it does not include very light or very heavy crude. Differences within the set of transactions are sometimes removed by fixed mechanisms, but more often all qualifying transactions within it are treated equally.

The abstraction mechanism for indices is defined by their methodology: for futures settlement prices, it comes through the specification of how the settlement price is determined both during the life of the contract and at final maturity. There will usually be arbitrary choices here. For instance, the principal¹³ mechanism for determining the daily front-month WTI future settlement price is the volume-weighted average price for relevant futures trades between 14:28 p.m. and 14:30 p.m. on the day concerned, while at maturity, there is physical settlement through delivery of oil with specified properties in Cushing, OK.

Thus, it can be seen that instruments in a derivatives market should not be thought of as mere by-products of the cash market. Their prices may be related to cash market prices, but they are seldom fully determined by them. Rather, each instrument trades independently and has a price set by the interaction of buyers and sellers of that instrument. The connection between the cash crude oil and WTI futures markets is simply that the future can be settled at expiry by delivering the relevant quantity of qualifying oil at an acceptable location—Cushing. It should be noted here that Cushing is connected via multiple pipelines and has a significant amount of crude oil storage capacity,¹⁴ but these facilities only represent c.13 per cent of total US storage capacity. If the delivery location for WTI was broadened to include the principal Texas and Louisiana storage terminals,¹⁵ a significantly larger volume¹⁶ of cash market flows would be included in the definition. Choosing to define WTI as only crude oil of a certain grade in certain storage locations at Cushing removes price variability caused by differing delivery costs to different places, but it makes the benchmark very sensitive to the ease of getting oil to a particular location in Oklahoma and storing it there, rather than to broader US cash oil market prices.

…Because that creates valuable derivatives market liquidity

Successful financial market benchmarks are useful because they are used. The idea of a coordination point helps to explain this phenomenon. A coordination point (sometimes referred to as a ‘Schelling point’ or ‘focal point’) is a solution to a problem that people tend to choose by default, and which has value purely because of that collective choice.¹⁷ Good benchmarks are therefore coordination points. There is a virtuous spiral whereby some instruments linked to a good benchmark are liquid, so many market participants choose to use these instruments, so they remain liquid.¹⁸ Market liquidity has substantial value to participants: it means that it is possible to conduct large transactions in the instrument without substantially moving the market prices, and that there are usually market participants who are ready to take the other side of an ordinary proposed transaction for a relatively small consideration. Thus, often, market participants prefer to transact a liquid instrument, such as an LME nickel or NYMEX WTI future, instead of one which more perfectly matches their needs, but which does not have the same liquidity. Thus, a US producer of extra light crude (which contains too large a proportion of light gaseous hydrocarbons to be WTI deliverable) might nevertheless hedge with WTI futures.

3. The 2022 LME nickel futures episode

This section discusses the events leading to the Elliott case against the LME and considers why some market participants considered the exchange’s conduct culpable.

The LME is the leading global exchange for derivatives linked to base metals. Standardized futures and options contracts are traded on metals including copper, nickel and aluminium, with clearing through the associated LME Clear clearing house. The benchmark contract for each metal is the 3-month future. For nickel, this references six tonnes of nickel of at least 99.8 per cent purity.

The episode

The benchmark nickel future on the LME closed on Friday 4 March 2022 at $29,800/ton, close to the cash market for comparable physical nickel.¹⁹ On Monday 7 March, it closed at $48,078/ton,²⁰ and the following day it traded above $100,000/ton. This was unprecedented volatility for a commodity that usually moved a few hundred dollars per ton a day.

The market background here is that in early 2022, significantly more nickel production was expected in the coming months, so some market participants had taken short futures positions in anticipation of falling prices. In addition, many nickel producers had their usual short positions to hedge the price of future sales. Then, in late February, Russia invaded Ukraine. Russia was at the time the third largest global producer of nickel. As noted above, the LME nickel contract can be physically settled by delivery of high purity nickel—and Russia had an even greater share of the production of this grade. Market expectations of the refined nickel price in future therefore suddenly changed from bearish to bullish, and the futures price started to rise. This rise created margin calls for holders of short positions.

One of the largest shorts in the market was Xiang Guangda.²¹ His Tsingshan Holding Group was a large producer of nickel pig iron.²² Many market participants thought that the rising nickel price was causing funding liquidity problems for the shorts, including Tsingshan. This was a short squeeze, with buyers of the future taking the view that short position holders would be forced to cover their positions, and profit was therefore likely from the resulting price rise. The price movement on Monday was estimated to create a total $3 billion margin call for Tsingshan,²³ so this view was not unreasonable.

