In the fourth quarter of this year, the London Metal Exchange (LME) is due to implement a new electronic depository system for warehouse receipts. It is a system distinct from LME Clear (the clearing and settlement service) directed at off-warrant metal. The objective is to streamline the process for the handling of warehouse receipts used in the over-the-counter metals market and make verification a much simpler and more secure process. In light of the recent scandal of alleged missing and over-pledged metal at various Chinese ports, in particular Qingdao, this is welcome news to commodity traders, warehouse operators and customers alike.

The new system, which is to be hosted on Sentinel (an electronic custody solution), is designed for the storage and financing of off-warrant metals. The service will provide a secure depository in which metal owners can lodge their warehouse receipts and according to its press release, will also offer “electronic transfer, pledging and administration functionality.” The roll out of the electronic audit system is geared towards providing a more accountable and efficient system for the tracing and transferring of warrants.

It is clear from HFW’s briefing on the Commercial Court’s recent decision in Mercuria v Citigroup(http://www.hfw.com/Qingdao-judgment-in-Mercuria-v-Citigroup-May-2015) that safe storage of goods, consistent auditing of warehouse stocks and an accurate and transparent database of receipts are vital for facilitating commercial transactions in the metals market.

In that case, which concerned a commodity repurchase agreement of approximately US$270 million worth of metal, it was found that the tender of warehouse receipts (which under English law are not documents of title) to Mercuria without release instructions from Citi, who were reselling the metal, did not constitute a valid delivery of the metal. While the parties had agreed that for the purposes of the trial, Citi had title to and risk for the metal, the court did not rule out further litigation once the nature and extent of the alleged fraud, and the existence of the metal and relevant warehouse receipts, came to light. It is speculation whether or not the new depository system could have prevented or minimised the chance of such an occurrence, particularly as the metals were not stored at an LME approved warehouse. However, it does demonstrate the need for more comprehensive auditing mechanisms to be adopted in respect of non-LME stock.

The new service, which is being developed in partnership with software-provider Kynetix, is being presented as a global warehouse receipt system that will accommodate both LME and non-LME stock. This announcement also appears to be part of LME’s wider push to break into China, a significant market that remains closed to LME as it does not currently have permits to license warehouses. A slightly unexpected side effect of the ongoing investigation into alleged fraud at the port of Qingdao in China has been to highlight LME’s reputation for only licensing warehouse firms with adequate capital security, appropriate insurance and strict auditing requirements. In fact, some banks who used metal as collateral to secure loans have requested that their clients shift metal stored at local warehouses in Qingdao to more regulated LME warehouses outside of China, including South Korea.

A more transparent system that improves warehouse storage, auditing and verification of warehouse receipts is a step in the right direction to creating commercial certainty. While further details of LME’s new warehousing receipt system are required before its legal and commercial implications can be accurately assessed, it is hopeful that market players will adopt a system that increases transparency and certainty.