MARKET manipulation may boost prices but in the long term it brings pain to producers and manipulators alike. Report by metals trading and hedging expert Lesley Campbell

Which piece of information, passed from broker to client, causes the most aggravation? Usually the hint that a market is being squeezed.

Even producers can be disheartened by this news. There can be a feeling that the market has lost its reason and, while prices may be higher in the short term, a catastrophe is bound to occur.

Most terminal markets claim to have measures in place to spot and prevent any attempt at manipulation, but in spite of this, there is a reasonable case for suspecting that one London Metal Exchange metal in particular has recently benefited from a concentrated effort to drive prices up. So can an operation like this be spotted in advance?

The first few steps of a market squeeze are usually completed in secret. If it is obvious what’s going on, others will buy and the manipulator will not be able to establish a big position.

Options are usually the first port of call. If the market manipulator buys 1000 tonnes of call options with a strike price close to the market price, the seller of the option will buy only 500t of futures.

So the manipulator has control of 1000t, but only 500t of buying has hit the market. This phase is relatively capital-intensive as the manipulator will have to pay cash for the options, but there are no margin calls thereafter.

Increasing option open interest can be an early warning signal of unusual market activity.

Phase two can involve the acquisition of physical stocks. This should be done at a fixed price rather than on an LME formula – if a long-term contract is based on a formula, the purchase price will rise as the price rises.

Depending on the standing of the producer and the financial strength of the manipulator, some performance guarantees may pass between parties. As the price rises, the producer will pay the manipulator to ensure against default. If the price falls, the manipulator may have to pay the producer.

Unusual activity in the physical market often causes questions to be asked: Why does a merchant or trader need so much material?

A bold third phase is to secure future production, again at a fixed price. By this time, the manipulator will have bought as much metal as possible while attracting as little attention as possible.

It has been alleged that some manipulators have, over the years, used less than honourable tactics during this phase.

One practice, known as “white-lining” involves moving metal from one part of a registered terminal market warehouse to another part, where the metal is not officially registered.

The effect of apparently diminishing stocks is bullish and prices move higher, although the material is still available and has not gone to an end consumer.

If the material cannot be white-lined, it can be moved out of warehouse and stored in a confidential location – with reports of shortages reported to the press.

The final acquisition phase is to buy futures discreetly, spreading the business between brokers.

It is essential to avoid concentration of the position on one day to evade the big position reporting. A seasoned LME player will always pick times when the market is liquid.

Exchange volumes and open interest can be a signal that a big position is being established. The spreads can give another useful hint – a narrowing contango or an increasing backwardation are both bullish.

Market psychology can assist the efforts of a manipulator. When news filters into the public domain that an influential player is buying, opportunistic buying and nervous short-covering usually enters the market.

On occasion, information is leaked to a chosen few. From there it begins to filter into the wider market. By this time, the manipulator’s long position should be very profitable.

Any number of factors can lead to the failure of a dominant long position – weakness in the price triggers margin calls which can’t be met; another equally determined player enters the market to take an opposite position.

The time to consider an exit strategy is when the market seems to be at its most bullish and the wise manipulator will capitalise on panic buying to take some pre-emptive action – usually by buying some put options.

In the same way as the delta hedging of call options reduces the volume of buying to hit the market, the delta hedging of put options can diminish the effect of selling futures.

But very often, the manipulator fails to respond to the appearance of the last buyers and fails to recognise that the market has become critically overbought. This tends to be where a squeeze can go wrong.

All too often, it seems that manipulators are reluctant to relinquish a winning position.

Having called the tune on the way up, they fail to recognise that their influence is spent and end up along with other disillusioned longs, selling the market right back down to where it started.

UK-based Lesley Campbell is retained by a number of industrial companies to advise on commodity, foreign exchange and investment risk, and writes regular technical analysis reports for business analysis and consultancy group CRU.

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