If Monday’s closing price created problems, Tuesday’s would have been much worse. Calling margin at a settlement price of $100,000/ton or thereabouts would likely have caused multiple defaults among LME’s clearing members. As LME’s CEO, Matthew Chamberlain, put it, the exchange ‘had significant concerns about the ability of market participants to meet those margin [calls, ie, at Tuesday’s elevated prices] and therefore [there was] the concern of multiple defaults’.²⁴

In response, LME cancelled all of the trades on Tuesday, 8 March—approximately 5,000 of them, with an estimated value of nearly $4 billion²⁵—declared that the market was disrupted and temporarily closed it.²⁶ These actions were within the exchange’s powers under its rules,²⁷ but they were unusual.

Market reactions

The reaction across much of the market was outrage, with one market participant saying that the cancellation of trades was ‘unforgiveable’.²⁸ The market reopened over a week later, on 16 March, with price bands in place to prevent large movements.²⁹ These were initially set at 5 per cent, then 8 per cent, and finally 12 per cent. The LME did not publish an official settlement price for nickel until the daily price move was not constrained by the price bands. This first happened on 22 March, when the future closed at $30,800/ton, close to its pre-squeeze level. The price bands and lack of an official close for some days caused further disquiet, with one market participant stating that LME’s ‘credibility is very quickly slipping through their fingers’.³⁰

The market participants most directly affected by LME’s actions were those whose trades were subsequently cancelled. Also affected, arguably, were those holding long positions in nickel futures when the market was suspended as, in the counterfactual of no suspension, these parties would have had a substantial mark-to-market gain on those positions at the close of 8 March. All of these parties were incentivized to argue that LME took the wrong action in cancelling trades or suspending the market. Indeed, many parties without a financial stake in the outcome also took this view.³¹

LME’s perspective?

Various explanations have been put forward for LME’s actions. While we do not know the thinking of the key participants during what was undoubtedly a febrile episode, the institutional context is important. LME has a long history.³² Its contract design was based on features of the early cash metals market: after the Suez Canal opened in 1869, both tin from Malaysia and copper from Chile took approximately 3 months to reach England; hence, LME’s use of 3-month maturity futures. This grounding of the cash market is important³³: markets require both long and short positions, and while both commodity consumers and investors are natural holders of long positions, the short side comes predominantly from producers. LME may therefore have wanted to protect holders of short positions from a margin call that they could not meet, not just to avoid having to manage (and potentially suffer losses as a result of) the resulting defaults, but also as a signal that the Exchange was a safe place for producers to hedge.

There are usually no easy answers to extreme market stress. Certainly, this was the case on 8 March 2022 for the LME. However undesirable it might be to cancel trades, it is also problematic to issue a margin call that creates multiple defaults based on a price that is three times the cash market level. Moreover, there is no question that cancellation is a rule book power, and hence on the face available to the exchange. The potential for its use is inherent in every future traded on the exchange, as discussed further in Section 6 below. Even if one were to suppose that the aspiration of the operator of a base metal futures exchange was to provide efficient price discovery and hedging mechanism for the broad cash market, this must be suffixed by ‘provided that trading is not disorderly, suspended, or operating within price bands which constrain the efficiency of price discovery’. While LME could have taken steps to reduce the probability of stress,³⁴ once it hit, their action was at least comprehensible.

4. Some causes of and uses for predictable relationships between prices in cash and derivatives markets

We now turn to the processes which tend to keep derivatives markets connected to their underlying cash markets. These are of particular interest because disorderly markets can occur when these processes are overwhelmed. This leads to a consideration of financial market indices, their regulation and in particular the expectation that they reflect an ‘economic reality’. Finally, the impact of the prices used for determining margin in disorderly markets, and the difficulty of fixing those prices, is considered.

