Dramatic fluctuations in commodity prices will challenge everyone in the supply chain from producer, trader, financier and consumer. Rebecca Spong reports from Unctad’s second global commodities forum.
As commodity price volatility continues into 2011, demand for commodity and trade financing will inevitably soar.
Producers will need finance to support their working capital needs, traders will need to support their growing network of trade flows and importers will have to pay for vital imports of raw materials and food.
Due to forthcoming banking regulation and the rising cost of funds, this much-needed supply of finance from banks could be constrained.
Lack of trade and commodity finance has already been cited by the World Trade Organisation (WTO) as one of the contributing factors to the fall in world trade witnessed at the height of the financial crisis. Blighted by their own problems in their domestic markets, some banks retracted from emerging markets and those borrowers most in need of financing.
Representatives of the commodity finance market gathered at Unctad’s (United Nations Conference on Trade and Development) in late January to argue that the forthcoming Basel III regulation, which demands banks put aside higher capital provisions, could further limit their capacity to lend.
This, bankers asserted, could have a negative impact on the development of emerging countries.
Peter Sargent, head of transaction banking Europe at ANZ, based in London, commented at the conference: “There is relatively less capital likely to be available to banks. At the same time, governments are expecting to use world trade to pull economies out of recession, and the WTO tells us that in the next decade trade is likely to double. Somewhere along the line something has got to give.”
Shaped by regulation
It is a strange world where our business is really being shaped by regulation.”
Fellow conference panellist, Jean-Francois Lambert, global head, sales and risk management, trade & supply chain, HSBC, remarked: “It is a strange world where our business is really being shaped by regulation, from who to lend to and at what price.”
One of the main challenges facing banks is that Basel III regulations will change the definition of tier one capital, and require banks to put aside more capital per transaction.
“We used to think about risk and return, now we talk about risk, return and capital,” Lambert noted.
John MacNamara, global head of structured commodity trade finance, at Deutsche Bank also spoke about how banks are changing the way they judge how well they are performing.
Banks have suddenly woken up to the fact that putting vast amounts into revolving credit facilities at low margins doesn’t make anyone any money.”
“They say that return of equity is not the best measure for their business, and that return on risk weighted assets is the best measure,” he observed.
This change is partly fuelled by the looming Basel III regulation, but is also caused by the rising cost of funds; the price the bank itself has to pay to borrow money. This is of particular significance for banks in the eurozone which have seen a significant hike in their cost of funds.
In practice, this means that price negotiations over a structured trade finance deal are less likely to be governed by commercial interests, but rather be a decision driven by funding cost concerns.
This has led to a change in the types of structured commodity finance deals banks are getting involved in. ANZ’s Sargent suggested: ”Banks have suddenly woken up to the fact that putting vast amounts into revolving credit facilities at low margins doesn’t make anyone any money. Banks [that are involved in this business] are looking to get rid of those loans as quickly as possible, and are looking for significant amounts of cross-sell, such as foreign exchange and cash management.”
Use of risk mitigants
The effective use of risk mitigants is one method where trade and commodity finance bankers might counter the ill-effects of Basel III, and achieve some capital relief.
Under Basel II, banks were often able to arrange and fund multi-billion dollar pre-export facilities by using the political risk insurance market to sell off some of their risk. The comprehensive insurance product which covers both political and commercial risks saw an explosion in popularity when Basel II was introduced.
Under Basel III and the new emphasis on return on risk weighted assets, the use of this type of insurance may not be as attractive. Some bankers report that their management is asking them to reduce their reliance on insurance, and sell down more risk to institutions that can fund the risk share in the primary and secondary markets, rather than pass on the risk to an unfunded institution such as an insurer.
The capacity for funded participation in syndicated commodity finance facilities is expected to increase, with bankers observing that the smaller banks that exited the market are returning. There are also a number of Chinese banks looking to take tickets in syndicated facilities.
Increasing use of securitisation, hedge funds and specialised trade finance funds were highlighted as other means of offloading risk.
James Parsons, portfolio manager at Bluecrest Capital in London, a specialised trade finance fund, remarked that demand from banks to transfer risk to funds is growing.
Some of the niche lenders have effectively been blown up by the crisis,”
“Bank demand to manage balance sheets and risk limits has always existed, and the current climate and regulation are increasing the demand for an ability to lay off risks,” he notes.
But the supply side is a little more constrained. “Some of the niche lenders have effectively been blown up by the crisis,” Parsons observed, noting some players are winding down their portfolios.
This, he notes, has made the investor community cautious about investing in trade finance funds. “There is a little bit of concern about the liquidity of trade finance assets. Even if one sub-sector was affected, everyone gets tarred with the same brush.”
It is also relatively hard for small, specialised trade finance funds to set up on their own. Parsons notes that for capacity to increase, the market will rely on larger organisations to finance the start-up of new funds. Trading company Trafigura is one such company looking to break into this market.
“One product we are looking to develop is effectively a trade finance fund,” Pierre Lorinet, chief financial officer at the trading company, explained to Unctad delegates.
The fund aims to bring in investors who don’t have access to flows of commodity finance, and to increase liquidity in the market.
