Commodities: for Whom the Bell Tolls

Richard Firth[1] has been kind enough to provide us with his insights into the news that Barclays, following the example set by a number of other global banks, looks set to wind down its commodities trading business.

Last Rites

Over the Easter weekend, the Financial Times reported that Barclays, for long the star of commodities trading among European banks, was understood to be preparing the funerary rites for its commodities business. In a memo released by Barclays yesterday, that state of affairs was confirmed.  We had been hoping for our friends and former colleagues at Barclays that the quote attributed to Mark Twain “Reports of my death have been greatly exaggerated” would be applicable[3].  But it was not to be.

However, a demise will not  be totally unexpected.  The symptoms of terminal decline have been evident for a while.  Notable was the departure in 2012 of Barclays’ commodities trading chief, Roger Jones to Swiss trader Mercuria which remains one of the biggest in a series of moves by commodities traders from banks to trading operations.[4]

FCA’s Feb 2014 Commodity Markets Update

The reasons for this sad state of affairs are readily to hand and many of them were set out in the February 2014 Commodity Markets Update published by the Financial Conduct Authority[5]. Those reasons include:

1. The declining interest in doing business by customers of the commodity investor solution sales desks in banks as: (a) there was less volatility in the commodity markets; (b) prices of commodities started to be correlated to the prices of other assets, rather than the negative correlation which was more common before the general 2008/9 collapse; and (c) the equity markets in some developed countries started significantly outperforming  the commodities sector as a whole;
2. Again, in relation to the commodities sales desks, the perceived end of the commodity price supercycle significantly lowered the anxieties of end-use consumers in relation to commodity prices, lessening their needs for elaborate hedges;
3. The facing by commodity desks of risks unique amongst the FICC desks[6] on the trading floor of a bank. As the update observed: “Commodity market activity creates a specific set of material risks for firms peculiar to this market, largely due to the interaction between financial market activity and the physical product, unregulated counterparties and developing jurisdictions.  Issues such as market abuse, management of information flows, conflicts of interest and mis-selling risks to corporate clients and to investors can therefore  arise in different ways to other asset classes.  Market participants  also face environmental risks where they are involved in the transport and storage of physical commodities…financial crime risk can arise in relation to compliance with sanctions regimes, lack of understanding  and awareness of bribery and corruption risks…”
4. The rise in regulatory costs associated with a financial institution undertaking a commodities business, as one of the asset classes most affected by regulatory change.  Regulators have imposed tougher standards on trading businesses, including the European Market Infrastructure Regulation (Emir) and US Dodd-Frank Act – both of which involve mandatory clearing and reporting for over-the-counter derivatives;
5. Anticipated more stringent capital requirement: the Basel Committee on Banking Supervision has inflicted more stringent capital requirements in the form of Basel III, parts of which are particularly harsh for commodities trading; and
6. Enforced remuneration restrictions.

Diversity and Highly Specialised Nature of Underlying Products

Not mentioned in the FCA update but which is also most relevant is the extreme diversity of the products which make up the commodities asset class. For example: “Freight” (the rate paid for transporting commodities at sea) is traded totally differently from precious metals.  Gold is traded and stored totally differently from base metals.  This extreme diversity in underlyings led to difficulties in attracting and retaining for some products a critical mass of suitably experienced staff.

Simon Firth at Linklaters reckons – and having written a book on derivatives of many hundreds of pages, Simon should know – that commodities are the most difficult to handle of all the various derivative underlyings.[7]  Similar sentiments have been uttered by the Chartered Financial Analyst Institute[8].

The King is Dead: Long Live the King!

It is not all doom and gloom. A number of smaller and regional players are becoming a more significant force in the commodities markets, including:

• ABN Amro
• BTG Pactual
• Canadian Imperial Bank of Commerce
• Macquarie
• Sberbank
• Standard Bank
• Standard Chartered Bank; and
• Wells Fargo.

In a very informative article, Gillian Carr explained last week[9] “Standard Chartered and Macquarie have already leapfrogged many more prominent commodity banks in terms of revenue, according to UK-based research firm Tricumen[10].  Both banks generated more than $350 million of revenue from commodities in 2013, putting them in the same peer group as Barclays and Bank of America Merrill  Lynch…That puts them ahead of other major global banks such as BNP Paribas, Citi and Credit Suisse, which earned more than $200 million in revenue from commodities during 2013, according to Tricumen.  Wells  Fargo, a major US bank that has historically not had a heavy presence in commodities, also made more than $200 million in revenue in during 2013, says Tricumen.”

 

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