Arbitrage relationships

Finance theory suggests relationships between the prices of certain assets that should hold as a result of ‘no arbitrage’ arguments. The essential idea is that if the relationship does not hold, then it is possible to construct a portfolio that profits with no—or in some cases, little—risk.³⁵ One simple example is cash/futures arbitrage: if a certain amount of a commodity is physically deliverable into a futures contract, then the prices of the commodity and the future should be related by the portfolios where either the future is bought and the commodity is sold short or vice versa.³⁶

Other regularities

Beyond purely financial arbitrage relationships, there are relationships that are determined by real-world processes. For example, a given grade of crude oil can be refined into a ‘stack’ of products often including gasoline, diesel fuel, fuel oil, heating oil, kerosene, liquefied petroleum gas and petroleum naphtha. The price of the ‘output’ basket of refined products plus the cost of refining should, after transport and other relevant costs, equal the price of the ‘input’ crude oil. Moreover, if the price of one grade of crude oil becomes too expensive versus another, given the value of the output baskets of each and the cost of refining, refiners with the capacity to use either input will tend to buy the latter, thereby tending to reduce the price differential.³⁷ Finally, beyond these regularities grounded in commercial processes, there are relationships that tend to persist between prices, but do not directly result from economic activity. These sometimes form the basis of trading strategies, but they tend to be less reliable than price relationships directly grounded in economic activity.³⁸

The roles of trading and physical settlement in strengthening regularities

The relationships discussed above are not laws of nature: rather, they are regularities that tend to hold because, all other things being equal, it is profitable for market participants to trade in a way that tends to maintain them. The strength of the relationship depends on the costs in all the relevant markets of these trades. For the WTI futures versus physical crude oil arbitrage, for instance, we might be concerned with pipeline, insurance and storage costs. These costs mean that there is typically an arbitrage channel: the difference between prices has to move outside the channel before there is a net profit available. Thus, when arbitrage or the ability to conduct a process such as oil refining ‘polices’ the relationship between the two markets, it usually does so within bounds rather than precisely. The relationship relies on there being sufficient activity. This, in turn, often depends on market participant’s access to capital and funding, their risk tolerance, and their ability and willingness to access the relevant markets and processes.³⁹

In this light, physical settlement is evidently a device that helps maintain the expected relationship between the price of a future and its underlying, as market participants with access to both derivatives and cash markets can undertake arbitrage trading should these prices diverge, relying on the potential for physical settlement to close the arbitrage. However, for this to be effective, there must be sufficient activity to keep the markets in line. This is not always the case,⁴⁰ and indeed differences can persist for an extended period of time.⁴¹ Successful contracts require liquidity, but if this largely comes from parties hedging non-deliverable physical positions or financial market instruments with futures, then their activities will not help to steer prices towards their theoretically predicted relationships.

Cash settlement

Cash-settled markets are attractive to many market participants. For instance, investors desiring continuous exposure to the performance of an asset class, perhaps because they are managing an investment fund linked to it, will often prefer cash settlement to physical delivery. Dealers hedging bespoke instruments like OTC derivatives may also prefer it. The vast majority of futures are either transferred into the next month’s contract—or ‘rolled’, as this process is known—or cash-settled. This demonstrates the utility of futures contracts which do not necessarily proceed to physical settlement.

The regulation of financial market indices

Financial market indices address market participants’ desire to have a fair, transparent, reliable and readily available reference from which the likely prices at which other transactions could occur can be inferred, and hence, in particular, to use as the basis for cash-settling derivatives. Following the scandal around the suite of interest rates known as Libor,⁴² regulators introduced various reforms to the policy around indices addressing their calculation, governance and dissemination.⁴³

A key strand both in transnational index policy⁴⁴ and the Benchmark Regulation is that an index should represent an ‘economic reality’.⁴⁵ In our context, this means that it should be designed to reflect prices in the cash market so that prices in the market for derivatives, which cash settles based on it are ‘in line’ with those in the cash market. Of course, this is easier said than done: often, there are too few cash market trades with identical properties to provide a reliable price. Indices solve this problem by grouping together similar transactions,⁴⁶ perhaps together with surveys of the prices at which market participants consider they could transact, or other data. The wider the data set used, the more robust it is to declines in cash market liquidity, but the more dissimilar transactions it is based on.

The role of margin

A physically settled future would seem to be the perfect instrument for the party who has, or who wants to receive, the underlying. If I know that I can deliver the required quantity of crude oil of the right grade to Cushing during the period specified by the futures contract, then I know that I can satisfy a short position in the future, whatever the final closing price is. Similarly, if I want the oil and I am prepared to pay the entry price, then it would appear that I can buy the future and thereby be indifferent to the future oil price. Unfortunately, this is not quite true: in the case discussed, there is no uncertainty in the flows at expiry with a physically settled future, but there is uncertainty during the life of the transaction, due to margin. The oil producer, despite being able to deliver, must nevertheless meet margin calls on their short futures position during the life of the contract. If the crude oil price goes up, they have to pay the increase as a variation margin. The oil they are producing has become more valuable, but this does not create a cash flow until it is sold.

