Trading Cos Look at New Sources of Financing after Credit Squeeze

Global trading companies’ talent and deep pockets have helped them get incredible powers. Regulators may be cracking down on big banks and hedge funds internationally but trading companies have largely remained untouched. Many are unlisted or family-run and have immense political clout. The commodities trading industry has diversified its sources of credit over the last decade as rising raw material prices have increased financing needs. However, most trading companies remain dependent on cargo-by-cargo short-term letters of credit.

Unlike commodity producers, trading firms don't just make money when prices go up. Most rely on arbitrage -- playing the divergence in prices at different locations, between different future delivery dates, between commodity qualities in different places… thus liquidity and cash flows are important.

The gains made in situations of short squeezes can often get negated if liquidity and credit squeezes have been triggered by their own banks. Global trading companies used to operate on huge liquid credit lines given by bankers. It seems that with the latest credit squeeze, trading companies are aggressively hunting for fresh lines of credit in the non-traditional geographies.

Three years ago, it was a freeze in trade lending which slowed global trade flows. Unfortunately, Europe’s sovereign debt and banking crisis is now resulting in numerous unintended consequences, especially in the commodities space. French banks such as BNP Paribas, SocGen and Credit Agricole are the main financiers of big commodity trading houses, many of which are run out of Switzerland. In recent weeks, as these lenders engage in significant asset contraction, they are reducing the availability of credit and raising its cost.

Three years ago, some of these large trading companies would have hardly glanced at alternative sources of commodity trade funding in non-traditional geographies. The scenario seems to be changing and borrowing in alternative currencies (other than US dollars) is no more exotic.

Trade finance is a huge business, with lending hitting more than US$170 billion. A drive by some banks to reduce the size of the balance sheets have aggravated the impact on commodities trade finance in light of new Basel III capital rules. While banks needed to hold capital equal to just 20% of the value of letters of credit under Basel II rules, the new agreement raises the bar to 100%, greatly increasing the cost of lending.

Trade finance, which supports US$14-16 trillion in annual global commerce, is crucial for international trade. Fewer than 3,000 defaults were observed by International Chamber of Commerce (ICC) in the full dataset comprising 11.4 million transactions. Therefore, it was argued that the increase in the leverage ratio under the new regime would not reflect market realities and may significantly curtail banks’ ability to provide affordable financing to businesses in developing countries and to SMEs in developed countries.

Following the recent consultation between the Basel Committee on Banking Supervision and World Bank, WTO and ICC, the rules for Basel III have been tweaked to promote trade with low-income countries. These alterations will reduce the amount of capital that confirming banks have to hold against letters of credit issued by lenders in low income countries.

The earlier insistence on the “sovereign floor” rule had made trade finance too expensive, even though it was extremely safe. The agreement to waive the so called sovereign floor for certain trade-finance related claims on banks using the standardised approach for credit risk will make credit more accessible in the low income countries. 

Published in The Economic Times

Just Use of Raw Material Key to Sustainable Development

Prior to the outbreak of the recent economic and financial crisis, there was a sharp increase in the demand for raw materials. Although the overheating has temporarily disappeared owing to the downturn, access to raw materials remains a highly important subject. This is because our concerns not only relate to prices but also to availability and relative prices. These factors determine industry competitiveness. Pressure will mount as soon as economic activity starts gearing up. Metals and fuels are source of our prosperity but the supply of some of these is faltering. 

At present, over 40 thermal power stations have coal stocks that are barely sufficient to meet the demand for about a week. As many as 29 projects have less than four days of coal reserves. The government has asked coal companies to step up supplies to power stations facing shortage of coal to ensure that power generation is not interrupted. 

A slew of factors, including less production from CIL collieries due to heavy rains, floods in Orissa and Telangana agitation, have hit coal supplies to power units. The threat of a strike by miners comes at a time when the power situation in the country is grim as many plants of NTPC, the country’s largest power generator, are running below capacity levels due to paucity of coal --the key raw material for generating electricity. 

Fuel prices have almost doubled over the last year and their impact on manufacturing have been worsened by the current power shortage, which has forced most local manufactures to use expensive diesel-run generators to power systems for more than the half of their production time. Any distortions in pricing and access to feedstock have a direct adverse impact on competitiveness, given that feedstock can make up a huge part of the production costs. 

Since August, the steel and allied industries in Karnataka have been facing acute shortages of iron ore, following the imposition of a mining ban in the state by the apex court. The iron ore supply crisis at JSW deepened last month when its longterm supplier NMDC stopped supply of the raw material. The state-owned company was adhering to the apex court order for selling all its ore from the state through the e-auction route. 

Industries need predictability in the flow of raw materials and stable prices to remain competitive. Policy makers should be committed to improve the conditions of access to raw materials, be it within India or by creating a level-playing field in accessing such materials from abroad. 

Our preoccupation with short-term price movement often ignores the potential of a more circular economy to increase economic resilience. Over a period of time, the pressure on raw materials will increase substantially. Therefore, we will need to use raw materials in a much more sustainable manner as the present pattern of exploitation and consumption cannot be maintained and our production process, feedstock use, consumption patterns will need to radically change to ensure sustainable development. 

