* LME gold and silver contracts to launch in second quarter
* Sources see contracts as inflexible and costly
* LME faces struggle to compete with New York, Shanghai futures
By Peter Hobson and Pratima Desai
LONDON, Jan 23 (Reuters) - Fears of inflexibility and rising costs are sapping enthusiasm for the London Metal Exchange's new suite of gold contracts, potentially leaving the exchange reliant on the threat of an increasing regulatory burden to drive uptake.
London's $5 trillion-a-year gold trade has, along with the rest of the City of London, found itself under increased scrutiny since the Libor scandal, with U.S. lawsuits alleging rigging against the banks that set bullion prices.
Regulatory pressure sparked the fall of the near century-old telephone-based gold fix, or benchmark pricing, which was replaced by an electronic alternative in 2015, and reform of the management structure of the London Bullion Market Association.
The LME, owned by Hong Kong Exchanges and Clearing Ltd (HKEx), says its contracts, which include spot, futures and options, would bring price-setting out of the back rooms of banks by creating a published forward pricing curve for gold and sliver out to five years.
It also says the contracts' central clearing would free the banks and brokers that dominate London's over-the-counter (OTC) gold market from increasingly onerous capital requirements, creating savings that could be passed to others in the industry.
But a source at a major gold trading bank said: "There's a lot of caution and probably outright scepticism from market participants whether this will add anything but another cost to the bottom line."
"In the OTC market there are no fees, you call somebody for a quote and you trade it," a source at a metals broker said.
The LME hasn't detailed the fees for trading and clearing using LME Clear, but said it is "confident that fee levels will be competitive".
Scepticism runs deep, however. Metal industry sources cite other failed attempts by the LME to establish new contracts including those for cobalt, molybdenum, plastics and aluminium premiums.
"This set of contracts was never intended to replace or undermine the OTC market." said Robin Martin, head of market infrastructure at the World Gold Council, an industry body that worked with the LME to design the contracts.
He said he expected most of the volume on the contracts to come from hedging between banks and brokers - which he said accounts for up to 90 percent of trading in the London market.
These could continue to agree trades bilaterally as under the OTC model, and then clear them on the exchange, enabling savings that would reduce costs for all the industry, he said.
LME brokers say the specifications are restrictive and the contracts, though physically deliverable, appear to be designed for finance professionals and not the physical market.
A key criticism is the size of the contracts: 100 troy ounces for gold and 5,000 ounces for silver. On the over-the-counter (OTC) market gold and silver can be traded in any number of ounces.
"What happens if our customers want to trade 330 ounces of gold?" asked one gold trader.
The monthly contract structure meanwhile undermines physical traders' ability to hedge specific dates beyond a month, said a source at a metals broker.
Martin said at least 30 firms had been consulted during the design process. The contracts allow combinations of daily and monthly futures to hedge any date, he said, while defined lot sizes allow easier netting, compensating for lost flexibility.
Most gold producers contacted by Reuters said they would not use the LME contracts to hedge, though one, Petropavlovsk, said it would consider doing so.
Five banks, Goldman Sachs, ICBC Standard Bank , Morgan Stanley, Natixis and Societe Generale, and proprietary trader OSTC have partnered with the LME and committed to supply liquidity.
But two of biggest gold trading banks, JPMorgan and HSBC, have not.
"We think we've got critical mass," said Martin.
Sources said the LME would struggle to gain a share of the market, particularly given that Shanghai and New York already offer well-established and liquid gold futures.
"Trading will always go to the place with the most liquidity," a source at a major gold trading bank said.
(Additional reporting by Barbara Lewis; Editing by Veronica Brown and David Evans)