and should therefore be treated
differently.
REGULATORY OVERSIGHT AND SYSTEMIC RISK
In the wake of the financial crisis, all major categories of intermediaries have come under intense scrutiny as potential sources of systemic risk. Prior to 2008 there had been little interest in global commodity trading firms (CTFs); they attracted much more attention in the aftermath. Regulators have focused on private firms, such as Trafigura, Cargill, Dreyfus, and Vitol; on public firms like Glencore and Archer, Daniels, Midland; and on the trading arms of major energy companies, including BP and Shell. Some regulators have suggested that some of these firms are ‘too big to fail’, and therefore pose a threat to the stability of the financial system, which would necessitate subjecting them to additional regulation, akin to that imposed on banks.
TRADING FIRMS ARE DISTINCT FROM BANKS
A comprehensive appraisal of the economics of commodity trading, and the structure of CTFs (and in particular their balance sheets), demonstrates that these firms do not pose systemic risks similar to those inherent in large, highly leveraged financial institutions. Trading firms are intermediaries that undertake various transformations of physical commodities like oil, metals, and grain, but the transformations they perform are very different than the transformations that banks undertake in their role as financial intermediaries.
They do not, as a rule, engage in maturity or liquidity transformation, which are core banking activities, and the ones that pose the greatest systemic risks. Nor do they serve as market makers for commodity derivatives contracts. Trading firms pose few, if any, systemic risks. They are fundamentally different to banks, and should therefore be treated differently.
THE SIZE AND STRUCTURE OF TRADING FIRMS
Trading firms have resilient balance sheets and are smaller than banks: • Even the largest trading firms are far smaller than banks that have
been identified as ‘Systemically Important Financial Institutions’. In particular, all but the largest have assets below the USD100 billion level identified by Financial Stability Board as a threshold for potential systemic importance.
• Trading firm balance sheets are not fragile in the same way that bank balance sheets are. The maturities of assets and liabilities are well matched, and many CTFs have more short-term assets than short- term liabilities. Moreover, they tend not to be highly leveraged: trading firm leverage is of a similar magnitude to that of the average non-financial firm in the US. These features make them less vulnerable to destabilising runs.
• Trading firm assets that are funded with short-term debt, such as oil and grain inventories, are generally highly liquid, and hedged. • Although trading firms extend credit to customers and suppliers,
these loans are typically structured or insured so that banks bear the bulk (upwards of 90 percent) of the credit risk.
• Historically, trade credit has experienced extremely low loss rates. • To a limited degree, CTFs engage in ‘shadow banking’ transactions
(eg, securitisation of trade receivables) but these invest in liquid assets, and do not engage in maturity transformation, which has been the greatest risk of other shadow banks.
TRADING FIRMS AND MACRO-ECONOMIC CONDITIONS
CTF profitability is relatively insensitive to macro-economic conditions, and the wider economic consequences of a trading firm bankruptcy are likely to be limited:
• Trading firm assets are highly redeployable. The financial distress of a trader does not reduce substantially the capacity of the trading sector to transform vital commodities in space, time, and form. A distressed firm’s assets can be transferred to others, or operated under bankruptcy protection. This is fundamentally different from banks, which are sharply constrained in their ability to provide intermediation services, and, most notably, provide economically vital credit, when in financial distress.
• Even though commodity prices are highly sensitive to macro- economic conditions (they collapsed during the late financial crisis, for instance, and have declined sharply in 2014) CTF profits, margins and volumes are far less so. This is due in large part to the fact that the supply and demand for most commodities is highly inelastic, meaning that shocks tend to affect prices more than volumes. Moreover, many trading firms have internal hedges: for instance, although profits in trading tend to decline during downturns, profits from storage tend to increase. The performance of profits and margins over the dramatic 2006-10 commodity cycle illustrates this: during this period, trader profits and margins remained relatively stable, and did not plunge in 2008-09 like bank profits. This stability in profits occurred despite extreme commodity price movements during this period: the price of oil rose from USD60 in 2006 to USD148 in July, 2008 before plunging to USD35 in December, 2008 and recovering by mid-2009.
• Low-price environments associated with weak economic conditions (such as during financial crises) actually have some benefits for CTFs. In particular, working capital needs are substantially smaller in low- price environments.
• Trading firms are large users of commodity derivatives markets, but almost exclusively as hedgers. Speculation is usually limited to spread trading. What is more, traders do not make markets in commodity derivatives, and their derivatives positions are predominately collateralised. They are buy-side not sell-side firms. They are unlikely to replace banks as market makers in commodity derivatives, even as some banks reduce their participation in commodity markets.
• On those occasions when a large number of CTFs have suffered severe financial distress, there were no spillover effects in the real economy. The merchant energy meltdown of 2002 in the US is a prominent example.
CONCLUDING REMARKS
In brief, economic and financial considerations strongly suggest that CTFs do not pose systemic risks either as an original source of contagion, or as a channel by which contagion is spread. Although they provide intermediation services, and engage in a variety of transformations, these services and transformations are fundamentally different than those undertaken by financial institutions that have been the sources of systemic risk in the past. CTFs are more analogous to non-financial firms than financial intermediaries. As such, there is no basis to subject them to a regulatory regime designed to mitigate the systemic risks posed by financial institutions that perform very different economic functions and which have very different balance sheets.
Professor Craig Pirrong
Professor of Finance, Bauer College of Business, University of Houston
THE ECONOMICS OF COMMODITY TRADING FIRMS
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the-economics-of-commodity-trading-firms/
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