Published in The Economic Times

Clearing Houses Now Accept Gold as Alternative Currency

Clearing arrangements for commodity contracts may be viewed as a process through which market participants seek to control risk. Such arrangements include both “clearing” in the sense of reconciling and resolving obligations between counterparties and “settlement” which finally extinguishes the obligations. 

One of the largest clearing houses of the world, LCH Clearnet, will begin accepting physical gold bullion (up to $200 million per member) as collateral amid growing demand to depart from the traditional reliance on cash and other securities to cover margin requirements. 

The move follows similar steps by many exchanges to increase the use of physical gold as an acceptable deposit and reinforcing the precious metal’s allure as an alternative currency. 

In October 2009, CME allowed physical gold to be used as collateral for margin requirements. ICE followed suit in November 2010. Last month, CME allowed the cap per member for gold collateral to be increased from $200 million to $500 million. 

It is important to point out a few facts that determine how clearing houses or central counterparties (CCPs) devise their margin strategies. First, it is critical to separate CCP margins into variation margin and initial margin. The variation margin is calculated on a trade-by-trade basis and offsets changes in value, whereas initial margin provides default protection and is usually calculated on a portfolio basis to allow for the offsetting of risk. There have been concerns that as the jostle for a piece of business continues, there may be temptations to relax financial standards and asset quality. That could include reducing the collateral quality instead of lowering margin requirements for members and a move which could weaken the mechanism in the event of a default. 

What is the fair price of commodity collateral? Given the complexity of pricing derivatives and the compounded challenges of calculating initial margins, there is no clear-cut solution to measure these risks. Physical commodity collateral may have a present market value of 100. However, on forced sale, the asset may be worth 60. In such situations, when a party approaches with an offer of 80 (with no other bidders in fray), should the offer be acceptable? The standard theory will say yes as 80 is more than 60. It’s a tough call for the creditors but not as tough as a forced sale. Book value may not be always the same as forced sale value. 

Clearing houses or CCP run a perfectly matched book. Every obligation to a member is matched by a precisely equal and offsetting claim against another clearing member. Therefore, clearing houses do not incur market risk. Collateral requirements do not in themselves provide adequate protection if collateral levels are not continuously monitored and related to risks incurred. 

Most clearing houses or CCP around the world conduct a routine margin settlement per day based on positions and market prices at the end of the trading day. The fund transfers associated with these margin adjustments are typically affected the following day. An essential condition for sound clearing and settlement procedures is that incentives to monitor and control risk should coincide with the capability to fulfill the monitoring/control function. The safeguard in the Indian context is that it is monitored on a real-time basis. 

Published in The Economic Times

Forex Swings Hit Commodity Values

We have seen that over the past few weeks, a number of central banks are stepping in, with a view to smoothing foreign-exchange volatility. Prices of internationally traded commodities are notoriously volatile due to market fundamentals and exchange rate movements. Commodities today are a diverse group of international markets that operate quite separately from each other. 

The value of commodities is dependent upon the currency they are exchanged for and when that currency is weak the commodity will appear to be very expensive and sometimes mistakenly very valuable. The effects of Currency Agreements as well as the Trade Agreements on the participating economies are important. Both types of agreement have multiplied in recent years. Many countries have fundamentally changed the way their currencies relate to the currencies of other countries either by adopting a common currency (Euro for EU) or through Bilateral Currency Swap Agreements where the trade settlements are done in their own currencies rather than in US dollars and finally by way of Multilateral Clearing and Payment Agreement (CPA).

While trade agreements and currency unions are often justified on the basis of the presumed effect on trade volumes, the reverse is also true. Currency agreements which lead to trade cannot be avoided. Erstwhile USSR and India used to conduct bilateral trade using an instrument called a “Rupee Rouble Escrow Account”. Boris Yeltsin unilaterally abrogated 1978 protocol without any legal or compensatory financial recourse.

China has signed Bilateral Currency Swap Agreements with Brazil, Korea, Hong Kong, Malaysia, Belarus, Indonesia, New Zealand, Kazakhstan, Uzbekistan, Argentina, Iceland, Russia, Indonesia and Singapore amounting to more than US $ 95 Billion. All these countries are important trading partners of China. In addition to border trade, ordinary trade can also be settled in both countries' official currencies. Chinese authorities are taking measured steps to internationalize the usage of the RMB (Renminbi) through a bilateral currency agreement. China which now holds large US assets is trying to diversify assets away from the US dollar.

China as per certain estimate undervalues its currency to almost 35%. China does not allow its currency, to float freely on exchange markets. This along with other subsidies and mercantilist trade policies keeps Chinese exports cheap and thus more attractive to consuming countries. Trade between India and China amount to around US$60 billion with an annual growth rate of 40%. The two countries in 2009 signed a bilateral currency swap agreement, but it has not yet been officially launched. There are also reports that some of the entities who are importing from China, are trying to tweak the existing commercial regime so they can borrow in the RMB to pay off the suppliers.

Chinese prefers to do things step by step. All the bilateral agreement should be seen as China's transitional move to make its currency RMB fully convertible and to challenge the US dollar. Eventually, wider use of the RMB outside China could redefine the balance of power as the rest of the world begins settling its bills with China in RMB instead of the US dollar.

Given the importance of China in the world commodity market, the ramifications can be significant.

Published in The Economic Times