This phenomenon illustrates the key role of margin. Both the cash market and the derivatives market have price risk, but only the latter is margined, and thus has what is commonly called ‘funding liquidity risk’.⁴⁷ The oil producer hedged with a physically deliverable future is price risk hedged, but they are not hedged against funding liquidity risk. If prices rise, their ability to sustain the position depends on their access to liquidity. Thus, the futures price used to determine margin calls determines the liquidity required not just by market participants with outright positions, but also by those hedging non-margined positions with futures. If prices in the derivatives market are in line with those in the cash market, this is uncontroversial: but if prices dislocate, as in the LME nickel episode,⁴⁸ the choice of the price used to determine margin can both have substantial implications for the demands placed on derivatives market participants and be highly contestable.⁴⁹

5. Stress in crude oil futures

Another dislocation between derivatives and cash markets, the day in April 2020, when the price of WTI futures turned negative, provides additional insight into some of the stresses that can occur in derivatives markets. This episode, its causes and the responses to it are considered next.

The day crude oil futures had a negative price

The central role of arbitrage in connecting cash to derivatives markets has been discussed in the previous section. A necessary condition for an arbitrage relationship to hold is that conditions in the cash market can sufficiently influence those in the derivatives market. When this influence weakens, the difference between the two markets, or ‘basis’, can widen. This means that if physical delivery is key to maintaining the connection, difficulties affecting delivery can cause this disconnection.

A good example of this effect was the negative closing price of the benchmark WTI future on 20 April 2020.⁵⁰ The front-month futures contract was for delivery in May. This had opened the trading session for the 20th (which began the previous evening) at $17.73 per barrel. During the session, the low was −$40.32 per barrel, and the contract settled at −$37.63 per barrel. The inference is that long position holders were paying shorts to take oil away.

The context here is that storage at Cushing was nearly full due to over-supply in the global crude oil market. The onset of the coronavirus pandemic suddenly reduced expectations of future demand. There was doubt about the ability of producers to respond quickly to this reduction, and hence concern about over-supply. The most liquid instrument for expressing the view that crude oil was too expensive, given these factors, was the WTI future. The resulting wave of futures selling meant that arbitrage between the future and cash crude oil broadly was not effective at maintaining the expected relationship. This was in part because market participants were not willing to undertake to deliver more oil at Cushing in the near term due to already almost full storage, and in part because many market participants had already rolled into the next month.⁵¹

Opposing flows

This episode highlights the fact that physical versus cash market arbitrage activity is not necessarily determinative of prices. Other parties will be transacting for their own reasons, such as expressing an outright view. If the impact of non-arbitrage transactions is greater than that of the arbitrageurs, then predicted and usually stable relationships can break down.⁵² In this case, the price of the front-month WTI futures did not represent the economic reality for broad crude oil prices in the USA that day, but it did represent the economic reality of the market for that future. There were good reasons that market participants did not want to buy the May 2020 contract in late April, including the impending physical settlement and the lack of free storage capacity in Cushing.⁵³

The aspiration that futures markets should always provide an efficient price discovery and hedging mechanism for the broad cash market is therefore seen to be fundamentally unfulfillable. Derivative markets can accurately reflect the forces of supply and demand internally. They cannot reflect a different market with different participants and different contractual arrangements, such as the cash market, perfectly. The quality of the representation will depend on the nature of the connection between the two markets and what forces can disrupt that connection. Similarly, an index can represent the economic reality of the precise transactions used to set it; it cannot always represent anything else accurately.

Exchange inaction

The events of 20 April did not result in emergency intervention by NYMEX or its parent, the Chicago Mercantile Exchange (CME).⁵⁴ This was not for want of powers: CME has a number of tools to address ‘emergency’ situations. These situations include events ‘in which the free and orderly market in a commodity is likely to be disrupted’.⁵⁵ If an emergency is declared, the CME can terminate trading in a contract, confine trading to a specified price range or alter the conditions of delivery. It has discretion to set a settlement price away from market prices, and to use that price to determine margin.

