Over the past dozen years or so, the major banks have probably been the most influential force in the commodities game.
More than any other participant, they have been responsible for shifting what is essentially a relatively straightforward business of moving metal around the globe from producer to consumer and providing a price-risk hedging mechanism, further and further into the realms of exotic derivative products.
The jury is still out on whether or not that has been a positive step.
Some anecdotal evidence suggests that the more exotic the derivative, the less effective it has been for the customer – but we can be charitable and say that the universe of possible trades has been expanded for users of the market.
In truth, though, the big benefit of the institutions in the market has been the liquidity they have provided, thus helping hedgers and, indeed, investors to operate.
Regulatory changes take their toll
But changes in regulation are beginning to bite. Proprietary trading by the banks is now the enemy of regulators and their political masters, and we can see the consequences.
Barclays and Natixis, for example, have announced reductions in their metal trading operations; Goldman Sachs have reduced commodity value-at-risk (VAR) to levels last seen around 2004 (although I appreciate that does not necessarily indicate a reduction of activity: a decline in market volatility would also produce a shrinking VAR number, so that figure has to be used with caution). Others are also quietly winding down some of their commodities trading operations.
Even if some choose to ramp up (less regulated) physical trading, the reality is that the substantial liquidity provided to the London Metal Exchange market by the banks will not be there once the new regulations have taken full effect.
Now, some will undoubtedly hail that as a move in the right direction, a recognition that it is a market for the physical users, not a financial casino.
Unfortunately, that argument is one of those toothpaste-back-in-the-tube ones.
The liquidity that the reduction of bank activity threatens needs to be replaced; hedgers and investors alike need to be able to conduct their operations against a (relatively) stable platform.
Who will take over?
So what we have to ask is who will step into the gap left by those departing banks?
Well, there seem to be two categories of candidates.
The major physical traders, with their growing financial power and their ability to stand outside the regulatory framework constricting the banks are obviously in pole position. They have the industry knowledge, the weight of their physical involvement and, crucially, with a very few notable exceptions, their ownership, which is still in private hands.
Last year Metal Bulletin reported on moves by companies such as Agrifert and Gunvor to ramp up their activities in base metals. Given those advantages, expect to see the physical traders expand further into the gap.
Added to that are those kind of hybrid operations, emerging out of the hedge fund and private equity space to take a more specialised role in trading in commodities.
It’s difficult to judge the decade or so of bank dominance we have been through in the commodities business – there is little doubt that for those who did it well, it has been a major money-earner, both corporately and personally. It’s undoubtedly raised the profile of the commodity sector, both to investors and regulators.
But I do think the activity in trading is coming to its end, as banks revert more to their traditional role as financiers of commodity transactions. However, given that the financing of the warehouse trade is the biggest deal – in metals, certainly – at the moment, it’s pretty clear they’ve still got a big part to play.