Are commodities traders 'too big to fail'?

When the banking industry's top lobby group commissioned a report by on commodity trading houses the idea was to show trading houses like Glencore Xstrata, Vitol or Cargill were "too big to fail" and therefore needed to be regulated in a similar manner to the banks.

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But the debate hasn't ended.

A separate report published in July by the Centre for European Policy Studies, a think-tank, argued the growth of commodity trading houses, which underpin the global trade in raw materials could "have systemic" implications.

Commodities trader Trafigura has become the latest to wade into the debate. In its recent prospectus to a €500m bond issue, the world's second largest metals trader and third biggest oil trader, addresses the GFMA report as well as the issue of systemic risk.

Making some tart observations, the trading house says the GFMA paper was aimed squarely at the Financial Stability Board, a group of global regulators.

"[The report] was widely seen as a tactic by some banks active in the commodity trading space as a way of creating more equality between market participants by seeking to usher in further restrictions on pure commodity trading companies," the prospectus says.

But its core argument is about financing. Just because trading houses play an important role in extending credit to producers from miners to farmers, it does not make them shadow banks, Trafigura says. What's more, they don't offer dangerous securitisation structures similar to the ones that almost brought the financial system crashing down.

Commodity traders typically "fund volumes of yet-to-be produced commodities in exchange for receiving the products when produced or extracted", it says.

"The products are essentially collateral for the financing provided to purchase future production," adding, "the performance and the credit risks of the producers are covered in most instances by insurance policies limiting the exposure of the commodity firm extending the credit."

As for securitisation, the prospectus claims the deals done by commodity traders don't involve the kind of complex products such as structured investment vehicles (SIVs) or collateralised debt obligations (CDOs).

Given the main role of commodities traders "is not to provide financial intermediation", but logistical services and due to the fact "their assets could be quickly re-deployed if needed", Trafigura concludes that it is "difficult to see how stricter regulations and capital requirements would be of benefit to the wider financial system".

However, the rapid growth of commodity traders over the past decade - the cumulative net income of the largest trading houses since 2003 surpasses Goldman Sachs, JPMorgan Chase and Morgan Stanley combined - means this isn't a debate that is going to go away any time soon.

All the more so, as investment banks' activities in commodity markets are currently under intense scrutiny and face even tighter regulations and capital provisions. Commodity traders are facing the need to be more open about their operations and lift the veil of secrecy.

Indeed, the author of the GFMA report - Craig Pirrong, a widely respected academic - is working on a white paper on commodities traders. Commissioned by Trafigura, it will look at what commodities trading houses activities and the recent trend to accumulate more assets, risk management as well as looking at different types of commodity companies.

The Commodities Note is a regular online commentary on the industry from the Financial Times

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