* Banks take stakes in LME gold contracts through new company
* They promise to supply liquidity in return for revenue share
* Built-in liquidity may give LME edge over U.S. rivals
* LME gold, silver contracts to launch on June 5
By Peter Hobson
LONDON, Feb 23 (Reuters) - The London Metal Exchange has reached a 50:50 revenue-sharing deal with a company founded by a group of banks to promote trade in its new gold futures contracts, sources said, aiming to overcome market scepticism surrounding their launch in June.
Usually, exchanges merely consult potential users about their needs when planning new financial and commodity contracts. But in this case, the LME has opted for a radical departure from normal practice as it tries to grab a piece of London’s $5 trillion-a-year gold market.
Sources close to the matter told Reuters that the five banks and a proprietary trader which are shareholders in the new company have undertaken to bring guaranteed minimum levels of trade in the gold futures.
Should they meet these levels, the project partners will receive a half share of the revenue under an incentive scheme designed to ensure the contracts have turnover, viability and credibility from the outset.
“We’re all committed to market-making and will at least bring our own trading book,” said a source at one of the banks involved in the project. “It’ll come with some built-in volume.”
The sources gave few details of the arrangement. However, one at a different bank backing the contracts said: “Do we have incentives for it to work? Yes.”
The LME, which is owned by Hong Kong Exchanges and Clearing Ltd, hopes the arrangement will give its contracts enough business to take off from June 5 despite doubts among many brokers and gold producers.
It also wants to shoulder aside U.S. exchanges CME Group and ICE which launched London gold contracts last month, although they have yet to attract any business.
The LME’s partners from the banking sector are Goldman Sachs , ICBC Standard Bank, Morgan Stanley, Natixis and Societe Generale. They have founded a company called EOS Precious Metals along with commodity trader OSTC and The World Gold Council, an industry market development body.
Together they have invested several million dollars in designing and building the spot, futures and options contracts and formed EOS to receive their share of revenues.
The LME and EOS have also offered the deal to all other market participants. However, London’s two largest gold traders - HSBC and JPMorgan - are missing from the consortium, as is ScotiaMocatta, another big bullion dealer.
Robin Martin, head of market infrastructure at the World Gold Council, said EOS shareholders would not get any preferential treatment in terms of fees paid to use the new LME contracts.
However, he told Reuters: “There is a commercial arrangement in place which reflects the fact that the EOS shareholders have co-funded the build-out of this service.”
The shareholders had invested in the project in terms of cash and time, “developing the product model and consulting with the LME over a drawn out multi-month process”, he said, without detailing the financial or trading arrangements.
The LME, Morgan Stanley and Societe Generale declined to comment on the deal with EOS. Natixis, Goldman Sachs and OSTC did not immediately respond to requests to comment.
At the moment, London’s gold trade is dominated by over-the-counter (OTC) business conducted bilaterally among networks of brokers, producers and consumers. Gold futures trading takes place chiefly on the CME’s New York market and the Tokyo Commodity Exchange.
However, the LME and its rivals see an opportunity as regulation of the market tightens, hoping this will force the trade onto transparent, centrally-cleared exchanges.
Bigger banks, which rely on their wide range of business relationships, stand to lose market share from such a shift because exchange trading would make it easier for smaller players to compete.
Gold dealers keep their volumes secret and no precise figures are available, but analysts and traders estimate the EOS shareholders may control up to 50 percent of OTC bullion trading in London.
Under the deal, the EOS partners will pay an annual fee to the LME, said a source at one of the banks involved. This represents an advance payment for clearing services, against which fees will be offset as the trades are transacted.
They will also promise to provide minimum liquidity levels, and to buy and sell gold and silver to facilitate trading.
“There is a share agreement taking into account how much volume you are contributing to the platform. If our volume explodes, we make money on top of that as a shareholder,” said a source at one of the banks.
Societe Generale, Goldman Sachs, ICBC Standard and Morgan Stanley have made larger commitments and investments than other, smaller EOS shareholders, sources said.
Backers of the scheme note that clearing gold business through an exchange will have regulatory advantages as it means banks would have to hold smaller capital buffers.
“For every open position that a bank has with its clients it has to set aside capital. If they net and clear it on the LME they have no exposure and no capital requirements,” said the head of a brokerage in London.
Tighter capital requirement regulations are due to be introduced next year across the European Union, although arrangements for when Britain leaves the bloc have yet to be made.
Further pressure for change is coming from the United States. London’s gold trade - along with the rest of the City of London - has come under greater scrutiny since a scandal over the setting of Libor benchmark interest rates, and U.S. lawsuits alleging rigging are pending against banks that set bullion prices.
The partners hope the LME contracts will eventually attract most of the hedging business between banks and brokers, which accounts for up to 90 percent of the more than $20 billion of gold traded in London each day.
Not everyone is convinced; brokers and gold producers fear the futures will be too inflexible and costly. Sources at two banks outside EOS said they would wait to see whether the contracts gain momentum before deciding whether to use them.
“If the LME can provide liquidity, then that’s where people will go and so will we,” said a source at one gold producer.
The LME plans to offer a much wider range of contracts than its competitors do at the moment in London.
The CME is offering gold and silver contracts to connect London with its established New York market. ICE runs the London gold auction, which sets a global benchmark price for bullion, and has a daily gold contract that will enable participants, which include most of London’s largest bullion banks, to clear their trades.
Neither set of contracts has traded since launching in January. The CME said it was working with major banks to synchronise their systems to start trading. ICE said it expected volumes to rise after it begins offering clearing in March.
In the meantime, the EOS partners hope the shareholdings will appreciate over time. “After a few years, possibly, we get a nice windfall profit, but it’s not a project to make profit in the short term,” said a source at one of the partners. (Additional reporting by Pratima Desai and Jan Harvey; Editing by Veronica Brown and David Stamp)