Moral hazard lessons from the nickel market disaster


The tide crumbled this week in the London nickel market, and we discovered – in the immortal words of Warren Buffett – who was swimming naked: a giant Chinese producer who couldn’t meet his margin calls, brokers additional security needed when leveraged trades lose money.

Instead of letting the market get rid of this indebted trader, the exchange decided to step in and save the company from the consequences of its bets by canceling the trades.

It’s not just a one-off in an obscure product. It is the natural conclusion of a trend that undermines free markets and creates all the wrong incentives: a growing reluctance by authorities to let financial groups fail, even when they are not too big to fail.

The problems began on Tuesday morning when traders at the London Metal Exchange smelled blood and nickel prices almost doubled. China’s Tsingshan Holding faced a margin call of around $1 billion that stock exchange officials feared it might not be able to meet. Rather than let it fail, which would likely have brought down many of the smaller LME brokers that had served Tsingshan, LME decided to cancel all of the day’s trades, over 9,000 trades worth around $4 billions of dollars.

This. Canceled. The. Professions. Not because of a fat finger mistake, which exchanges often cancel. Not even because of a malicious algorithm (as claimed by regulators in the 2010 US stock flash crash). But because someone with too much leverage was going to explode, with ripple effects on some members of the exchange.

This is moral hazard taken to its extreme. It’s always been true that if you’re facing a $100 margin call, that’s your problem, whereas if you’re facing a $1 billion margin call, that’s the brokers’ problem – and the authorities could save them. What is almost unprecedented here is that the exchange authorities decided to save them with money taken from other traders, who would otherwise be sitting on big profits.

I say almost unprecedented because it has happened before: arch-speculator Jay Gould, dubbed “the most hated man in America”, bribed Senator William “Boss” Tweed and bribed the judges of New York in 1869 to delay the settlement of his gold affairs, etc. avoid losses after the collapse of its efforts to corner the market.

Moral hazard is nothing new in markets, of course, usually resulting from a choice to inflict long-term damage on incentives to avoid impending financial system failure. But the money needed to rescue the financial groups that could bring down the system usually comes from other financial institutions, as in 1907 or 1998, or from central banks, government and taxpayers, as banks and insurers did in 2008.

Taking legitimate profits from traders in order to fund the bailout undermines the very idea that markets can themselves punish people who are heavily indebted. This means that more interventions and regulations will be needed in the future to limit the additional leverage that these bailouts encourage.

Worse still, the smaller brokers facing problems don’t appear to be too big to fail. If brokers know they will be saved by the exchange if things go wrong, they have even less incentive to worry about large leveraged positions taken by their clients.

It also, of course, makes the LME a less attractive place to trade, and its officials accept that they may lose business as a result. Some indignant traders who had bet on the price increase are consulting lawyers.

The underlying problem of too much and too concentrated leverage is a staple of financial history. Tsingshan is primarily a producer, selling futures as a hedge rather than speculation, although it is unusual to have such a large position and is considered to be on the flip side of hedging. , according to an LME trader.

Former MF Global chief Jon Corzine testifies before a House Financial Services Committee Oversight and Investigation Subcommittee hearing into the collapse of MF Global, at the United States Capitol in DC in the end of 2011.


Photo:

Jonathan Ernst/Reuters

But in a crisis, the distinctions between what is supposed to be very low-risk hedging, low-risk arbitrage and pure speculation disappear. Tsingshan is the world’s largest nickel producer, and while the LME covers don’t exactly match the type of nickel it produces, there was little chance it would run into a mature problem. But in the short term, if the LME had not acted, it would have had to raise liquidity without covering the margin calls.

There are recent parallels in the blowouts of hedge fund Long-Term Capital Management in 1998, high profile quantitative fund Goldman Sachs in 2007 and brokerage MF Global in 2011.

All had taken high leverage for relatively low-risk bets: LTCM mainly on normalizing Treasury swap spreads, Goldman on a range of popular trades and MF Global on troubled European government bonds. The trades eventually bounced back and made money, but it was impossible to hold them for investors with such leverage. LTCM failed and was rescued and dissolved by a Wall Street consortium, Goldman eventually closed its fund and MF was forced into bankruptcy amid a scandal.

Every crisis brings explosions, and the global disruption caused by Russia’s invasion of Ukraine may well bring more. There are times when we have to hold our noses and save too-big-to-fail financial institutions, but they should be rare, because moral hazard is real. The danger to free markets is that governments, regulators and, in the case of nickel, the exchange itself set the bar for bailouts lower with each crisis.

Write to James Mackintosh at james.mackintosh@wsj.com

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