Ever since the 2008 meltdown, financial market observers and regulators have been scouring the horizon for where the next bout of instability could come from. And increasingly, it seems, their watchful gaze is scrutinizing the commodities markets and commodities trading houses in particular, a group of players as opaque as they are colossal.
Now, there are a number of ways to sell, buy and bet on commodities. There are markets so-called spot markets, where buyers take immediate delivery of the goods purchased. Then there are futures and forward markets, where delivery can happen at a later date at set prices. Some markets operate through formal exchanges; others are “over the counter,” meaning that trading takes places between two parties.
The major buyers and sellers tend to be either producers or consumers of the commodity in question, or speculators seeking to profit by betting on the direction of future prices. So, for instance, a farmer may decide to sell forward next year’s wheat crop in order to lock in favourable prices, and a speculator may take the other side of the trade, agreeing to purchase the grain, believing that prices will move higher in the interim.
But buyers, sellers and speculators are not the only players. As in many other markets, the commodity markets are populated with intermediaries who both buy and sell, who hold inventories and who ship metals, grains and energy across the world.
In a speech before the CFA Society of Calgary on Sept. 25, Deputy Bank of Canada Governor Timothy Lane noted that the nature of these intermediaries—essentially the biggest commodity traders—has changed since the financial crisis. Banks used to play a key role, but they have since retrenched and commodity trading houses, also known as commodity merchants, have further expanded to occupy that void.
Describing the pre-2008 commodity markets, Lane said:
A central element in the financing of commodities leading up to the 2008 crisis was the increasing participation of major global investment banks. Because of their access to wholesale funding markets, which provided them with cheaper funding than was available to other participants in commodity markets, the large banks became increasingly important in a range of commodity-related activities. They provided a large share of the lending to commodity dealers. They also themselves came to play a central role as dealers in over-the-counter derivatives markets in commodities. More recently, they have become more and more involved in the physical trading of commodities: holding physical inventories, making markets in commodities and even creating supply chains by providing shipping and commodity storage.
In parallel, the globally active commodity trading houses assumed a large and expanding role. These institutions hold inventories of commodities, store them over time, move them around the world, and make markets in both physical commodities and their derivatives. As these trading houses grew, they played an increasingly important role in facilitating the trade in commodities. They are not financial institutions, but they do require large amounts of financing.
After the financial crisis, though, the banks have retreated from commodity markets, owing to new obligations for banks to hold higher reserves of capital, as well as U.S. legislation aimed at preventing deposit-taking institutions from taking on risky bets in financial markets. As Lane put it:
Banks have been pulling back from the commodities sector, both in terms of their lending to commodities traders and their own market-making and proprietary trading activities. Until recently, European banks provided up to 80 per cent of the financing for the trading of commodities worldwide. But, as those banks have had to repair their balance sheets, they have scaled back their lending, bringing their share down to about 50 per cent. To some extent, U.S. and Asian banks as well as banks in the Middle East have stepped into the breach: they have increased their share of financing for commodity houses. However, in the current climate, that financing is more limited and has come at an increasing cost. For banks doing business in the United States, the anticipated impact of the Dodd-Frank legislation on their commodity trading operations has been an important additional reason for curtailing these operations.
Filling the void left by the banks have been the large commodity trading houses, which have grown even further. Reuters published a lengthy report last year explaining just who these trading houses are and how influential they’ve become:
They form an exclusive group, whose loosely regulated members are often based in such tax havens as Switzerland. Together, they are worth over a trillion dollars in annual revenue and control more than half the world’s freely traded commodities. The top five piled up $629 billion in revenues last year, just below the global top five financial companies and more than the combined sales of leading players in tech or telecoms. Many amass speculative positions worth billions in raw goods, or hoard commodities in warehouses and super-tankers during periods of tight supply…
And their reach is expanding. Big trading firms now own a growing number of the mines that produce many of our commodities, the ships and pipelines that carry them, and the warehouses, silos and ports where they are stored.
But Lane suggested that their source of ongoing funding is not as stable as that of a bank:
As banks have scaled back their involvement in commodities, commodity trading houses have grown in importance and have changed their funding models. Some commodity companies have begun tapping the capital markets for the first time. Sales of investment-grade bonds by commodity companies are up 90 per cent over last year, and commodity-linked junk bonds have risen by an estimated 40 per cent so far this year.
Lane also appeared to worry that some of these trading houses are not just acting as middlemen who buy from one party and sell to another, but are actually taking large outright bets on the future prices of commodities, with risks to commodity markets and the financial system itself if the bets go awry. He didn’t name anyone in particular, but numerous observers believe the following to be a veiled reference to traders such as Glencore International:
…the large trading houses, together with the physical trading operations of some large investment banks, are playing an increasingly prominent role in a number of commodity markets. This raises the possibility that some of these institutions are becoming systemically important. Just as the 2008 financial crisis revealed the need to assess the systemic importance of institutions that play a central role in particular financial markets, we should be asking the same questions about institutions that are interconnected with various commodity markets. Here, I have two general questions in mind: Could the failure of one of the large trading houses cause serious disruption in the commodities markets in which it played a market-making role? And, could the losses that a trading house incurs through the positions it has taken in commodities have significant knock-on effects on the financial system? [Emphasis added]
Reuters seemed to echo those concerns:
U.S. regulations are now pending to limit banks’ proprietary trading—speculating with their own cash. The new rules don’t apply to trading firms. ‘Trading houses have huge volumes of proprietary trading. In some cases it makes up 60-80 percent of what they do,’ said Carl Holland, a former price risk manager at oil major Chevron Texaco, who now runs energy consultancy Trading Solutions LLC in Connecticut.
As everyone knows, Canada is a resource-centric economy. And with the commodity “supercycle” in trouble given the weakening global economy, there is a heightened risk that the bullish bets of large commodity traders will go awry, exacerbating the pain. It’s no wonder the Bank of Canada is alarmed.