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Global Outlook

Commodity Financing Crisis

June 11, 2014, Wednesday, 09:02 GMT | 04:02 EST | 12:32 IST | 15:02 SGT
Contributed by eResearch


For years, we have heard the doom and gloom remarks from many experts; for years, we have seen the market move higher. This week, the S&P crossed 1950. The charts of many stocks are breaking out, and that means the short-term momentum could easily carry us forward beyond 2000 on the S&P 500 Index. If it does indeed cross this psychological threshold, a short-term bet on a triple-leveraged ETF could make us some quick and easy dollars.

By now, you have read many reasons in my past letters on why to proceed with caution as the stock market climbs. That is because there are always underlying events that could cause the market to break at any time. This week, the focus is on one that could break the commodities/metals market.

For years, I have talked about the manipulation of gold and other metals. For years, I have talked about how these hard assets are being used to create paper (artificial) assets with values which are exponentially compounded. One of these is the "rehypothecation" used in commodity financing deals.


Commodity Financing Deals

In short, banks and brokers lend money to their clients using assets that have been posted as collateral. These assets can be anything from currency to hard assets, such as gold or other base metals. The banks/brokers can then take these assets and use them for their own purposes to create other financial instruments; metal-backed currency, so to speak.

This is called rehypothecation. And, yes, it sounds almost like a Ponzi scheme.

Many times, these assets are "supposed" to be sitting in a vault or storage facility somewhere, but because the "rehypothecation" process is often repeated many times over, no one really knows where the assets/metals/commodities are - if they exist at all.

For years, I have warned about the problem with the rehypothecation of commodities and metals, and that we could see a major break in this system if strong evidence were presented that many of these collateralized assets may not actually exist.

So, what would happen if a nation - that is home to the world's largest market for two of the world's most widely used base metals, copper and aluminum - were to tell the world that it may have a problem with collaterized lending, where the collateral does not exist?


China to Investigate

Just this week, China announced that it is investigating a potential problem where copper and aluminum used as collateral to fund other deals may not actually exist.

Via Reuters:

"China's northeastern port of Qingdao has halted shipments of aluminum and copper due to an investigation by authorities, causing concern among bankers and trade houses financing the metals, trading and warehousing sources said on Monday.

...The port of Qingdao is China's third-largest foreign trade port and the world's seventh-largest port, trading with 700 ports in more than 180 countries, according to its website (www.qdport.com/).

"Banks are worried about their exposure," one warehousing source in Singapore said. "There is a scramble for people to head down there at the minute and make sure that their metal that they think is covered by a warehouse receipt actually exists," he said.

Metal imports have been partly driven in China as a means to raise finance, where traders can pledge metal as collateral to obtain better terms. In some cases the same shipment can be pledged to more than one bank, fuelling hot money inflows and spurring a clampdown by Chinese authorities.

"It appears there is a discrepancy in metal that should be there and metal that is actually there," said another source at a warehouse company with operations at the port.

"We hear the discrepancy is 80,000 tonnes of aluminum and 20,000 tonnes of copper, but we hear that the volumes will actually be higher. It is either missing or it was never there - there have been triple issuing of documentation," he said.

Beijing last year set new rules to curb currency speculation amid signs that hot money inflows helped push the Yuan to a series of record highs. The rules required banks to tighten the management of their foreign exchange lending and types of clients that are able to access those loans.

"It is such a massive port I would think virtually everybody has exposure," the trading source said."

Also via Reuters:

"...The investigation is looking into whether single cargoes of metal were used multiple times to obtain financing, according to industry sources. Trading houses and banks have sent executives to the port to physically check on their exposure, while some banks have stopped new metal financing to some clients in China.

... Most metal financing deals in China are done outside exchanges and, in those deals, warehouse receipts are used as proof of ownership of metal. This is agreed typically by a bank or a trading house with a warehouse."

China is the world's leading copper and aluminum market and news of this has already hit traders; the price of copper has taken a nose-dive downward, with its biggest weekly loss since March.

And if you go by the notion that copper is often referred to as "Dr. Copper" because of its unique ability to forecast economic trends, what does that say about the future of our world economy?


Further Downside?

While the price of copper has already dropped, the news of this could have further downside implications - much more significant than most realize at this point.

First of all, much of China's shadow banking system relies on commodity finance deals. According to Goldman Sachs, commodities financing-related FX loans represent 35% of China's total short-term FX loans.

But what happens when many CFD's are no longer approved? What happens when a commodity used in the rehypothecation process needs to be verified, each and every time a loan is made?

This could lead to less credit expansion, and a tightening of the shadow banking system, which may cause many banks to run into liquidity issues. China's credit system is already in trouble. Could this recent investigation at the Qingdao port be the straw that breaks China's credit system?


A Fall in Prices

The first thought is that if there really is not as much copper or aluminum in storage to back up these commodity-financed deals, the prices of the metals should rise. But that is not the case here ... at least not with the base metals.

From a commodity market perspective, the use of metals as collateral for financing deals creates excess physical demand. This puts tighter pressure on the physical markets, forcing prices to rise temporarily.

I have mentioned before how (some) institutions have manipulated prices of the metals higher by soaking up the supply from the physical market and holding them in storage. In simple terms, institutions which hold even a small amount of metals in storage can unleash some of these metals into the physical market to lower prices in the futures market, or buy and withhold them from the physical market to increase the prices in the futures market.

