Craig Pirrong’s white paper on the economics of commodity trading firms (CFTs), sponsored by Trafigura, has been released and can be found here.
Overall conclusion: commodity trading firms are not systemically risky because they do not engage in the sort of maturity transformation that banks do. They also tend mostly to operate on a hedged basis, via “basis trade” exposure. Short-term assets meanwhile are funded with short-term debt while long-term assets are funded with long-term debt, meaning the institutions are not heavily leveraged at all, though balance sheets are exposed to liquidity or rollover risk.
Counterparty exposure, meanwhile, is dismissed as insignificant because of the general use of central clearing within the industry. If there is credit risk, Pirrong notes, it primarily arises from the 15 per cent of Trafigura’s transactions that are uncleared OTC trades. But these are transacted with a varied amount of counterparties, consisting primarily of prime financial institutions and large physical participants on a credit quality basis.
As Pirrong notes:
Based on a credit review process, Trafigura assigns credit limits to each counterparty, and requires the counterparty to post collateral when the limit is exceeded. Credit limits and collateral control credit exposure to an individual counterparty, and by trading with a large number of counterparties Trafigura can obtain the hedge transactions it needs without taking on a large exposure to any counterparty, or counterparties from any region. The use of standardized contracts (ISDA Master Agreements or long-form Confirmation Agreements) with derivatives counterparties also facilitates the management of credit risk, most importantly by establishing procedures to address a credit event (such as a default or downgrade) suffered by a counterparty.
That said, there is little mention of wider hedging asymmetries. For example, while commodity trading companies use derivatives to hedge physical positions — and are thus balanced overall — those providing hedges on the other side may be using derivatives to hedge the performance of unrelated asset classes, and/or holding commodity derivatives on an entirely speculative and unhedged basis.
True, central clearing is there precisely to counter that sort of risk. But in the event that one-sided hedges walk away unexpectedly this can leave commodity traders exposed to costly hedging and rolling costs, incentivising inventory liquidation and opening the door to unexpected systemic feedback loops.
The report also highlights the rise of “non-traditional” short-term financings which could be characterized as shadow bank transactions.
From Pirrong (our emphasis):
These include the securitization of inventories and receivables, and inventory repurchase transactions. Borrowings secured by inventories pose limited credit risk to the lender, especially to the extent that these inventories are in relatively liquid commodities (e.g., deliverable aluminum held in an LME warehouse) and are located in jurisdictions where there is little risk of perfecting legal title; borrowings secured by less liquid commodities, and in some jurisdictions, pose greater risks. Commodity receivables that back some securitization structures historically have exhibited very low rates of default, and rates of default did not rise appreciably even during the 2008-2009 crisis period. Moreover, these structures do not generally exhibit the maturity mismatches that contributed to runs on the liabilities of some securitization vehicles during the financial crisis. Indeed, in some of these structures, the liabilities have longer maturities than the underlying assets, meaning that the challenge they face is replenishing the assets, rather than rolling over the liabilities.
These non-bank financing vehicles may become increasingly important because broader financial trends may constrain the availability of, and raise the cost of, traditional sources of transactional financing. Historically, banks, and especially French banks, have been major suppliers of credit to commodity trading firms; five banks, three of them French, are reported to provide 75% of the commodity trade finance for Swiss-based trading firms. Deleveraging post-crisis and dollar funding constraints on European/French banks have led to a reduction in bank extensions of commodity credit. This has led to increases in funding costs and reductions in the flexibility of credit arrangements. The impending Basel III rules impose greater capital charges on commodity lending and trade finance generally, which could further reduce bank supply of commodity credit.
Footnote: The earliest such transactions that I am aware of is a securitization of base metals inventories undertaken by Glencore and a securitization of receivables by Vitol in 2003. The term “shadow banking” is used in many different ways. Here is used to mean financial intermediation through the issuance of debt outside the insured banking system.
There is also an interesting section on the role of commodity trading firms as financial intermediaries, in which the funding arrangements used by CFTs are discussed in some detail. These are often focused on prefinancings and prepay structures.
