As many (but not all) banks reduce their paper and physical commodity market activities, it is often suggested that commodity trading firms like Glencore, Vitol, Trafigura and Mercuria will step into the breach, and become swap dealers offering customized risk management structures to clients (and loans to customers to boot). Mercuria CEO Marco Dunand says his company is exploring that:
Last month Swiss trading house Mercuria completed the purchase of U.S. bank JPMorgan’s physical commodities unit. It now wants to expand its provision of hedging services to external customers.
“There’s the desire for the company to enter a bit more into the space of customer service – trying to see whether we can offer some solutions to clients, primarily in Europe,” Dunand told the annual Reuters Commodities Summit.
Others, including Trafigura’s Pierre Lorinet, expressed skepticism.
When asked about this over the past several months, I have been firmly in the skeptic camp. It all comes down to balance sheet.
Yes, commodity traders utilize paper markets extensively, but as hedgers to reduce risks. This allows them to deploy their capital, and leverage it, so that they can carry out their core transformation activities: logistics, storage, processing, and blending. They are really buy-side firms, with relatively thin capital bases.
Derivatives market making, particularly in long tenor deals, or structured ones, is a very capital intensive activity. Indeed, one of the reasons that some banks are cutting back is that particularly in the existing regulatory environment, the capital commitments for this business make it difficult to operate profitably. If Barclays can’t make money, how can Mercuria?
I can see joint efforts between banks and commodity traders in offering such products, in the same way that banks and traders collaborate to provide commodity prepays. But in those deals, the risk participation of the traders is usually 10 percent or less. Maybe something similar will evolve with commodity derivatives, where the trader faces the customer but most of the risk-and the capital to bear it-resides on bank balance sheets. Perhaps clever bankers will be able to find ways to engage in capital arbitrage in these kinds of deals, but I doubt it.
There is another big impediment: Frankendodd and its European equivalents. Under Dodd-Frank, becoming a swaps market maker brings with it a variety of burdens, including reporting requirements, and most notably capital and collateral requirements. Capital requirements are an anathema to trading firms, precisely because they are typically very capital light. They are also not keen in tying up working capital in margins. One of the factors that drove “futurization” in energy derivatives is that due to the swapaphobia of Congress, swaps were subject to more onerous treatment than swaps: to avoid becoming swap dealers energy market participants eagerly stopped using swaps and switched to economically equivalent futures instead.
The trading arms of two oil majors-BP and Shell-have become swap dealers and will offer risk management products to customers: they were so big, that it was likely infeasible to escape the swap dealer designation. Cargill has become a swap dealer as well, and will make markets. But these are large, asset-heavy firms with the balance sheets to carry these sorts of activities. Although I could see Glencore making a similar choice, I can’t see the rest of the big traders doing the same.
Banks and commodity trading firms are fundamentally different. They are both intermediaries that engage in various transformations, but the transformations that banks and traders perform are quite different. Banks are in the business of bearing credit risk and intermediating market price risks (e.g., by hedging in listed markets exposures they assume through OTC transactions). Traders are in the business of transforming physical commodities. Traders are natural customers of banks, not competitors in credit and risk intermediation. These different functions mean that banks and traders have different capital structures. This further means that it commodity traders cannot readily step into functions that banks exit or cut back.
So methinks banks will remain banks, and traders will remain traders.