LME Warrants

The LME is a physically backed exchange, meaning it can be used as both a source of material and a delivery point for material. On occasion, physical consumers, producers, or traders will take advantage of this and use the exchanges to either buy metal from or deliver metal to.

Except for steel contracts, every lot that is traded on the LME is backed by a physical warrant. A warrant is a physical parcel of metal in an exchange-approved warehouse, of an exchange-approved brand. The tonnages of warrants must be within two percent (higher or lower) of the size of the futures contracts: 25 mt (aluminum, copper, lead, zinc), 20 mt (aluminum alloy, nasaac), 6 mt (nickel), 5 mt (tin), or 1 mt (cobalt). If you are long one lot of copper futures and allow that long position to become prompt without lending it, you will be delivered 25 mt (+/- 2 percent) of an LME-approved brand of copper, in an LME warehouse somewhere in the world. Similarly, if you are short one lot of copper futures and allow that short position to become prompt without borrowing it, you will be obligated to deliver 25 mt of an LME-approved brand of copper, to an LME warehouse of your choice.

The LME keeps an updated list of all of their approved warehouses globally along with all of the approved brands of metal. Provided metal meets the chemical specifications that the LME has defined as acceptable for delivery, any amount of metal produced by those approved branded producers can be delivered onto warrant.

When you are buying warrants, most of the time you do not want to be delivered a random brand of metal without knowing exactly where you will be receiving it. The holders of warrants are actively trading them between one another or to traders or end consumers of that material. Buyers of warrants will typically pay a premium to the holder of the warrant to guarantee a certain brand or a certain location for their material. It is usually at this point they would establish their futures long position, or let their existing futures length become prompt, because they know what metal they will be delivered and where. Once you have been delivered your warrants and they have been paid for, you will issue cancelation instructions to the LME warehouse. By sending cancellation instructions, the material will be removed from the LME system and will no longer be an LME warrant. At that stage, it will simply be physical material in an LME warehouse, ready for physical consumption. 

It is important that once a company cancels their warrants, it pays the warehouse charges (rent and FOT) as quickly as possible. Until these charges are paid, the warehouse will not allow the holder of the metal to schedule its removal from the warehouse. If another warrant cancelation comes in prior to the company paying these charges and requesting to remove the metal, it may find itself at the back of a long queue to remove metal. This can add significant cost in the form of additional LME rent.

For larger traders, another option is sifting warrants. If you know there are specific warrants available, either brand or location, but you don’t want to pay a premium for them, sifting can be a good option. It is called sifting because a trader will typically pick up a very large number of warrants, so they are casting a large net. Although they will receive a lot of material that doesn’t necessarily interest them, they will also hopefully be delivered some material they actually want. For example, a trader may get long 1,000+ lots of aluminum by borrowing the position. That means that they will be long nearby and when that 1,000-lot long position becomes prompt, they will be delivered 25,000 mt of aluminum. When the warrants are delivered to you, you receive the list of all of the brands and locations you have received. The trader quickly reviews this list (or sifts through), identifies any warrants they want to keep, and then starts the process of delivering back the warrants they don’t want. To do this they simply establish a short position by lending. This creates a short position to deliver the warrants they don’t need, and squares out the short position created from the initial borrow. If you are quick enough in your decisions, this can all be effected the same day you receive the warrants and delivered back the following day (tom). Sifting is not without risks-if the spread changes too much between putting on the initial borrow and lending to deliver the unwanted warrants back, you risk paying out more on the carry trade than you would have in premium to just select the warrants you wanted. You also have to pay rent, and finance costs on all of the material until you can deliver it back. Sifting is a calculated risk, and traders will work to mitigate those risks as best they can.

Traders and producers also utilize the LME as a delivery point for metal. Sometimes market conditions may make deliveries to the LME profitable. Provided you own an LME-approved brand metal in an LME-approved warehouse, you will be able to deliver material onto the LME exchange by creating warrants. Once the metal is in an LME-approved warehouse and lotted up into 25 mt (+/- 2 percent) parcels, you would send instructions to the warehouse to create the warrants and deliver them to the broker you have established your short futures position with. There is no limit as to how much metal can be delivered onto the exchange, provided it meets the exchange set specifications for brand, analysis, and location.

There could be many reasons someone would want to deliver metal onto the LME. There could be a large backwardation, and if you have a short position, you would have to borrow through that backwardation, costing you money. Instead, you could deliver metal against that short, saving the cost of the borrow. Or, a trader may actually capitalize on a backwardation and create a short because they have excess metal and their position is already borrowed past the backwardation. By lending into the backwardation, they aren’t just saving the cost, they are creating P&L. 

A company may be holding a large amount of stock and want to reduce these holdings but the physical demand for that product in the consumer market is weak at that time. Provided the metal meets specifications, the LME would provide an immediate delivery point to sell that metal into. 

Warehouse companies themselves may also incentivize deliveries into their warehouses. LME warrants earn warehouses a predetermined daily rent. There are also set fees for load-out charges upon cancellation of metal. Warehouse companies can calculate the time they believe metal will remain in their warehouse and pay incentives to producers or traders to deliver metal to them. If the local premiums in the physical consumer market are comparable or even less than the incentive a warehouse is offering, you may see metal flow onto the LME instead of being physically consumed. While LME warehouses themselves are prohibited from owning LME warrants, they can still have an influence on the warrant market.