London, 1 December 2010

Is too much liquidity ever a bad thing for a futures exchange? The answer, it seems, is yes. That, at any rate, is the obvious conclusion to be drawn from the Shanghai Futures Exchange's ( SHFE) new margin requirements, which became effective today.

The SHFE last week announced margin increases on all its contracts effective close of business yesterday. What is interesting, though, is the calibration of the increases. Margins on copper, aluminium, steel wire rod, gold and fuel oil have been hiked to 10 percent. Those for zinc and steel rebar now stand at 12 percent, while that for natural rubber has been lifted to 13 percent.

Within the metals contracts, what differentiates zinc from copper and aluminium? Or rebar from its sister contract wire rod?

POOR MAN'S COPPER

Taking zinc as an example, the difference between it and other base metals such as copper and aluminium is liquidity. Zinc volumes have soared this year. They totalled over 270 million contracts in the year to Nov. 26, dwarfing the 95 million contracts traded on the copper contract, according to the SHFE's official figures.

From an old-fashioned fundamental perspective this looks strange. After all, everyone, both in China and the rest of the world, by now knows copper's bull credentials. Exchange stocks are falling, mine production is underperforming and a global supply-demand gap is expected to widen next year. It's why the LME 3-month price earlier this month registered a new all-time high of $8,966 per tonne.

Zinc's fundamentals lie at the opposite end of the spectrum. Notwithstanding robust demand the global market is widely perceived to be in supply surplus. Stocks are high, both on the LME and the SHFE itself. Indeed, Shanghai stocks of zinc earlier this month registered a new life-ofcontract high of 303,429 tonnes.

Why, then, is it that zinc has attracted all the trading volume on the SHFE? Are there no copper bulls in China? The answer is simply one of cost. SHFE spot copper closed on Tuesday at 62,380 yuan per tonne. The spot zinc contract , by contrast, closed at 16,595 yuan per tonne. Moreover, the previous margin on zinc stood at just 7.5 percent, compared with 8.5 percent on copper.

As a result zinc has been a much cheaper metal to trade than copper, particularly for a day-trader. And there appear to be a legion of small-time Chinese speculators prepared to play the market on an intra-day basis, judging by a comparison of volumes against open interest on the two contracts (see graphics below).

As such, SHFE zinc has become "the poor man's copper," a cheap punt on both the hard-asset and industrial recovery plays that have attracted investors' attention both in China and on the LME.

The SHFE's rebar contract is cheaper still, which is why its volumes have gone equally stratospheric. Wire rod has never really taken off and volumes are tiny by comparison with rebar. Just 38 contracts traded on Tuesday, Rebar volume was 966,150 contracts.

The SHFE has discovered that super liquidity and trading volumes are not in themselves a good thing, if they lead to "irregular" trading activity, to use the exchange's own word, when it warned it might take further regulatory action to ensure smooth market operations.

TARGETING THE SPECULATORS

What is happening on the SHFE metal contracts is of course just part and parcel of a much bigger clampdown on commodity speculation by the Chinese authorities. Alarmed by simmering inflation, particularly for foodstuffs, a source of potential social instability, Beijing is targeting "speculation" across the commodities spectrum.

Rising margin requirements are one manifestation of the clampdown. The Dalian Commodity Exchange, which trades mainly agricultural products, last week also raised margins on soy meal and soy oil. Increasing supply is another weapon in Beijing's armoury. The State Reserves Bureau has been unloading both zinc and aluminium from the stocks it built up during the price collapse of early 2009.

So far it has sold around 50,000 tonnes of zinc and almost 215,000 tonnes of aluminium. The move seems carefully timed to offset any speculative price surge resulting from the energy-efficiency campaign which has affected large parts of China's heavy industry, base metals producers included. Price controls remain an option, although China's top planning body, the National Development and Reform Commission, this morning expressed satisfaction that the measures taken so far were sufficient for the time being.

However, it remains to be seen whether the genie of speculation will so easily be put back into the bottle. Is the margin hike on SHFE zinc big enough to deter the day-traders? Will they switch to aluminium, which on a combination of outright price and margin is now a cheaper punt than zinc? Its fundamental outlook is possibly even worse than zinc in terms of stocks overhang and excess capacity but then the only fundamental that matters for a day-trader is the cost of trade.

ER...TARGETING THE SPECULATORS

It's ironic that China is now targeting excess speculation in its commodity markets at precisely the same time that the rest of the world's exchanges are targeting the liquidity promised by Asian investors.

The LME, for example, has dusted down its moribund mini contracts and re-launched them both in London and via a tie-up with SGX, in Singapore. The stated aim is to grab a slice of all that hot money washing around Asia. In doing so it has one eye on rising volumes on the copper mini contracts offered by its U.S. competitor COMEX.

Chasing volume beyond the LME's traditional industrial user base is already proving something of a double-edged sword. The LME may want to reach out to a new retail investor but what if the retail investor actually wants to invest in a physically-backed ETP rather than a mini contract? There seem to be a number of investment banks that think this may be the case and if they are right and such products prove successful, will they facilitate or hinder the exchange's price discovery mechanisms?

The liquidity provided by professional speculators, such as fund managers, is one thing. Liquidity provided by "dumb" punters, who simply want to make a buck on a quick day-trade or hold copper for ever and a day is quite another.

The SHFE, albeit under direction from Beijing, seems to have realised there is a difference. For the LME and its push into the retail investment space, it might be a case of being careful what you wish for.

Ends --

Andy Home is a Reuters Columnist - For Commodities Now.

The opinions expressed are his own.