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The Rupp Report: Big Business With Raw Material

Jürg Rupp, Executive Editor

For centuries, trading with raw material has been an integral part of economic life. Stock exchanges started everywhere and eventually developed into the stock exchanges that exist today, dealing with shares, too. The first stock exchange started in 1409 in Bruges, which is now in Belgium. Stock exchanges were and are the starting point and the center of an economic, but also social life within an industry. This applies particularly to cotton, where "Friday gatherings" played an important role in business and social life. In any case, most of these transactions were based on real values or raw materials.

Radical Change
The model has changed radically in recent decades. Today, there are a variety of stock market types: commodities; commodity futures exchanges, where commodity forward transactions are carried out; and derivatives trading. Further on, there are securities exchanges, the best-known form of trading stocks or fixed-income securities such as bonds; and currency exchanges for the trading of foreign currencies. In the past, no one knew a lot about these businesses. Even that has changed radically in recent decades:

The business with warehouses for aluminum, zinc and copper is rarely in the headlines. For some time, however, these warehouses, which are connected with the London Metal Exchange (LME), have come under criticism. A sluggish, but conforming to LME rules extradition has led to high inventories of metal and rising delivery premiums. The problem first emerged in the aluminum industry, but also the zinc and copper markets are affected. It is said that investment banks are behind the schemes.

Already, the second lawsuit in a short time has been filed against major U.S. banks because of their controversial operations with metals. In the United States, now JPMorgan Chase & Co. and commodities trader Glencore Xstrata Plc, Switzerland, must now take responsibility for excessive aluminum prices. This also includes the U.S. investment bank Goldman Sachs Group Inc. and the LME, which manages a global network of warehouses. They are accused of usury and participation in a cartel.

On A Carousel
The LME supervises more than 700 warehouses worldwide, and dictates to the operators that a certain minimum quantity of goods, depending on the warehouse size, must leave the store per day. The rules refer not to a single deposit, but to all stores in the same city. In addition, the regulation does not define where the goods must be delivered. Rather than sending the goods to the ultimate consumer, the operator can transport goods from one warehouse to another. With this "carousel" the minimum conditions are satisfied, but increase the delivery time for the customers. The LME already responded to complaints about long delivery times and will at least increase the minimum delivery quantity.

Shrinking Sales
A large number of the LME warehouses are in the hands of U.S. banks such as Goldman Sachs Group Inc., Morgan Stanley and JPMorgan, which are now a target of attention for the regulators. In this context, members of Congress and authorities in the U.S. have been watching the role of banks in the commodity business more closely. Following these investigations, a class action lawsuit against Goldman Sachs and the LME has been filed.

Some ten years ago, the Federal Reserve Bank granted financial institutions permission also to physically trade commodities. With this permission, investment banks could fill the gap between the financial markets and the trade of physical goods. As a consequence of the financial hype at the commodity markets, banks bought power plants, mines, fields, refineries, transport infrastructure and also warehouses.

Insider Knowledge (?)
The advantage is that in-depth information on the raw materials market is available only through the ownership of assets. So the banks became more and more competitors to the traditional commodities traders. Some traders had also purchased in the previous production, storage and transportation facilities. In the U.S., one wonders whether institutions that represent a systemic risk should themselves be allowed to engage in commodities transactions.

In response to the governmental activities, some banks have announced they will withdraw from trading commodities or reduce the business. JPMorgan recently announced it would sell parts of its business for physical trading. Last year, Morgan Stanley was looking for a buyer for parts of its commodities business. Goldman Sachs has sold power plant participations. But also the trading of financial products in the raw materials sector dropped. A lower volatility in the markets led to the situation that the bank customers concluded less trading or hedging transactions.

Less Regulated Dealers
The financing of commodities trading transactions was affected by the financial crisis, too. Due to a shrinking confidence, the crisis led to lower U.S. dollar loans from European banks. Fluctuating commodity prices also raised the capital requirements of banks to back the loans. These short-term loans to physical dealers, however, are considered to be relatively less risky and less profitable. They differ significantly from the trade of the banks on a foreign account or their own account.

However, the withdrawal of some market participants means more possibilities for the remaining market players. Competition comes from commodities traders, for example, who hired former investment bankers. Here, the banks object that the trader business is less regulated than business from financial institutions, even though some businesses are identical.

This situation is also reflected in the fact that the commodities traders in recent years recognized the business with warehouses as well. According to Bloomberg.com, Glencore Xstrata, via its subsidiary Pacorini Metals, is the largest owner of LME warehouses, followed by companies such as the Netherlands-based C. Steinweg Handelsveem BV, Goldman Sachs, JPMorgan and Singapore-based Trafigura Beheer BV.

Rather than manage the goods only, a warehouse operator can buy the metals on his own account, store them and sell them at a profit. In recent years, such transactions — which are probably operated by banks, dealers and hedge funds that do not have their own warehouses — became common. The transactions are often financed with debt — a practice which is favored by low interest rates.

In such a transaction, a futures contract is concluded with the customer at the same time. In this case, the selling price of the metal is already fixed and obligates the owner to deliver the goods at a certain time in the future. If the spot price is below the price in the future, it is worthwhile to wait for the sale. The profit for the owner of the metal is equal to the difference between the futures price less and the purchase price including storage and capital costs.

The stored goods provide their owner another advantage: He can deposit the goods for a limited time as a security for loans to carry out more transactions, such as purchasing additional goods. Using this procedure, the profit could be increased. Apart from the low interest rates and the development of the prices, the rules of the LME allow this particular business model.

Artificial Waiting Times
For some time, customers have accused the banks of extending the waiting time artificially in order to achieve higher prices and higher rent costs for warehouse operators. Some of them have to wait up to one year to get their goods. According to calculations of one brewery, these costs of the schemes are estimated at US$3 billion.

But obviously, the financial world is very forgetful: Through the boom on the stock exchanges, primal instincts are awakened. Data of the New York Stock Exchange (NYSE) show that many investors started without considering the risks of a bailment of their stock of shares to borrow loans to further increase their stock of shares. With this dangerous behavior, they want to benefit even more from the stock market boom.

What was the first line of Blood, Sweat & Tears' great song "Spinning Wheel"? "What goes up must come down."

August 13, 2013