Hedge fund enters LME fob China HRC market

Hedge fund participation in the contract is a crucial step in broadening the liquidity pool ahead of widespread use by physical market participants to hedge risk. Seven banks are using the contract as a risk management tool on behalf of clients, but hedge funds provide a counterparty to take the other side of trades.

The first bank traded the contract in June, while first Chinese bank started trading last month.

The fob China hot-rolled coil (HRC) contract had a record month in October with 7,736 lots traded. Open interest ended October at 3,501 lots. The contract traded 2,653 lots from 1-18 November.

The small size of the lots, at 10t each, limits risks in the early development of the market.

New participants are testing back-office processes and taking small directional positions at this stage, but as volume picks up hedge funds will be able to take larger and more complex positions, said Joel Parsons, a Singapore-based ferrous metals trader at Drakewood.

The LME fob China HRC contract provides exposure to the world's largest producer and consumer of steel, which accounts for half of global production and is closely watched for its influence on other markets. The US-China trade war has also factored into the development of the contract by adding to market uncertainty, as HRC is a major industrial input and so acts as a gauge of China's macro-economic strength.

Intense competition from Indian coil exporters weighed on the region's seaborne prices in August-October, sending the underlying Argus fob China HRC index down by 15pc to $426/t on 29 October from $501/t on 1 August. Indian exports surged while Chinese exports fell to an eight-month low in October.

A pause in the US-China trade war, stronger-than-expected construction demand in China and the end of India's monsoon season gave a boost to demand outlooks, lifting the fob China HRC index by 5pc to $450/t this month. The LME contract settles against the monthly average of the index, which is at $436/t so far in November.

The forward curve has bulged for December-January on a bullish demand outlook for China's winter season, when steel inventories build ahead of spring demand. December and January traded at $452.50/t and $452/t respectively yesterday, a premium to November at $443/t, with the rest of the curve backwardated to January 2021 at $417/t.

In early September, the curve was backwardated all the way from November at $442/t to May 2020 at $427/t. The curve then moved into contango, with June and July 2020 at $427.50/t and $431.50/t respectively, before weakening for the remainder of next year with December 2020 at $428/t.

The LME now has 10 liquidity providers listed for its ferrous contracts after the entry of Mettalex, Mercury Derivatives Trading and Theme International Trading in October-November.

By Chris Newman