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McKinney Working Papers on Risk, Number 39 Commodity trading at a strategic crossroad Jan Casher Paul Laszlo Gallinule Quiver December 2012 Copyright 2012 McKinney & Company 2 Contents Commodity trading at a strategic crossroad Introduction and executive summary 1 Changes In global commodity trading: Three trends Imperatives for commodity traders 6 Conclusion 8 McKinney Working Papers on Risk presents Necklines best current thinking on risk and risk management. The papers represent a broad range of views, both sector- specific and cross-cutting, and are intended to encourage discussion internally and externally.

Working papers may be republished through other internal or external channels. Please address correspondence to the managing editor, Rob Monish ([email protected] Com). Commodity trading at a strategic crossroad Introduction and executive summary The global commodity-trading business is a central component of our modern ability to lay off or take on risk. Against a background of rising and uncertain prices for many core commodities In food and Industrial materials, the Industry Is on the verge of substantial change over the next two or three years.

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It Is experiencing eroding margins as competitive intensity, price transparency, and the capital requirements of decrease. Imminent regulatory changes will lead to rising complexity costs and a further toughening of the financing environment, which look set to accelerate the industry transformation. The traditional composition of the landscape, featuring a small number of “professionals” and a large number of “customers,” is also about to change, with an increasing number of players acquiring trading skills.

This will enhance liquidity but will also reduce arbitrage opportunities. Commodity traders should act swiftly now, addressing four imperatives: First, traders need to prepare rigorously for the impact of regulatory changes on the global commodity-trading system. Leaders will have to develop proprietary strategic insights through systematic, analytical business-impact assessments, stand ready to adapt operating models quickly, and seize any opportunities that arise in the transition phase.

Second, contrary to the traditional culture of the sector, traders should put cost control on the agenda of top management. Third, traders should restructure heir balance sheets and explore alternative and innovative sources of capital. This will likely include more radical measures, such as large-scale asset sales, M&A among complementary houses, large private-equity placements and, potentially, Ipso. It will also require a thorough assessment of realistic working-capital costing for transaction evaluation, in those cases where it is not already happening.

Fourth, traders should develop mid- to longer-term company strategies that include substantial investments in differentiating downstream and upstream assets in core and new geographies. The trading units of large commodity producers/consumers will likely find it challenging to attract sufficient support and capital from their parent companies. Smaller independent trading houses are equally likely to struggle to adapt their business models fast enough and continue raising financing at competitively low costs.

The challenge for the largest independent trading houses is likely to lie in seizing the most attractive opportunities in physical and paper markets while embedding these in a consistent and differentiating strategy. Who will be the winners? Those players that have retooled for the new high-cost environment, increased discipline in capital deployment, created strategic clarity, and strengthened their balance sheet accordingly. Winners will have moved quickly to capture M&A or market opportunities.

Success in the future will be at the intersection of much more disciplined capital consumption and careful balance- sheet expansion around physical assets, as well as stronger positions in financial trading. Changes in global commodity trading We can identify three trends that will reshape global commodity trading over the next two to three years. Trend 1 : Increasing competitive pressure and customer pacification is likely to lead to further erosion of the profitability of core trading operations. This is exacerbated by an environment of low volatility across commodity markets. 0 Growing global profit pools, rising profiles of industry leaders, and generally decreasing barriers to entry have attracted a large number of new players into commodity trading. In Geneva alone, the number of contradicting companies This has resulted in higher liquidity but also stronger competition and an erosion of trading margins. 00 Commodity producers become increasingly assertive in the price-discovery recess and in the centralization of their production. Rather than handing this business to trading houses, they are now setting up their own trading units.

For the production they do not actively place, they also increasingly resort to cost, insurance, and freight pricing and self-manage shipping or price risk management. 00 Beyond their initial paper focus, many financial institutions have expanded into physical commodity trading in the past five to ten years. The largest institutions own and operate storage facilities and can enter into long-term off-take agreements with producers 0 As a result of higher competitive pressure, traders must take on more risk. Locking in trading margins in well-hedged positions becomes more difficult.

Trend 2: Given high commodity prices and an increasing need to invest in physical assets, capital needs are set to increase substantially. 00 High commodity prices mean high working-capital needs for commodity traders. Over the last two years the price of Brent crude oil has increased by approximately $40 per barrel. For example, the financing requirement for a very large crude carrier (with carrying capacity of two million barrels or more) has risen by $80 lion. 00 Across the commodity-trading market, the competitive advantage from superior price information has largely disappeared.

For instance, the number of active price quotes on the Plants and Argus platforms has increased exponentially over the past two decades and now stands at almost 12,000 quotes. To protect their margins traders increasingly seek to own and operate physical assets that they arrange into complex end-to-end supply chains. Such supply chains provide access to unique profit pools, for example, sourcing and blending streams to meet local requirements cross the Atlantic basin or to provide turnkey services such as fuel supply and conversion into power for smaller nations.

