FT/Kaminska: Financial intermediation and shadow banking through commodities

28 April 2014

Writing for the FT Alphaville Blog, Izabella Kaminska reviews Craig Pirrong's white paper on the economics of CFTs, concluding that commodity trading firms are not systemically risky because they do not engage in the sort of maturity transformation that banks do.

Overall conclusion of the paper: commodity trading firms are not systemically risky because they do not engage in the sort of maturity transformation that banks do. They also tend mostly to operate on a hedged basis, via "basis trade" exposure. Short-term assets meanwhile are funded with short-term debt while long-term assets are funded with long-term debt, meaning the institutions are not heavily leveraged at all, though balance sheets are exposed to liquidity or rollover risk.

Counterparty exposure, meanwhile, is dismissed as insignificant because of the general use of central clearing within the industry. If there is credit risk, Pirrong notes, it primarily arises from the 15 per cent of Trafigura’s transactions that are uncleared OTC trades. But these are transacted with a varied amount of counterparties, consisting primarily of prime financial institutions and large physical participants on a credit quality basis.

The report also highlights the rise of "non-traditional" short-term financings which could be characterised as shadow bank transactions.

Pirrong writes: "These include the securitisation of inventories and receivables, and inventory repurchase transactions. Borrowings secured by inventories pose limited credit risk to the lender, especially to the extent that these inventories are in relatively liquid commodities (e.g., deliverable aluminum held in an LME warehouse) and are located in jurisdictions where there is little risk of perfecting legal title; borrowings secured by less liquid commodities, and in some jurisdictions, pose greater risks. Commodity receivables that back some securitisation structures historically have exhibited very low rates of default, and rates of default did not rise appreciably even during the 2008-2009 crisis period. Moreover, these structures do not generally exhibit the maturity mismatches that contributed to runs on the liabilities of some securitization vehicles during the financial crisis. Indeed, in some of these structures, the liabilities have longer maturities than the underlying assets, meaning that the challenge they face is replenishing the assets, rather than rolling over the liabilities."

These non-bank financing vehicles may become increasingly important because broader financial trends may constrain the availability of, and raise the cost of, traditional sources of transactional financing. Historically, banks, and especially French banks, have been major suppliers of credit to commodity trading firms; five banks, three of them French, are reported to provide 75 per cent of the commodity trade finance for Swiss-based trading firms. Deleveraging post-crisis and dollar funding constraints on European/French banks have led to a reduction in bank extensions of commodity credit. This has led to increases in funding costs and reductions in the flexibility of credit arrangements. The impending Basel III rules impose greater capital charges on commodity lending and trade finance generally, which could further reduce bank supply of commodity credit.

There is also an interesting section on the role of commodity trading firms as financial intermediaries, in which the funding arrangements used by CFTs are discussed in some detail. These are often focused on prefinancings and prepay structures.

Full blog post

Craig Pirrong’s white paper on the economics of commodity trading firms (CFTs) can be found here.

© Financial Times