As Pirrong notes:
In addition to traditional trade credit, firms involved in commodity trading (including, notably, some banks that have physical commodity trading operations) increasingly provide structured financing to their suppliers and their buyers. A common element of these structures is an off-take agreement, whereby a trading firm agrees to purchase a contractually specified quantity of a commodity (e.g., copper concentrate or gasoline) from a producer (e.g., a miner or refiner) usually at a floating price (benchmarked to some market price, plus or minus a differential). These contracts can vary in duration (e.g., a year, or multiple years) and quantity (e.g., the fraction of a mine’s output, or its entire production).
Pirrong also reveals that when a prepay structure is used the deal can be structured in one of two ways. In the conventional structure, the bank would provide full recourse financing to the trading firm, which makes the loan to the producer. In this structure it is the trading firm not the bank that bears risk that the producer will not repay or deliver the prepaid amount.
The other structure — which is now apparently more commonly being used, a la the famous prepay deal which Rosneft struck with Vitol, Glencore and Trafigura – is an arrangement in which the bank provides limited recourse financing to the trading firm. The trader assigns the rights under the off-take agreement to the bank as a security. In other words, the trading firm provides the funds to the producers, but the bank absorbs the credit risk on the loan, although in some instances the trading firm might be left with a marginal exposure of some 10 per cent.
In that second variant it is up to the bank to hedge the exposure rather than the trading firm. If the bank in question has a lot of natural offsetting client flow, which would otherwise have to be transacted in (more transparent) futures markets, these sorts of flows can be fully internalised by the bank, with a minimal impact on the market.
Which leads to a question. To what degree do such deals, by diverting speculative flows away from futures markets and over to offsetting prepaid volumes yet- to-be produced, end up easing the speculator footprint on futures markets and in so doing make them more representative of the fundamentals of today?
But also, to what degree do these deals obscure the volumes that have been pre-committed to the market in the future?
I.e. before these deals came to prominence, speculator flows — by steepening the futures curve beyond the fundamentals — would arguably lead to over-production today by encouraging the cost efficient storage of excess volumes.
But prolonged inventory accumulation tends to make markets skittish, especially when the levels accumulated trend above the market’s volatility buffer requirements. Not only does it symbolise the direct financialisation/collaterlisation of commodities, non-consumed stocks begin to weigh on market prices leading either to inevitable corrections or declarations of broken or financially distorted markets. What’s more, those stocks still have to be fully funded regardless, a fact that adds pressure to the balance sheets of those firms who wish to exploit the arbitrage being offered by investors.
Such prepay deals, however, transform what would otherwise be balance-sheet encumbering contango deals into cheap financing for producers, on the presumption that most of the speculative interest will probably never turn into physical demand at the end of the day.
And in many respects, matching tomorrow’s yet-to-be produced commodities with today’s speculative financial demand makes a lot more sense than encumbering today’s available commodities for that purpose instead. The presumption being, if markets are efficient, speculators will move out or roll-on before any of these commodities come to delivery, either because their bets have proved fruitful after all or alternatively because they haven’t.
Either way, better to intermediate these flows and turn them into cheap financing for producers for long term investment, than to incentivise unnecessary commodity accumulation which can lead to industry bankruptcies and supply shortfalls in the long run.
The plus side is clearly that the deals reconnect the physical market of today with real supply and demand fundamentals. In doing so they prevent financial flows from distorting market prices today, in favour of encouraging industry investment more generally. On the flip side, it potentially masks the real scale of supply that has been pre-committed to the market in the future, whilst transferring all of the risk of that oversupply to financial speculators. In way — not too dissimilar to what happened with subprime.
Related links:
On the intriguing drop in commodity correlation – FT Alphaville
Influence of banks, hedge funds on commodities lowest since 2008 – Reuters
The synchronized and long-lasting structural change on commodity markets: evidence from high frequency data – UNCTAD discussion paper
A little case of commodities/FX fragmentation – FT Alphaville
The power of dark inventory – FT Alphaville