8/12/2019 Commodity Firms "Too Large to Ignore"
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July 2014 | 1
Maybe not too big to fail but certainly too large to ignoreCommodity traders forced to come out as regulatory pressure increases
Todays commodities traders are more scrutinizedthan ever, but further regulatory change andincreased transparency will remain key topics forthe industry heading into 2015. Commodity tradinginevitably had to emerge from the shadows as majorplayers engaged with global capital markets, suchas Glencore going public in 2011 and Tragura
and Louis Dreyfus Commodities tapping thebond markets in 2012 and 2013. At the same time,international and national regulators have becomeincreasingly interested in classing commoditytraders as non-bank, non-insurer global systemicallyimportant nancial institutions (NB-NI-GIFIs). As aresult, some commodity trading companies seemto be indicating that the time has come to shedlight on their business models in order to avoidunnecessary new regulations. So the question is, arewe now at a turning point for the regulation of the
commodity trading industry? >>
Certainly the relationship between commodity tradingand banking has changed signicantly. Post-2008regulatory constraints have resulted in an increasein investment banks costs of nancing by not onlyrequiring lending institutions to hold higher capitalreserves, but also by imposing new clearing, reportingand transparency requirements. This has had anumber of consequences. In practical terms, banks
have slowed down their capital intensive commoditybusinesses, i.e., commodity trade nance, hedgingand direct investment in physical assets. BNP ParibasCIB, Credit Suisse, Socit Gnrale CIB, CrditAgricole and Santander have retreated or scaledback their commodity activities, although falling protmargins, difcult access to dollars and post-nancialcrisis political pressure have also played a role. Asa telling example, Deutsche Bank, one of the vebiggest players in commodities over the past decade,has almost completely abandoned the sector, as hasUBS.
The rst who sensed this shift were the commoditytrading companies, mainly established in Switzerland(Geneva is world leader in trade nance, handling40 60 percent of global transactions). In order tocope with their existing funding and hedging needs,commodity traders hired bankers who formerlyheaded commodities activities, and some now ndthemselves engaging in traditional bank rolessuch as risk management and energy or commoditynancing. It is worth noting here that as non-bankentities, these commodity traders are able to takeadvantage of less stringent capital requirements anddifferent reporting or transparency regimes. As such,
some parts of the sector are engaging in shadowbanking, as Vitol and Glencore did in 2013 whenthey agreed to lend $10 billion to Rosneft to nancethe acquisition of TNK-BP. At the same time, thinprot margins and erce competition in the physicalmarkets has pushed the largest commodities tradingcompanies to invest in xed assets such as mines,oil elds and pipelines. Some companies still stickto more asset-light strategies of course, but there isa clear trend showing towards extending businesslines and engaging aggressively in upstream anddownstream diversication strategiesfrom theorigination and production of raw and agricultural
products to customization and distribution throughprocessing, rening, storage and transportation.
8/12/2019 Commodity Firms "Too Large to Ignore"
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Despite engaging in up/downstream activities andshadow banking, commodity traders are still seen asnot subject to comprehensive prudential or reporting
regulatory requirements. In addition, they still have ahabit of disclosing signicantly less information thanconventional nancial rms, if they disclose at all, giventhat many of the biggest players are privately ownedcompanies. These companies are often domiciled inSwitzerland where no regulatory remit on the tradingarms of big commodity traders exists. This mighthave worked in the past, but the case for change waswell made in September 2012. Timothy Lane, DeputyGovernor of the Bank of Canada, asked if a largetrading house failure would cause serious disruption inthe commodities markets where it played amarket-making role and if a trading houses losses
due to positions taken in commodities could havesignicant knock-on effects on the wider nancialsystem.
As a result, it seems that international and nationalregulators are now on the verge of imposing greatertransparency and more regulation on the sector.In fact, regulators have a wide range of issues inmind, including shadow banking, systemic risk,nanciarization of commodity markets and marketconduct. Moreover, the more commodity tradersextend their business, the more regulation will touchthem, from country-by-country reporting of taxes and
royalties paid to governments, to trading positionlimits, conict minerals and the environmental impactsof their activities.
This hasnt come out of the blue. The commoditytrading business model has been facing increasedscrutiny since the nancial crisis. At the global level,the Financial Stability Board (FSB) had committed at2009s Pittsburg Summit to improve the regulation,functioning, and transparency of nancial andcommodity markets to address excessive commodityprice volatility. This was followed in September2011 by the International Organization of Securities
Commissions (IOSCO) publishing The PrinciplesFor The Regulation And Supervision Of CommodityDerivatives Markets.These principles were endorsedby the G-20, which in 2012 also created the Energy and
Commodity Markets Working Group, demonstratingthat derivatives are not the only entry point forregulators.
In 2014, the FSB published a consultative documentcalled Assessment Methodologies For IdentifyingNon-Bank Non-Insurer Global Systemically ImportantFinancial Institutions(NB-NI G-SIFIs) that could
include some of the activities of commodity tradingcompanies. Another Swiss-based internationalinstitution, the United Nations Conference on Trade& Development (UNACTD), regularly calls for greatertransparency in the commodities trading sector andclosely monitors the correlation between returns onthe equity markets and returns on commodities futuremarkets.
More broadly, the OECD has been consistentlypushing for more rules on tax and conict minerals.The Extractive Industries Transparency Initiative (ETI),an international standard for openness around the
management of revenues from natural resourcesthat presses governments to disclose how muchthey receive from extractive companies operatingin their country and presses companies to disclosehow much they pay, has been onboarding more andmore countries, companies, civil society organizations,partner organizations, and institutional investors.
