The London Metal Exchange (LME) is the world’s premier futures market for non-ferrous metals. The LME Copper Settlement price is effectively the world price for copper. As such, it should represent the balance of supply and demand in a world market in which turnover for 1995 was nearly $34 billion.

But last year it emerged that the price of copper on the LME had been systematically manipulated over a period of at least six years, and possibly from as early as 1985. The manipulation had been perpetrated by Mr Yasuo Hamanaka, the chief copper trader at Japan’s Sumitomo Corporation. His activities had resulted in substantial departures of the LME price from fundamental values, particularly in the closing months of 1995 and at the beginning of 1996.

These revelations prompted the Securities and Investment Board (SIB), regulatory overseer of all London’s financial markets, to undertake a major review of the functioning of the LME, which was published in December 1996. At the same time, Christopher Gilbert, one of Britain’s leading experts on commodity futures markets, completed the first independent study of their regulation in Britain and how market manipulation can be prevented in future.

Gilbert’s analysis begins by noting that futures manipulation is the activity of ‘cornering’ or ‘squeezing’ a futures market. It typically involves exploiting features of the market, in particular the delivery provisions of futures contracts, to create an element of monopoly power. This then allows the manipulator to raise prices to his or her advantage.

Manipulation is regarded as anti-social (and is generally made illegal) because it distorts market prices causing them to depart from their fundamental values. This reduces the benefits of using the futures markets for hedging. Manipulators are parasites of futures markets: in extracting monopoly profits from a thriving market, they sap the strength of the host.

The 1986 Financial Services Act (FSA), under which the SIB regulates Britain’s financial markets, fails to give explicit consideration to futures manipulation. While the SIB deems futures manipulation illegal under section 47 of the FSA, Gilbert suggests that the section is too narrowly directed to sustain such a view. He points out that the provisions are directed at equity market manipulations, such as concert parties and fan clubs, and do not address the issue raised by futures manipulations.

This is in contrast to the position in the US, where manipulation is explicitly prohibited under the Commodity Exchange Act. The implication is that the FSA should be amended to make illegal any exercise of monopoly power in futures markets that has the effect of generating artificial off-exchange prices.

At the same time, US experience indicates that it is very difficult to bring successful prosecutions for futures manipulations. The emphasis should therefore be on prevention rather than prosecution. Successful manipulations require secrecy and are more difficult the more transparent is the market. The key tool for enhancing transparency is client position reporting, which currently exists only on a voluntary basis on the LME. Gilbert argues that this should be put onto a statutory basis; it should also be extended to include metal in LME warehouses and to other London futures markets.

Greater transparency is the best deterrent to manipulation. Publication of aggregated position information can act as a significant impediment to manipulation, since market participants can act early to close out positions when they see evidence of the emergence of a potentially manipulative situation.

Gilbert also argues that the SIB should introduce a new reporting system based on the US Commodity Futures Trading Commission’s Commitments of Traders in Futures system. Reporting should cover both futures and options positions, augmented by summary statistics showing concentration of open interest. Reporting should also cover stocks in LME warehouses.

The LME differs in a number of respects from standard futures markets. These differences arise from the LME’s traditionally close links with the metals industry, which are a significant source of strength for the exchange. Some of these differences, in particular non-cash clearing and the use of ‘historic price carries’, are in Gilbert’s view unwise and impose additional risks on LME members, but they do not raise regulatory concerns.