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