(Since many western banks, such as JP Morgan, have been leaving the metals storage market, we have seen the prices of base metals - such as copper - fall as these banks unwind their physical position.

Here is the price chart of copper, showing when JP Morgan and other banks came under heavy scrutiny for manipulating the price of commodities:)



As with most financially-derived products, the paper market value is generally much larger than the actual value, in relative terms, than the physical market. As such, physical inventory is much smaller than the open interest in the futures market. That means the impact of purchasing the physical commodity on the physical market has a much stronger effect than the impact of selling the commodity futures on the futures market.

These Chinese commodity-financing deals take supply from the physical market and, thus, places upward pressure on the physical price, giving the illusion of stronger demand.

If these Chinese commodity-financing deals begin to unwind as a result of the investigations, those who have claims to the underlying commodity would likely sell their ownership in physical inventory, while those with hedges against it would buy it back in the futures market. Since the physical market has a stronger effect on prices, it would likely send the price of the underlying commodity lower.

As Reuters recently reported, those involved are beginning to question the legitimacy of their collateralized financing deals, and it would appear that an unknown number of deals have already begun to unwind. That is likely why we are beginning to see lower commodity prices.

But base metals, such as copper and aluminum, are not the only metals that are used as collateral in these deals. In fact, there is one metal that is the most widely used in terms of value to provide funding for deals in China.


Tired of Gold?

The thought of gold is almost tiring. We all know of the fundamentals that should push the metal higher: central bank demand; lack of gold in the vaults of the big banks; the potential that the U.S. does not have all of the gold it claims it has at Fort Knox; proven price manipulation; and increasing world demand. Yet, the metal has not done much over the past few years. Every time a price break-out has been attempted, it has been smashed right back down.

So, today, I am not going to talk about the merits of gold, or why everyone should have some in their portfolio. I simply want to keep you up-to-date on what is happening.

In 2013, when Chinese physical buying hit an all-time record and overtook India as the world's largest gold consumer, gold tumbled nearly 30%. It was also a year where gold-backed funding deals rose to an all-time high. Clearly, the surge in physical gold demand in China (and all over the world, including central banks) could not have forced gold prices to tumble.

I have discussed the unloading of paper gold by Western Banks many before many times. But, what about the Chinese? Could the Chinese have unloaded "hedged" paper gold assets in the futures (paper) market, intentionally forcing the price of paper gold down, as it, and its billionaire citizens (with strong ties to its government), purchased physical gold at its fastest pace ever? All signs point to YES.

If collateralized commodities deal funding slows, the price of commodities could likely fall in unison. However, in the case of gold, the opposite could be true. If China were to dump its physical gold, it could cover its future "hedges" by buying gold in the paper market, sending the price of gold higher. Is it possible China was the culprit for the gold's drop in 2013?


Liquidity Crunch Round 2

Last year, China experienced a banking liquidity crisis as a rapid rise of short-term lending rates followed a regulatory crackdown by the People's Bank of China (PBOC) on shadow banking requirements. Following PBOC intervention, the loss of liquidity from shadow banks caused money market rates to soar, resulting in a 7% market drop, the largest decline in nearly 4 years.

If it comes to light that the base metals are missing, or grossly inaccurate, from the port of Qingdao, the unwinding of the shadow banking system would further accelerate, once again leading to another liquidity crisis.

While the amount of metals in question is very small when compared to the whole market, it puts a major halt to the liquidity provided by commodity financing deals in China.

Via Reuters:

"International and Chinese banks have been forced to make urgent checks on the situation at Qingdao.

Standard Chartered has suspended new metal financing to some customers in China, three sources familiar with the matter said. The bank said on Friday its commodity financing business remained a key focus area and it would continue to support its clients. "We recognise that there are currently issues in China around commodity financing which we are monitoring."

Citigroup Inc. is among banks financing copper on behalf of clients at the port, according to people familiar with the situation. The bank said: "To the extent Citi's clients are affected, Citi will work closely with the relevant authorities, warehousing companies, and clients to resolve the matter."

A head of trade finance at a South East Asian bank said the bank was not accepting warehouse receipts from Qingdao for the moment but would accept them from LME locations or Shanghai.

He also said that metal financing was likely to continue but in tighter collateral management agreements (CMA) signed by a bank, trading company, and warehouse.

This is likely to be more expensive than many of the current agreements, which are only based on warehouse receipts."

For non-precious metals, this could lead to a further drop in price. But, for gold, the most widely used (notional value) metal used in commodity financing deals, it could lead to surge in price.

Of course, tens of thousands of tons of missing copper and aluminum does not suggest that gold could be missing as well ... does it?

For now, we focus on the investigation of the missing base metals.

Meanwhile, what was once conspiracy theory is now fact: gold futures were indeed manipulated by banks, and this has now been publicly proven in more than one case - the latest being from last week when Barclays was slapped with a $44 million fine for fixing the price of gold.


A Major Scam

While authorities investigate the missing metals, it seems the world continues to be shrouded in "fake" gold. According to the South China Morning Post, one Hong Kong businessman just bought HK$270 million worth of "fake" gold bars from Africa.

Via SCMP:

"On Wednesday, Zhao Jingjun, 43, opened part of his shipment in front of his buyer in Hong Kong and discovered the gold had been switched for worthless metal.

A senior officer said it would be the city's biggest heist in a decade if it was confirmed that all the gold had been stolen."

Which raises the question, "How much gold is actually out there?"