(The author is a Reuters Breakingviews columnist. The opinions expressed are his own.)
By Kevin Allison
LONDON, July 8 (Reuters Breakingviews) - It was July 2015, and Global Materials Partners (GLOMP), an unlisted Swiss commodities trader, was in trouble. Data showing a rapid slowdown in the Chinese economy had pushed the copper price down 15 percent in two days. Then one of GLOMP's star traders came clean: over the past several months, the former back office worker had built up a huge, unauthorised long position in copper derivatives.
GLOMP struggled to unwind the bad trades but the trader's losses quickly chewed through its thin capital, tipping it into bankruptcy. Its lenders' credit default swaps ticked higher as panicked investors struggled to assess the damage, sparking fears of a broader crisis.
This may be fantasy. But there are many reasons why real-world commodity traders should now be attracting greater scrutiny. Regulators think it's risky for investment banks to trade commodities. They are pushing banks out of proprietary trading in commodity derivatives, or forcing them to hold more capital against trades. Investment banks' retreat has left a bigger share of the commodities business in the hands of independent trading houses and other non-bank institutions. The question is whether these unregulated, often opaque firms – from secretive Swiss commodity houses to the marketing arms of the oil majors – could be a source of hidden risk.
But we're different
How could a commodity crisis start? The perception is that traders hold big positions, financed by borrowed money. But the reality is that traders like Glencore Xstrata (GLEN.L), Trafigura and Vitol [VITOLV.UL] more closely resemble logistics companies than financial speculators. They make money not by betting on price movements, but by moving stuff around.
A metals trader might be aware that a mine operator in Peru is willing to sell copper for $100 below the benchmark London Metals Exchange price, while a customer in China is willing to pay $200 above the LME price. The margin on each such trade may be small, but by borrowing to finance many similar trades, a small team of well-connected traders can reap huge profits.
Despite the liberal use of leverage, in theory it's a pretty safe business. A trader might not be able to match a buyer and seller straight away, or customers may refuse shipments if prices fall sharply during transit. But such risks can be hedged in the derivatives markets. In fact, price volatility just increases the opportunities for profitable arbitrage.
That, at least, is the ideal. Occasionally, things go wrong. No hedge is perfect. In 2011, Glencore lost $330 million trading cotton after a series of wild price swings led to ineffective hedging, difficulty securing supplies, and some buyers refusing shipments. The financial hit was small – less than 10 percent of operating cashflows that year. Had the merger with Xstrata already taken place, it would have been less than 2 percent of the combined group's 2011 EBITDA.
The bigger worry is what happens when traders make outright bets on price moves. In 1999, a rogue trader at Andre & Cie, a big grain merchant, lost an estimated $200 million betting on soybean futures. It proved a terminal blow to the secretive 120-year-old family firm. The collapse wasn't immediate, but in 2001, after a failed turnaround bid, Andre's lenders threw in the towel. When it succumbed, Andre & Cie had $400 million of debt spread between 40 banks. Glencore Xstrata reported pro-forma net debt of $29 billion at the end of 2012, spread across more than 100 lenders.
In theory, even a struggling trader should be more resilient than a flailing bank. Banks and commodity houses both rely on short-term funding, but traders' assets tend to pay back faster – about a few weeks, or the time it takes for a cargo of ore, oil or grain to cross an ocean. The ability to unwind books quickly may be one reason the industry made it through 2008 without a big crisis.
Regulators need a hedge, too
The fact that the industry weathered the financial crisis fairly well doesn’t mean it is truly safe. The sample size is too small and the history of modern, globally connected traders too short to rule out a blowup infecting the financial system or even the real economy. Trading companies have huge influence over the flow of essential raw materials. Disruptions to world trade could be significant, if only temporarily.
There are a few things overseers could do to make the industry safer. Standardised and rigorous rules for risk reporting, even for unlisted firms, could identify where tension is building up in the system. Extending new financial regulation to limit trading houses' use of use of derivatives to old-fashioned price hedging would be another obvious place to start. If the financial crisis taught regulators one thing, it's that they shouldn't rely on self-interested industry players' assurances that they have a handle on risk.
SIGN UP FOR BREAKINGVIEWS EMAIL ALERTS:
- Morgan Stanley (MS.N) last month said it would exit some areas of commodity trading, including agricultural products, freight and some European power and gas markets, marking the latest pullback in commodities by a big investment bank.
- The head of JPMorgan’s (JPM.N) oil unit left the bank to join Noble Group (NOBG.SI), a Singapore-listed commodity trader, SparkSpread.com, an industry website, reported on July 2.
- Reuters: Morgan Stanley to exit some commodities markets [ID:nL5N0EW3RF]
- Reuters: Report for banks finds they pose more risk than commodity traders [ID:nL6N0DU40U]
Trading up [ID:nL3E8L45S8]
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(Editing by Chris Hughes and Sarah Bailey)
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