Some traders are venturing into new territories, such as distribution-system supply and proprietorship (for example, Vito in Africa). Physical assets and end-to-end supply chains also open opportunities to gain access to exclusive and unpublished market information. Hence, while price- reporting agencies are relentlessly increasing price transparency, the informational value of physical-asset ownership is increasing. 00 Traders are also increasingly considering the ownership of physical upstream assets. Such assets are highly capital intensive and illiquid in the short term. 0 As a consequence, the balance sheets of traders are growing substantially? often much faster than income levels. The sustainability of commodity-trading profits now relies more than ever on balancers optimization and continued access to capital (Exhibit 1). This will force trading houses to seek new sources of capital and financing. Trading environments will further drive up financing and transaction costs while also creating new business opportunities for physical players as banks scale down their own commodity-trading activities (Exhibit 2).

Regulation Main regulatory changes Impact on commodity traders Basel Ill (worldwide) Scope: bank companies Full effect: 2018 Transition: from 2013 Delivering of banks’ balance sheets given new requirements Maximum leverage ratio Minimum target capital Minimum liquidity ratio Credit-valuation adjustments Tightening access to financing as ankhs lower trade-finance exposures Less availability of letters of credits, especially for higher-risk counterparts Difficulty to raise syndicated loans Higher costs across all trade-finance products Dodd-Frank Act (US) Scope: “swap dealers” In effect from: July 20101 Stronger regulation of over-the-counter Increasing complexity and cost derivatives intensity of trading operating model Systems and processes upgrades Central clearing and reporting given new reporting requirements Increased working-capital needs Reporting to central trade repository (clearing fees, margin, collateral) Daily mark-to-market/collateral needs Compliance upgrades (tracking trading Trading on organized trading venues thresholds, position limits, etc. Position limits More regulatory oversight/intervention EMIR (ELI) Scope: all derivative trading In effect from: 2013 Miffed 114 (ELI) Scope: systemic financial institutions In effect from: 2014/15 earliest Blocker Rule (US) Scope: banks, financial institutions In effect from: July 2010 Implementation from: Q/20121 Limits to banks’ trading activities Ban of proprietary trading (financial, physical) Potential limits to banks’ ownership/ control of physical trading assets (egg, storage) Changes to competitive set as banks exit/spin off commodity trading Less market making, less hedging tools (further rising trade-finance costs) Banks to spin off commodity-trading units, potentially sell physical assets New opportunities for traders in paper trading, physical assets, M 1 Implementation from: Q/2012 (further clarifications to rule likely after 2012 presidential election). 2 European Market Infrastructure Regulation. 3 Exemption: central clearing not required for trading by “nonofficial’ firms for edging purposes or other trades below a certain clearing threshold. 4 The Markets in Financial Instruments Directive II. 5 Exemptions: commodity traders if trading is an “ancillary’ business and dealing on own account and not a subsidiary of a financial group.

Basel Ill: Global regulatory standard on bank capital adequacy In September 2010, the 620 approved Basel Ill, which will result in substantially increased capital requirements for banks starting in 2013-17 (transition phase) and with full effect from 2018. In particular, Basel Ill will increase capital requirements for trade-finance activities. 0 Under the new leverage-ratio rules, banks will need to fully back trade-finance assets with capital?despite the very low default risk of, for example, letters of credit compared with other bank assets. 00 Established trade-finance banks are already in the process of decreasing the level of their trade-finance activities and increasing the price of their trade-finance products.

To some extent this is due to the short-term nature of trade-finance assets and the relatively low importance of trading houses as bank clients (compared with large industrial corporations, for instance). 0 New trade-finance players, notably banks in emerging markets, will partly fill this void. However, the net effect will still be less access to inexpensive trade finance. This is especially true for syndicated loans. As a consequence, Basel Ill is expected to lead to higher trade-financing costs at a time of rising working-capital financing requirements driven by high commodity prices. Beyond Basel Ill, 620 leaders made a commitment in September 2009 that “all standardized ETC derivative contracts should be traded on exchanges or electronic trading platforms, and cleared through central counterparts by end 2012 at latest.

ETC derivative contracts should be reported to trade repositories. Non- centrally cleared contracts should be subject to higher capital requirements. ” US regulators reacted with the Dodd-Frank Act and European regulators with the European Market Infrastructure Regulation (EMIR) and the Markets in Financial Instruments Directive II (Miffed II). These new regulations will also affect the contradicting sector. Dodd- Frank (US), EMIR (ELI), Miffed II (ELI): Regulation affecting over-the-counter derivatives trading The Dodd-Frank Act brings profound regulatory changes to the US financial market. It has important implications for commodity traders.

