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22 July 2013

Free to Trade?

My general approach to life is that in principal, people should be allowed to do what they want. The caveat, of course, is that that is valid, as long as what they do doesn't harm anybody else. If it does, it falls into the category of crime, or anti-social behaviour, or however you choose to define it.

Nevertheless, I quite like the idea that the US regulators are intending to take a look at the issue of banks being directly involved in trading physical commodities. Over the last ten or twelve years, the powerhouse international banks have become some of the largest players in both the metals and oil industries, both physical and derivatives. There is a certain logic to this, given that these trades are both high value and often long-dated. So it makes sense that the counterparties would welcome a bank balance sheet on the other side of their trade. They can take comfort from the financial security that offers.

Liquidity Providers

Banks provide liquidity as well. Their position-taking – both in futures and physical – has been of vital significance in the growth of commodity trading volumes over the same period. Without them, the commodity boom would have had a more difficult life.

Now, in recent years, the banks have (rightly or wrongly: I make no comment on that) come in for an awful lot of criticism, often questioning how effective they have been at certain areas of their business. In the commodity field, though, it is inescapable that they have been massively successful; just look at the cumulative profits generated in industrial commodities in recent years by the major commodity banks. It’s a big number.

Regulators taking a long hard look

So why would I welcome the regulators taking a long hard look at their activities in commodities? Well, I guess the answer, paradoxically, is that they have been too successful, with a number of unintended consequences. The thing is, if you have a very large balance sheet, and you find a trade that looks profitable and satisfies your risk criteria, then you will do more and more of it; and why not? It’s profitable, secure and you’ve got plenty of money to throw at it. That philosophy works very well in those markets like interest rates or F/X, where liquidity is, in a way, quasi-infinite. In industrial commodities, though, the effect is somewhat different, and the investment of very large amounts of money into a market with restricted liquidity creates different sorts of pressure. Look at the aluminium market if you want confirmation of that. The willingness of banks – amongst others, I know – to throw money at that commodity has distorted the normal supply/demand structure of the market. Yes, it makes money for the financiers, but it also creates a disequilibrium which will take a long time to resolve.

Within the rules

We have to be careful here; despite squeals of protest from some quarters, what the banks are doing here is not wrong; it’s quite within the rules. The problem evolves because governments are not willing or able to control the use of the new money they are digitally creating; it doesn’t go into loans to develop industry, which is what they would like, it goes into creating asset bubbles, as the money itself is devalued. So in the interests of, hopefully, seeing the markets for industrial commodities presenting a more rational reflection of the supply/demand picture, we should welcome the regulators taking a closer look; perhaps they will understand that it’s not only futures that can influence markets.

Benefit for the big traders

As always, though, we should beware of unintended consequences; pushing the banks with their financial clout out of physical trading will create a void that the few mega-traders will be only too willing to exploit. They have the money and the balance-sheet strength to do a lot of the resource industries’ banking business, as well. They are the ones who will score any big benefit from changes.

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