Bank exposure to commodities traders is likely to have jumped as hedging strategies evolve in response to market volatility, the Financial Stability Board (FSB) has said, warning that already high concentration in the market could increase the risk of contagion.
The FSB, established by the G20 to monitor the global financial system and whose research informs regulation worldwide, on February 20 published an in-depth report on the commodities market and the exposure of financial institutions to the sector.
The commodities market has attracted regulatory attention over the last year as Covid-19 containment measures and Russia’s invasion of Ukraine fuelled price swings for key products, in some cases causing higher borrowing, big margin calls and soaring profits.
The FSB said that while the commodities market has largely adapted to price volatility, participants have taken on more credit and market risks in the process, increasing the probability of contagion in the event of future disruptions.
In response to higher margin calls on hedging positions, some traders have switched from centrally cleared exchange-traded derivatives to the largely uncleared and more opaque over-the-counter (OTC) market, with the report noting that “such a move has also increased counterparty credit risks in the commodities ecosystem”.
“There are also indications that certain players in European commodities markets may have reduced their hedging of commodities prices due to the increased margin calls,” according to the FSB. “While this again reduces funding liquidity risks, it raises commodities firms’ market risks.”
While bank exposures to commodities traders “appear manageable in aggregate”, a closer inspection reveals a strong concentration in the eurozone, with significant concentrations of exposure among five unnamed banks.
Those five eurozone banks have an average exposure to the largest 27 commodities traders of 15% of their common equity Tier 1 capital, the report notes, with a similar situation among Swiss lenders.
Data collected for the report likewise shows concentration in syndicated lending, with just five banks holding one third of all such exposures to large commodities traders, according to analysis of 33 deals made between 2020 and 2022.
The relationships are further enmeshed as banks can also be counterparties in OTC contracts, as well as lending to hedge funds that trade commodities derivatives.
The report notes that “in the event of a failure of a commodities trader, banks would also be potentially exposed to insolvency processes, especially for institutions with a large and complex set of open derivatives positions across both OTC and centrally cleared markets”.
“Contractual arrangements can be complex in physical markets and are often accompanied by financial hedges as well as financing trades (e.g. syndicated loans or letters of credit),” the FSB says. “Given the cross-jurisdictional presence of commodities traders, the lack of contractual continuity provisions, and the likely absence of replacement clauses, an orderly wind down of a material player may prove to be highly challenging.”
Banks have already copped significant losses after a clutch of commodities traders collapsed in Asia and the Middle East in 2020, amid plummeting crude oil prices and tighter lending by banks.
Some traders, later found to have been acting fraudulently, borrowed hefty sums from banks in order to plug ever-widening holes in their books, with collateral often pledged to multiple lenders or even fabricated.
The FSB’s report comes shortly after McKinsey said commodities traders’ demand for trade finance is likely to swell against a backdrop of higher prices and steeper margin calls. The consultancy predicts that between US$300bn and US$500bn of additional financing could be required to facilitate commodity flows and market sources suggest banks are eager to grow their exposure to the sector.
The FSB says large commodities traders have assets of roughly 3.5 times equity on average, but some are leveraged much higher. For example, Trafigura has assets of more than eight times its equity, the report says, adding that the trader and its peers including GrainCorp, Wilmar and Louis Dreyfus rely strongly on liabilities due within the next year, meaning they “not only have significant amounts of leverage, but also face rollover risks on their funding”.
Trafigura, Wilmar, GrainCorp and Olam also have a debt to asset ratio of 50% or more, according to data included in the report.
“Certain banks are more highly exposed to commodities traders, some of whom represent a significant share of market activity, are highly leveraged and rely on short-term debt,” the report notes.
That reality, combined with the concentration of commodities derivatives clearing among a few large clearing houses and the outsized role of some banks in derivatives markets, raise concerns over a “significant concentration in commodities markets” that could spell trouble in the event of a major shock or downturn.
As such, the FSB warns: “the juxtaposition of this concentration and interlinkages in the commodities sector – along with large and leveraged commodities traders, less standardised margining practices and opacity in OTC markets – could all come together to propagate losses”.