The reasons that an emergency was not declared and that CME did not use the powers available, likely include the sizes of the positions in the affected contract. LME’s issues affected a contract, which was both the most liquid nickel futures contract and the global benchmark for the price of (high-grade) nickel: a dislocation in it would have wide effects. In contrast, most market participants in the WTI futures market had rolled, so the dislocation in the former had much more limited effects. Strikingly, while the nickel episode did result in recommendations for market reform,⁵⁶ the WTI one did not, and CME’s plan to accommodate negative prices for certain commodity contracts in its systems remains in place at the date of writing.⁵⁷

Expert judgment does not always resolve the problem

The LME nickel and NYMEX WTI episodes affected markets with physical delivery. It might be imagined that moving to cash settlement based on an index determined using a wider range of price inputs would be more robust. The problem here is that markets in stress tend to become illiquid, so representative transaction prices are often unavailable or too sparse to provide a reliable reference.

The use of expert judgment about where market prices ‘should be’ is problematic too. This was evident from the problems with Libor. Libor was determined based on submissions from a panel of banks who were each asked the question ‘At what rate could you borrow funds, were you to do so, by asking for and then accepting interbank offers in a reasonable market size just prior to 11am?’. When interbank market liquidity disappeared during the 2008 global financial crisis, there was little economic reality to reflect, and hence the question arose whether panel banks’ answers to this question represented a robust basis for pricing hundreds of trillions of dollars of interest rate derivatives. Thus, while there is some evidence that some submitters did not provide honest answers to this question,⁵⁸ the broader problem was that there were too few transactions to support a robust response, especially once the interbank market became stressed.⁵⁹ In short, if an index is determined using only actual transaction prices, there is the risk that there will be insufficient volume to support robust determination; while if expert judgment can be used, there is the risk that the experts will provide opinions that are insufficiently supported by transactions to attract full confidence.

6. Disorderly markets and the tools which address them

Examples of dislocation between derivatives and cash markets have been briefly discussed. These are part of a long history of such events.⁶⁰ Unsurprisingly, then, exchanges and clearing houses have developed tools to address disorderly markets. This section considers when such tools are used, what measures are commonly available and how the decision to use them will be treated by the Courts in the light of Elliott.

Disorderly markets and the use of tools

The notion of a market being ‘orderly’ is an important one in exchange and clearing house rules. The current LME rule book, for instance, uses the term 23 times, often in the context of the ability to use a power. For instance, in Part 3, rule 1.13 states that the exchange ‘may, at its absolute discretion and acting reasonably suspend trading on one or more of the Execution Venues for such period it considers necessary in the interests of maintaining a fair and orderly market’. Unfortunately, the rules define neither an orderly market nor a fair and orderly one,⁶¹ but the Court took the view in Elliott that it was legitimate for LME to assess the orderliness of the nickel futures market ‘by considering whether there was a disconnect between the 3M [three month future] nickel price and the value of physical nickel, which could not be explained by any relevant macroeconomic, geopolitical or other factor relevant to the market for the underlying commodity’.⁶²

CME’s rules grant a similarly wide degree of discretion to the exchange both in deciding when markets are stressed and in acting to address the situation. For instance,⁶³ in the event ‘that the Board or a hearing panel of the Board determines that an emergency situation exists in which the free and orderly market in a commodity is likely to be disrupted, or the financial integrity of the Exchange is threatened, or the normal functioning of the Exchange has been or is likely to be disrupted, it may, upon a majority vote of the members present or upon a majority vote of the members who respond to a poll, take such action as may in the Board’s sole discretion appear necessary to prevent, correct or alleviate the emergency condition.’

The tools available to exchanges and clearing houses

The tools available here are typically wide ranging and powerful. In addition to market suspension, for instance, LME can terminate (or ‘invoice back’) contracts at a price it determines⁶⁴ and fix settlement prices ‘otherwise than in accordance with the applicable Pricing Methodology’.⁶⁵

In addition to their emergency powers, as discussed in Section 5.3, CME’s tool set is similarly broad: it includes the ability to suspend trading, terminate contracts, alter delivery requirements and fix settlement prices.

Exchange and clearing house rule book powers are, as Elliott demonstrated, integral to the contracts traded. A futures contract is not just a margined, forward sale or purchase: it also incorporates and is bound by the entire exchange (and, where different, clearing house) rule book. Furthermore, these powers are not purely private choices made by the rule-book-writing entity under their chosen governance arrangements, at least in the UK and the EU. Relevant regulation, for instance, requires trading venues to have certain measures in place to prevent disorderly trading conditions, including trade cancellation processes and mechanisms to manage market volatility.⁶⁶ Thus, regulated exchanges must have at least a limited set of rule book powers to address disorderly markets.