In concrete, regulatory terms, the U.S. addressed thecommodities issue with the Dodd Frank Act, and EUlawmakers did the same with legislation on marketinfrastructure (MIFID/R II), derivatives reporting(EMIR), benchmarks (Regulation on Indices Used as
Benchmarks in Financial Instruments), market abuse(MAD/MAR) and stringent rules on wholesale energytrading (REMIT) and conict minerals (Proposed EUregulation on conict minerals from March 2014). TheUK Financial Conduct Authority (FCA) published aCommodity Markets Updatein February 2014. TheSwiss Federal Administration published BackgroundReport: Commoditiesin March 2013 and a StatusReporton the implementation of its recommendationsin March 2014. The Swiss Financial MarketInfrastructure Act recently sent to the Swiss Parliamentis also an important milestone in the regulatoryframework applying to commodity trading.
Escalating pressure for new reporting and regulatoryrequirements for commodity trading companies isreal, potentially even bank-style transparency rules orcapital requirements. Certainly there would be bankskeen to see potential new competitors restricted, andthere are many people in civil society who would liketo manage the risks they now perceive in a previousobscure sector. Furthermore, there is political capitalto be made by being seen to act, e.g., the SwissSocialist Partys youth wing that gathered nearly116,000 valid signatures in April 2014 to organize apopular vote on an initiative entitled No Speculation
In Food Commodities. The vote, due in the next twoor three years, could stop to all trading in nancialinstruments linked to agricultural products in theglobal center for commodities trading.
Switzerland counts about 500 companies withactivities directly related to commodity shippingand trading: One-third of world trade in Crude Oil and
Number 1 worldwide in Grains and Oil Seeds; Number 1 in Europe in Sugar; Number 1 (tied with London) in Cotton; Number 1 worldwide in the nance of
commodity trading; Number 1 worldwide in Inspection and
Certication; 22 percent of global movement of commodities
8/12/2019 Commodity Firms "Too Large to Ignore"
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Driving Global Dialogue
For the moment, answers from commodity tradershave been fairly technical and articulated underpractical risk-based arguments. Accusations of beingtoo big to fail are often countered with concernsthat a new round of regulations might result in a lossof market liquidity, a reduction in customer choiceand the rise of barriers to entry in the market. Whatworries most trading companies is actually a reduction
of liquidity and an increase in bid/offer spreads,due to both higher capital requirements and a pushto using clearing houses to settle trades. Finally,commodity traders have often emphasized that moretransparency, especially on payments to governments,would force them to reveal commercial secrets.
However, there is scope for new approaches. Tragura,one of the biggest players in the sector, has recentlysent a new signal to its stakeholders by sponsoring awhite paper, authored by Craig Pirrong, a professor atthe University of Houstons Bauer College of Business.The scientic paper aims at shedding light on the
commodity trading industry, acknowledging that astrading companies get bigger, lling in the space leftvacant by banks, it is high time for them to engageand explain who does what, and especially how, in thisbusiness. Pirrongs arguments underline the fact thatthe commodity trading sector should be explainingits business in order to improve transparency sothat, ultimately, there will be less demand for newregulation. As a telling example that times havechanged, Tragura came to Brussels to presentPirrongs conclusions that commodity trading housesare not a source of systemic risk. Surely, other bigplayers will follow suit in some fashion.
There is, however, a need to move beyond a strictcomparison between banks and commodity traders.In fact, trading companies might not be too big tofail in banking terms, but they are certainly toolarge to ignore in political terms. Diego Valiante,Brussels-based head of research at the European
Capital Markets Institute, even describes the biggestcommodity houses as too physical to fail. For Diego
Valiante, the up/downstream strategy of major tradinghouses, which have acquired a range of assets atdifferent points along the value chain over the years,paves the way for too much market power. He believesthis will lead to security supply issues for governments,potential temptation towards market manipulation,
possible conicts of interest between businesslines and harmful impacts on the end-users of vitalcommodities, possibly resulting in systemic risk.
Pirrong and Valliante disagree, for example, on theimpacts of the collapse of a commodity trader oroperational discontinuity on the supply chain and themarket, but the academic debate conrms at leastone thing that the sector will have to address as soonas possible: commodity traders have never offeredthe level of transparency required for regulators toconrm that they might not represent a systemic risk.Thus, since their size is increasing and regulators have
started looking into them the only solution to avoidbank-based regulation would be to properly introducethemselves to the public and to policy-makers,eventually ending their reputation as theknown-unknown. Sincere explanation of thebusiness model and the way commodity tradingcompanies create value will build trust and preventnew regulations from putting more burdens on thebusiness.
Even if the benets of transparency might not alwaysseem obvious for commodity trading companies,shedding light on commodity trading activities
will enhance companies long-term value andsustainability. Winning the systemic risk battle will notbe the end of the journey, and as long as commoditytraders continue to grow by acquiring physicalassets such as reneries and oil terminals, proactivediscussions with regulators will be an obligatorystep. However, commodity traders that embrace thenecessary transparency will be free to establish theright dialogue with stakeholders in Basel, Washington,Brussels, London, Bern and Geneva, and will likelynd lasting business advantage by having adapted tobeing too large to ignore.
For more information about these issues, or to learn aboutAPCO Worldwides capabilities in Brussels and across EUmember states, please contact:
Theo Mooresenior directorPhone: +email@example.com
Alphonse Daudr-Vignierproject consultantPhone: +...