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Banks and Commodity Trading: Sell Signals

Thin margins, tough regulations and worries about reputation make trading commodities look like a source of worries not profits for nervous bank bosses. Barclays, one of the biggest in the business, is the latest to head for the exit. This week it announced it would give up most of its metal, crop and energy trading.

Barclays is following JPMorgan Chase, which last month sold its physical commodities division to Mercuria, a private trading firm based in Switzerland, and South Africa’s Standard Bank, which sold its commodities unit in London to Industrial and Commercial Bank of China in January. Morgan Stanley sold its physical oil-trading division to Rosneft, a Russian oil giant, in December, just as Deutsche Bank said it would stop trading most raw materials. Earlier last year UBS decided to shrink its commodities business sharply.

Others, notably Goldman Sachs, are staying firmly in the business and most banks are still buying and selling for their clients. But returns are weak. Commodity-trading revenue for the ten biggest banks was $4.5 billion last year, down from more than $14 billion in 2008, according to Coalition, a research firm.

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That makes commodity-trading an inefficient use of capital at a time when other markets, such as equities, are booming. Margins are scanty, particularly in oil, where prices are boringly stable. Shipping natural resources around the world ties up a lot of money, and profitability comes from using ships, terminals and warehouses efficiently at every leg of the journey, from mine to end-user. Big integrated trading houses are likely to do that better than banks can.

Meanwhile, the dangers are mounting. Commodities trading (especially when accompanied by fancy derivatives) creates complex risks. Regulators and some influential American senators worry about banks being in natural resources at all. When highly indebted financial institutions own big industrial assets, an accident may be a financial catastrophe as well as an environmental one.

Perhaps more ominously, America’s Federal Reserve and other oversight bodies suspect that temptations arise when the same people are involved in a physical market, and thus help to fix prices there, while also trading derivatives based on shifts in those prices. Detecting whether private traders engage in untoward antics is hard, but the authorities can, and do, pore over banks’ activities.

Another cost — and risk — is the network of wily and well-informed human sources needed to gain an edge in commodity trading. Reports of port congestion and equipment breakdowns, security problems, aerial photography (perhaps clandestine) and weather forecasts all help paint the fullest possible picture. Such intelligence-gathering is not part of banks’ core business. And when the information comes from dodgy characters (perhaps with payment involved) compliance officers and regulators get twitchy. It all looks increasingly unattractive, especially for managers with necks cooled by regulators’ breath.

As banks move out of commodities, others are moving in. Hong Kong Exchanges and Clearing, which used to focus on equities, bought the London Metals Exchange in 2012. Now it is planning to offer local futures contracts for zinc, copper and nickel (in Chinese renminbi) and for thermal coal (in dollars).

Hong Kong may find it hard to compete with the big and fast-growing mainland Chinese commodities exchanges in Dalian, Shanghai and Zhengzhou. But few doubt the overall shift in power from West to East, in setting both prices and rules. Shanghai’s International Energy Exchange says it will start trading crude-oil futures this year; similar moves into other commodities are expected. Asian customers recall with bitterness how Western banks cut their credit lines during the financial crisis, leaving them painfully exposed — another mispriced risk in a business which bankers are queuing up to leave.

©The Economist Newspaper Limited, London, April 26, 2014