LME’s decision-making process and its judicial review

It was common ground in Elliott that the exchange and its clearing house were both recognized bodies under Part XVIII of the Financial Services and Markets Act 2000.⁶⁷ As such, their decisions are amenable to judicial review and they are public authorities for the purposes of the Human Rights Act 1998. This formed the basis for the claim against them. In contrast, as noted above, LME rules are private law arrangements. However, the Court found that ‘the regulatory context makes it necessary to interpret’ the LME and LME Clear Rules ‘by reference to the overarching legislation’. Thus, trading on regulated exchanges (and perforce clearing on the associated recognized clearing house) entails a hybrid of public and private law arrangements. This mirrors the nature of regulated exchanges like the LME as private bodies, which serve public policy as well as private, commercial purposes.

There are some duties of consultation on exchanges and clearing houses.⁶⁸ However, as the Court noted in Elliott, these do not apply to the use of rule book powers in disorderly markets or other emergencies. Furthermore, no common law duty to consult arose in the nickel episode.⁶⁹ Thus—however unfair such a fact may appear to members who face losses as a result—unilateral use of rule book powers is possible in stress.⁷⁰ This emphasizes the importance of market participants understanding the powers available to financial market infrastructures and the governance around their use.

Given the extent of the discretion available to exchanges and clearing houses in their rules and the lack of a duty to consult on action to address an emergency, the question naturally arises as to how the Courts will interpret exchange and clearing house decision-making in response to market stress. Elliott clarified this question: given the urgency of the situation, the decision maker’s specialist knowledge in a complex, technical area and the fact that market participants had voluntarily subjected themselves to the provisions of the LME rule book by trading on the exchange, the claimants’ case in relation to procedural fairness and the failure to consult was rejected.⁷¹ The usual public law Wednesbury standard of reasonableness in decision-making was affirmed.⁷² This leaves potential claimants with a substantial burden of proof in any challenge against the use of rule book powers by a recognized exchange or clearing house in response to market stress.

7. Concluding remarks

We have seen that standard mechanisms, such as physical settlement or cash settlement to an index designed so that it usually reflects the economic reality of the cash market, often work to keep prices in cash and derivatives markets close to their expected relationship. However, despite these efforts, these mechanisms do not always work, as evidenced by the LME nickel and NYMEX WTI episodes discussed.

This issue has been known since the early days of futures markets and, as a result, exchanges and clearing houses typically have extensive powers in their rule books to address markets that they deem not to be orderly, including the ability to cancel trades, terminate them at prices determined by the exchange and alter delivery requirements. Settlement prices—which determine margin requirements—can be modified too. The use of these powers is discretionary, often not bound by a duty of consultation, and subject to public law standards of review. Market participants should be aware of this when choosing to trade in these markets.

The court’s judgment as to whether the use of powers by exchanges and clearing houses is (Wednesbury) reasonable will depend on their purpose. This is typically not explicitly stated, but, based on the discussion in the prior parts of this article, it can reasonably be inferred to be 2-fold. First, the restoration of orderly markets, meaning ones with reasonably stable prices in broadly the expected relationship with those in the cash market, and where liquidity is at close-to-normal levels. Second, keeping or restoring confidence in the exchange and the clearing house by, in addition, protecting the exchange’s and CCP’s financial stability and mitigating the risk of unjustified and potentially damaging calls on market participants.

The episodes of dislocation discussed also throw light on the expectation of some market participants and the requirement in regulation for benchmarks to reflect ‘economic reality’. As we have seen, even well-designed and broadly used markets can sometimes become disorderly. Thus, the reflection of the ‘reality’ of the cash market, even if there is broad agreement about what that means, is an aspiration rather than something which can be guaranteed. Regulators should also focus on the adequacy of the powers available to exchanges and clearing houses for addressing stressed situations, and the decision-making processes around the use of those powers.

The author would like to acknowledge insightful comments on earlier versions of this article from Jo Braithwaite, Elizabeth Howell, Sarah Paterson, Heather Pilley, Edwin Schooling Later and Robert Steigerwald. The law, regulation and exchange rules are as stated in January 2024.

Footnotes