Emerging market growth is changing the strategy for the commodities business at the same time that tighter regulation is altering the relationship between banks, merchant traders and investment funds.

Few markets are so global and interconnected in their fundamentals as commodities. Tensions over Iran and the strength of demand in Asia drive oil prices higher, which in turn fuels investment in Brazilian bio-ethanol as an alternative energy source.

But few markets are so localised in their specifics. While the price of the latest fad technology stock is the same the world over, the spread between UK Brent and US WTI benchmark oil prices has rarely been wider, as production and consumption patterns vary by country. This presents banks with strategic dilemmas for the commodities business. It is clear that Asian markets represent a substantial growth opportunity, but exploiting that opportunity is not straightforward.

"Everyone sees the potential, but products and legal frameworks are still very fragmented, which means bank participations in local Asian players are not necessarily delivering yet," says Amine Bel Hadj Soulami, head of commodity derivatives at BNP Paribas. "We see the fragmentation as an opportunity for our derivatives expertise, because we can craft a solution that is better matched to the client’s exposure than the most liquid indices, but less costly than an exact hedge in an illiquid local product."

Physical presence

The need to get the strategy right is acute, because commodities businesses often require large capital investments. Many of the leading banks have increased their capabilities to trade and stock physical commodities.

This is seen as an essential part of their franchise in a market where about 80% of transactions are undertaken by non-banks, including producers, consumers and merchant trading companies. Barclays acquired a stake in Erus Metals warehousing company in mid-2011. JPMorgan’s acquisition of Sempra from RBS in 2010 added physical product suites in oil and metals especially.

Everyone sees the potential, but products and legal frameworks are still very fragmented, which means bank participations in local Asian players are not necessarily delivering yet.

Amine Bel Hadj Soulami

“The acquisition allowed us to have new and more in-depth conversations with clients. Our existing financial product teams already had relationships with corporate treasuries for hedging transactions, but the Sempra team brought with it relations on the procurement side of the business,” says Mike Camacho, head of Europe, the Middle East and Africa commodities business for JPMorgan.

Simon Grenfell, head of metals sales at Deutsche Bank, says physical trading is also becoming more important for non-financial clients relative to derivative transactions. “Accounting changes mean derivatives are marked to market, which introduces more volatility in the profit and loss versus fixed-price physical contracts. And physical trading is potentially beyond the scope of the Dodd-Frank Act and other new regulations imposed on derivatives markets,” says Mr Grenfell.

He is anticipating a binary development in client preferences. Financial clients will want more exchange-traded products to comply with the pressure they are under on reporting requirements and central clearing, whereas industrial end-users will prefer physical markets to avoid the cash-flow implications of managing margin for central clearing facilities.

New competition

Merchant trading companies may fall within the scope of the Dodd-Frank Act’s 'major swap participants' category, requiring them to report and centrally clear derivative trades. But they are definitely not affected by the Volcker Rule that bans banks from proprietary trading activities.

This has fuelled tension between the banks and a key group of commodities clients. As The Banker noted in its previous commodities special report in December 2011, banks have been reducing their credit lines to merchant traders. Capital and liquidity constraints in Europe are a major reason, but bankers also acknowledge off the record an uneasy feeling that they are funding the expansion of their own, less highly regulated, competitors.

Merchant traders have begun to offer traditional banking products, such as credit lines, market-making and risk management solutions, to producers and consumers, as well as poaching investment banking staff. Most recently, Swiss energy trader Mercuria hired two metals traders from Goldman Sachs as well as Barclays global commodities head Roger Jones to lead its expansion into non-oil commodities.

Investor products

Regulatory pressure is also driving the growth of commodity-focused hedge funds founded by departing investment bank traders. In May 2012, three commodities bankers from Société Générale, which is a category one member of the London Metal Exchange (LME), announced the creation of a commodity macro fund called Belaco Capital.

Liquidity and transparency are essential to stimulate the growth of commodities as an investor asset class. Richard Jefferson, head of global institutional commodities sales at Deutsche Bank, expects electronic execution to rise further as regulated financial entities are pushed onto swap execution facilities in the US and organised trading facilities in Europe. “We already offer direct market access to the LME and electronic quote requests via Autobahn Metals, and we are also conscious of helping clients with pre-trade services such as charting, fundamental analysis and research that go into investment decisions, via our electronic platform,” he says.

Deutsche was instrumental in the creation of the first iron ore swap three years ago, which can now be cleared via LCH.Clearnet and the Singapore Stock Exchange, gradually creating increased transparency and volumes. Mr Jefferson says there is growing investor interest at the moment in products that are less likely to be correlated to financial turbulence in the eurozone, including iron ore, coal and power.


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