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Trading housesInvestment banks entering the
metals trading space ace compe-
tition not only rom incumbent
banks, but rom a large number olong-established independent
trading
houses such as Glencore, Sempra and
Louis Dreyus t rading houses that are
not subject to the same regulatory restric-
tions as investment banks.
Its an interesting time in the market
in that the marketplace is populated by
a variety o dierent concerns all oper-
ating within vastly di erent mandates and
controls, says Silbert.
Trading houses trade physically as well as in
the nancial base metals market. Banks rarely
trade physical, even i they hold or nancephysical assets.
Customers who want a physical delivery
element in a trade would thereore preer to
go to a trading house.
From a regulatory perspective, trading
houses are able to act in ways that banks
cannot, says Russell Plackett, head o metals
products at BNP Paribas.
Banks must look at the use o capital more
closely and the credit process at a bank is
more ormal than at a trading house.
Structuring expertiseAt the same time, however, the strong
credit
o an investment bank is an advantage.
Trading houses will a lways be disadvan-
taged by their credit rating, says one trader
at a European investment bank. Some
compete with the same kind o business
models, but without the credit rating, or the
inrastructure, or the ul l range o products.
For price risk management, says the trader,
corporates generally insist on using counter-
parties with at least an A+ credit rating in
other words, investment banks.
As a result, bankers dont admit to losing
too much sleep over the possibil ity o being
outmanoeuvred by more fexible
trading houses.
There will always be activities that
smal ler players can do that banks cant, but
these represent a small portion o the oppor-
tunity set, says Silbert.
A signicant part o the opportunity set is
the growing market or structured products
in the commodities markets, including
base metals. Here, banks
with experience in structuringproducts in other markets have
a
competitive advantage.
Hybrid products, which hedge price risk
exposure to multiple commodities at the
same time, al low corporate hedgers to
take advantage o the correlation between
dierent commodity prices to lower
hedging costs.
The heart o this market is driven by
corporates with hybrid industrial processes
that hedge themselves with hybrid nancial
products or example, a steel producer
that hedges both its base metal and
energy costs in one hedging product.
Such structured products can yield
high margins or banks.
Today, the commodities market is more
dynamic than other markets in terms o inno-
vation. New cross-commodities products,
as well as hybrid products with commodi-
ties components, have been introduced to the
market because o the recent interest rom
the nancial sector in a market original ly
designed or industry, says Jihad Al-Chaer,
projects manager or commodities at sotware
provider Sophis.SGs Neviaski predicts that
the next generation o hybrid products or
corporates will link companies credit with
commodity prices.
In the base metals market, this could apply
to mining companies, whose creditworthi-
ness depends heavily on the market price o
the metal they are producing.
A second actor driving bank participa-
tion in base metals is the increased investor
appetite or commodities as an a sset class. It
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22 special reportmetals trading May 2007
Banks and base metals
$200 million is a good year in metals,which is well short o what
banks
are making in energy.Anonymous trader
is now common or banks equity derivatives
businesses to expand into the commodi-
ties space, in response to the desire o their
clients to diversiy their portolios rom
equity into commodities.While the UKs Barclays Capital is
recog-
nised as a market leader in commodity
investor business eld, in general it is the US
banks that have developed their commodity
trading businesses rom this investor perspec-
tive. Several US banks, such as Bear Stearns,
also have signicant hedge und and prime
brokerage businesses.
But now many European banks, tradition-
ally more ocused on the corporate side, are
targeting investors.
Speculative money attracted to metals
has grown massively, says SGs Neviaski.Corporates are our
natural customers but
or the past couple o years we have decided
to attach an investor commodities business
that serves both hedge unds and traditional
investors.
Well balancedWe are now well balanced between corpo-
rate hedging and investor business, adds
Franois Comes, head o metals
trading at SG.
Deutsche Bank also has both corporate
hedging and investor businesses, marketed
separately but traded by the same desk.
As a bank, we see investors who want
exposure to metals and we look or ways to
package and sell them products that match
their risk appetite, says Silbert. This
activity fanges nicely with our corporate
hedging programmes where some o that risk
can be sourced.
Again, banks are able to distinguish
themselves in this space by vir tue o their
structuring expertise. Both traditional inves-
tors and hedge unds have shown an interest
in hybrid investment products. A common
hedge und strategy is to a rbitrage between a
set o commodities and the equity o corpo-
rates that use those commodities.
Silbert notes, however, that while investor
business creates a sort o baseload demand
or metals trading, the bigger transactionscome rom corporate
business: Right now,
the corporate hedging side o the business is
driving the bus.
PitfallsThere are clearly opportunities or banks
that get the base metals trading ormula
right. But there are also pitalls the market
is less ecient and less liquid than other
commodity markets, while there is a history
o gamesmanship in it.
The base metals market is not as well
behaved as other markets, says one trader.The same ideas about
air play dont exist.
Liquidity is perhaps the key issue.
More people are coming in, but a ew have
pulled back, says Plackett, citing HSBC as
an example. Its not like the FX market,
with near-innite liquidity.
The infux o banks into the space
over the past ew years hasnt necessarily
increased liquidity, he argues, as not all new
participants are committing risk capital to
the market.
This lack o liquidity is not helped by the
act that, unlike in other commodity markets,
there are no recognised market makers in
base metals.
There is very little market making and
ew liquidity providers, explains SGs
Neviaski. Banks are not keen to provide
liquidit y to other banks I dont think the
market will change.
On a more prosaic level, some report that
the limited amount o experience in the
sector makes it dicult to sta up.
Hiring is a challenge, as banks like to hire
rom other banks, says one market partici-
pant. I you really want to get into this
space, you will need to look in more uncon-
ventional places.
Finally, the stakes in the base metals market
simply dont match those oered in some
other commodity markets.
Its not a market or the aint-hearted and it
wont make the returns you see in energy,
says one trader. $200 mil lion is a good year
in metals, which is well short o what banks
are making in energy.