It will require central clearing of ETC derivatives and therefore more stringent capital requirements (except physically settled forwards, including book-out deals). It will introduce limitations on leverage and stricter requirements on transparency, risk management, and governance. The Dodd-Frank Act was signed into law in July 2010 and was originally supposed to go into effect on July 21, 2012. However, full implementation has not yet taken place and the act’s future will not be clear until later in 2012 or beyond. In Europe, EMIR brings similar regulatory changes. It will come into effect in January 2013, as no national transpositions are required.

It stipulates the need for central clearance of “eligible” derivatives contracts, stringent trade-reporting requirements, and, importantly, tightened risk-mitigation rules. These rules will lead to increased 00 EMIR will have the most negative impact on those traders that are not forced by their counterparts to post collateral. 00 All traders will have to invest quickly in additional mid- and back-office infrastructure to comply with the new rules by January 2013. Europe also has Miffed II, which foresees changes similar to those set out in EMIR?in fact, the regulations overlap in requiring centralized derivative-trading venues and more stringent disclosure rules.

Miffed II expands on Miffed I through more expansive regulatory oversight of trading positions, stricter position limits, and compliance rules to handle conflicts of interest. 00 While most trading houses are exempt from Miffed l, they are expected to be subjected to Miffed 11. 1 00 Furthermore, the exemption of commodity traders from Capital Requirements Directive IV will be reviewed by December 2014. Should this exemption be removed, the economics of commodity trading will further deteriorate. Dodd-Frank, EMIR, and Miffed II are relevant across country borders. The Blocker Rule applies where any party to a trade is a resident of the United States (for example, foreign subsidiaries of US companies; US subsidiaries of non-US banks).

EMIR and Miffed II will apply not only to transactions among EX. counterparts but also to transactions between two entities established in one or more third-country locations that would be subject to the obligations if they were established in the EX. (the so- allied third-country rule). Blocker Rule: US regulation limiting proprietary trading of banks The Blocker Rule is a specific section of the Dodd-Frank Act. It restricts US banks from making certain kinds of speculative investments. This includes commodities-linked activities. 00 The Blocker Rule stipulates that investment banks (given their conversion into bank holding companies) must dispose of proprietary trading activities, including in commodities. 00 The Blocker Rule also potentially puts pressure on banks to sell their physical commodity assets and storage facilities.

Some estimates predict that banks will earn less than half of their current return on equity in commodity trading going forward. As a consequence, the Blocker Rule looks set to substantially reduce the participation of banks in the commodity-trading business. Other geographies Other major trading hubs outside the 620 are also likely to adopt the requirements of Dodd-Frank, EMIR, and Miffed II. For example, the Monetary Authority of Singapore released a consultation paper in February 2012 clearly stating that its regulations will be brought in line with global rules. As a consequence, there will most likely be emitted latitude for regulatory arbitrage?at least in today’s main trading hubs.

The combination of these new regulations will affect the shape of the global commodity- trading market: 00 Financial institutions will find it much less attractive to engage in successful in the past) will likely try to “save” their business through ring fencing and recapitulating their activities. On December 8, 2010, the European Commission stated that “recent experience with various commodity firms setting up Miffed-licensed subsidiaries and the political consensus to limit exemptions from financial regulation only to necessary cases Leary underlines [that] the former Justification for a specific exemption from Miffed for commodity derivative trading houses is no longer valid. According to the draft of Miffed II, exemptions will in the future only be provided to players that trade for hedging purposes as an “ancillary activity’ to their main business and qualify for one of three primary business categories: dealing on own account, providing investment services to other group companies, or providing investment services to clients of the main business. A prerequisite for qualifying as an ancillary activity is that the many owns significant physical commodity-trading assets relative to the volume of derivative trading. 5 00 Physical players will need to shore up their balance sheets. At the same time, the retreat of banks will create opportunities for them to step into the financial-services arena more broadly. 00 Finally, new regulations will result in lower liquidity and fewer counterparts in select derivatives markets.

Market observers state that the response from the commodity-trading community has been disparate and fragmented, reflecting a lack of collective representation, and also probably for cultural reasons. In the absence of an established representative body, the leaders in the industry have not created a unified response to regulators. Commodity trading is still shrouded in a culture of secrecy: it is anathema for many traders to divulge their economics, hence a wider reluctance to discuss the cost impact of regulations. We believe commodity traders should take four immediate steps: Imperative 1 : Rigorously prepare for the impact of regulatory changes on the global commodity- trading system. 0 Develop proprietary strategic insights through systematic, analytical business-impact assessments. Traders must anticipate changes in global market structures based on a solid understanding of how banks and smaller traders will be affected. Leaders will act decisively on new business opportunities, especially in paper trading and physical-asset acquisitions 00 Stand ready to adapt their own operating models. As capital becomes scarcer and more expensive, leaders will continue to pay particular attention to optimal capital allocation. At a minimum, traders will take a book-by-book lens and optimize capital consumption across books (for example, North Sea cruder versus Med

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