To date, the trade finance and commodity finance industry has struggled to gain recognition, despite its much-stated importance in propping up world trade.
Does your boss even know what commodity finance is?”
Deutsche’s MacNamara remarked:”We are a minority sport.” While others commented that even within their own institutions there was a lack of awareness, with one panellist asking: “Does your boss even know what commodity finance is?”
The overriding message the market representatives strived to present to Unctad delegates was the low default rate of commodity and structured commodity finance.
“Throughout decades trade finance has survived the difficult issues and found new ways to deal with this,” comments John Turnbull, global head of structured trade and commodity finance group, at SMBC Europe.
It is the strategic importance of commodities to the importing countries that help ensure the commodity finance asset class maintains a good track record.
We’ve seen in the last 17 years virtually no default whatsoever.”
“If there is a default or an issue, you will always find a solution,” argued Trafigura’s Lorinet.
“Why? Because otherwise it stops; you just cut your supply chain. That’s why we’ve seen in the last 17 years virtually no default whatsoever. We’ve had difficult situations where we’ve had to make recoveries, but you always find solutions, as it [the commodity] is so essential to the end user.”
Evidence of the historic default rates of trade and commodity finance was compiled by the Asian Development Bank and the ICC Banking Commission, and presented to the Basel Committee last year, but as yet it has not resulted in any significant reviews of how the asset class would be treated.
According to Lambert at HSBC, there is further work in progress involving the ICC to present new data to the Basel committee.
Bankers argued that although the commodities market goes through cycles of high and low prices, commodities remain a reliable form of collateral for lenders to use.
“One of the first things I was told when I started my career was there will always be trade and commodities. We haven’t seen great changes in the underlying business,” remarked MacNamara.
“We have to communicate that to our regulators; otherwise we will end up with regulation that does not help us”. GTR
UN warns against
As prices for basic farm produce and raw industrial materials continue to rise, senior United Nations officials call for urgent action to be taken to rein in volatile commodity markets.
Supachai Panitchpakdi, the secretary-general of the UN Conference on Trade and Development (Unctad), stated that price volatility continues to hit the poorest the hardest.
There are serious concerns about the way in which commodity markets have been evolving in recent years.”
“Such volatility has huge negative impacts on vulnerable groups, such as low-income households in developing countries, for whom food expenditure can account for up to 80% of household budgets,” he told delegates at the agency’s second commodities forum held in Geneva in late January.
Despite a temporary slump in prices at the height of the financial crisis, commodities have resumed pre-crisis levels. Sugar and cotton hit 30-year highs at the end of 2010. Copper is up 35% since mid-2010 and oil is also trading around the US$90 per barrel mark.
“There are serious concerns about the way in which commodity markets have been evolving in recent years. Since mid-2010, commodities have, for the second time in three years, been experiencing extremely high price volatility.”
He spoke of “speculative distortions that complicate the economic management of commodities production and trade”.
The ‘financialisation’ of commodities was a key focus of the conference, with many expressing the belief that the increasing number of investors seeing commodities as a financial asset through which they can secure high returns, rather than as a physical entity, was fuelling volatility.
Environmental events such as fires in Russia and the Pakistan floods also pushed up commodity prices in 2010, and demand for the growing economies such as India and China are similarly fuelling prices.
With the world only entering a fragile recovery, Andrey Vasilyev, deputy executive secretary of the UN Economic Commission for Europe, told the conference that rising commodity prices might impose negative inflationary pressure on economies.
He urged that commodity prices should reflect economic fundamentals of supply and demand, and the influence wielded by speculators should be reduced.
Pascal Lamy, director-general of the World Trade Organisation, spoke of the need to complete the Doha Round on world trade rules as a way of smoothing out some of the volatility. He noted “tariff walls, price suppressing subsidies, and restrictions on exports” as significant contributing factors to rising prices.
“Volatility is at its worst in tight and closed markets. It eases in open and, hence, deeper markets,” he added.
Rather than blaming financial speculators, Lamy spoke of export taxes and export restrictions being the “single most important reason” for the price explosions in the rice market in 2007-08.
Oil has emerged as an asset rather than as a commodity.”
He also pointed to the price escalation of cereals in Russia and Ukraine in 2010 being as a result of constricting export and trade regulations.
Conference speakers added that commodity-dependent developing countries should not rely on the rising commodity prices as their main income stream, and should work to diversify their economies. Speaking specifically on oil markets and Iraq’s re-emergence as a major oil producer, Iraq’s deputy prime minister for energy affairs, Hussain Al-Shahristani, asserted that oil price volatility is being fuelled by speculation.
There is, he told delegates, “a broad acceptance that volatility in the oil market was driven by speculation and not by market fundamentals. Oil has emerged as an asset rather than as a commodity”.
Fellow panellist, Ali Ibrahim Al-Naimi, Saudi Arabia’s minister of petroleum and mineral resources, echoed such views saying: “I believe it can be explained in part that in recent years, oil has become well-established as an attractive asset class for a growing and diverse set of investors.
“This trend appears unlikely to abate anytime soon unfortunately, and is likely to contribute to the ongoing volatility as investors’ money moves in and out of oil future markets based on a variety of factors that may have little to do with basic oil supply and demand fundamentals.”