FT Alphaville " The dawn of systemically important commodity traders Presenting some very insightful comments about developments in commodity financing from a speech by Timothy Lane, deputy governor of the Bank of Canada, given to the CFA Society Calgary on September 25. Emphasis, FT Alphaville's: One area, however, in which some banks have been maintaining, or even expanding, their activities is in the physical side of the commodity business, increasing holdings of physical products and investments in the supply chain. These activities are more akin to those traditionally being undertaken by the commodity trading houses themselves. Recently, investors have also grown more cautious, pulling back their commodity-related investments. Commodity-related assets under management have declined, reducing another financing flow into commodities trading (Chart 5). As banks have scaled back their involvement in commodities, commodity trading houses have grown in importance and have changed their funding models. Some commodity companies have begun tapping the capital markets for the first time. Sales of investment-grade bonds by commodity companies are up 90 per cent over last year, and commodity-linked junk bonds have risen by an estimated 40 per cent so far this year. As commodity traders have increasingly been funding themselves directly through the capital markets, they have been making greater use of innovative financing tools. Some have used hybrid or convertible structures, and (particularly in Asia) have been making broader use of collateralized financing. In Europe, some banks are using structured trade credit insurance as a means of deleveraging while also remaining active in the commodity trade in emerging markets. Another development that partially reflects these changes in financing conditions is the wave of mergers and acquisitions that has been sweeping the commodity-trading sector. In a number of cases, the logic of these transactions is to bring trading houses and producers together. That's not a new business model - indeed, the oil majors have had their trading operations for many years. But it is an increasingly attractive one in the current climate of dwindling bank financing for commodities. Lane also offers some thoughts on the possible implications of these developments: The flows of financing for commodity trading activities can affect the liquidity and efficiency of these markets and thus the extent to which prices reflect those fundamentals. As well, the financialization of commodities has the potential to affect the degree of short-term volatility of the markets. Although it is too early to assess the implications of the recent changes in financing patterns I have been describing, these developments bear watching. A second set of issues pertains to systemic risk. In particular, the large trading houses, together with the physical trading operations of some large investment banks, are playing an increasingly prominent role in a number of commodity markets. This raises the possibility that some of these institutions are becoming systemically important. Just as the 2008 financial crisis revealed the need to assess the systemic importance of institutions that play a central role in particular financial markets, we should be asking the same questions about institutions that are interconnected with various commodity markets. And systemically speaking... Could the failure of one of the large trading houses cause serious disruption in the commodities markets in which it played a market-making role? And, could the losses that a trading house incurs through the positions it has taken in commodities have significant knock-on effects on the financial system? We are far from having answers to those questions, but they need to be addressed. Third, commodities trading can potentially be an important link between the financial system and the real economy. With the financialization of commodities, financial system stress has the potential to affect commodities markets. Commodities markets, in turn, have an important influence on the economic outlook of a commodity-rich country such as Canada. Moreover, movements in commodity prices may pose risks to the financial institutions that channel funding to commodity-trading activities. We wonder whether he had any specific "systemically important" commodity traders in mind? Who was it again that was recently active in Canada? The name, temporarily, escapes us ... Related links: Commodity encumbrance and Joseph's storage play - FT Alphaville Glenstrata extends - FT Alphaville Outing the aluminium squeeze, Deripaska style - FT Alphaville This entry was posted by Izabella Kaminska on Wednesday, September 26th, 2012 at 17:48 and is filed under Capital markets, Commodities. Tagged with commodities, commodity traders.