FT Alphaville reports that the UK Parliament’s Science and Technology Committee is all hot and bothered about bank ownership, and particularly JP Morgan’s (JPM) ownership, of LME delivery warehouses:
79. We heard that there were large companies dealing metals within the UK and an allegation was made by the MMTA that a company through a subsidiary may be behaving in an anti-competitive manner: on the London Metal Exchange there are four very large companies that own the very warehouses that people deliver metal into, J.P. Morgan is one of them.
They own a company called Henry Bath. They are, therefore, a ring-dealing member of the exchange and they also own the warehouse. That is restrictive. They were also reported, at one point, to have had 50% of the stock of the metal on the London Metal Exchange.[113] 80.
We would be concerned if the ownership of metals storage warehouses by a dominant dealer on the London Metals Exchange were to be anti-competitive. We would also be concerned if a dealer who had the resources to own over 50% of stock on the London Metals Exchange impeded the correct functioning of the market.
81. We use this report to bring the alleged activities of large dealers on the London Metals Exchange to the attention of the Office of Fair Trading. We would be concerned if a dealer were undermining the effective functioning of the market and we look for assurance that the market is functioning satisfactorily.
The confusion about the anti-competitive effects–or, more correctly, the lack thereof–of vertical integration is pervasive. This is just another example. JPM ownership of a delivery warehouse is not per se anti-competitive, and indeed, it is difficult to see how it could be a way of leveraging market power as the Committee insinuates.
Insofar as ownership of 50% plus of deliverable supply is concerned, that is a completely separate issue. Sumitomo never owned any delivery warehouses, but it (and its pilot fish) cornered the market with abandon in the 1990s. To my knowledge, none of the other frequent squeezes on the LME in recent years have been facilitated by ownership of warehouses. What’s more, it’s most effective to attack corners and squeezes directly, rather than through restrictions on asset ownership.
I’ve also written from time to time on how ownership of physical assets is an important part of many commodity trading firms’ strategies. In particular, commodity trading firms can optimize use of physical assets based on their access to information and their ability to exploit the option value of these assets.
With respect to delivery warehouses in particular, come on. In the grain markets in Chicago, big merchants like Cargill, Continental, and ADM long owned delivery houses. They did so for the exact same reason that many energy and metals traders today own physical assets like storage.
Where ownership of physical assets may be somewhat problematic is when it gives the owners privileged access to information. By trading on that information, the asset owners create an adverse selection problem that reduces market liquidity.
Perhaps the most famous example of this occurred in the Chicago grain markets in the 1860s. At that time, there was a veritable war between grain brokers and traders and the owners of the grain elevators in Chicago. The Chicago Board of Trade was the representative of the interests of the brokers and traders, and fought hammer and tong against the “piratical” elevators.
The elevator operators had information about the quantity and quality of grain in store. This information advantage allowed them to trade profitably. For instance, elevator operators from time to time learned that grain was getting out of condition–”heating.” Given this knowledge, they would go short, and cover their positions at a profit when news of the spoilage became public.
This is akin to inside trading, and has deleterious effects on market liquidity: it transfers wealth from the uninformed to the informed.
The elevator operators also allegedly operated a cartel that fixed storage rates at supercompetitive levels. This again harmed grain merchants–and also farmers. Elevators also took advantage of their ability to mix grain down to the minimum required to meet grade. This effectively transferred wealth from those who stored above average quality grain into the warehousemen’s pockets.
The CBOT tried mightily to get the elevator operators to report information about the quality and quantity of grain in their facilities, and to charge reasonable rates. The elevators basically told them to pound sand. The CBOT had little leverage over the elevators: the brokers and merchants needed the elevators, but the elevators didn’t need to the CBOT, so threats of expulsion had little effect.
Eventually, the CBOT prevailed on the legislature of Illinois to regulate grain warehouses. This is actually an extremely important event in American legal and regulatory history, for one of the elevator operators, Ira Munn, challenged the Illinois regulation. He appealed all the way to the Supreme Court, which decided in favor of the state, thereby establishing the power of states–and the federal government–to regulate business “in the public interest.” The regulatory state in the US traces its roots to that decision in Munn v. Illinois.
One of my favorite papers discusses this episode in more detail. You can find it here.
Going back to the hyperventilating Parliamentary Science and Technology Committee and JP Morgan’s ownership of a delivery warehouse, the things that were arguably inefficient in 1867 Chicago are completely absent in 2011 Bath. The LME announces stocks held in warehouses on a daily basis, meaning that elevator operators don’t have privileged information on quantities in store. Quality is monitored by independent inspectors. The fears of vertical integration resulting in a leveraging of market power are neurotic. Merchant ownership of delivery and storage facilities is a virtually universal feature of the commodity landscape.
In other words: Move along. Nothing to see here.
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