by Mark Ford

Major changes are afoot in the substantially L/C-dependent commodity financing market, as Europe's banks continue to reduce their exposure to this important aspect of global trade. The lack of liquidity caused by the eurozone crisis has forced the same banks to reduce their historically dominant position in this market and curtail speculative commodity trading activities.

The swift actions of the European Central Bank (ECB) may have alleviated funding pressures on the eurozone banks, helping prevent what seemed like an imminent meltdown of L/C-based commodity trades at the end of last year. But this is not a purely European issue, and other forces are reshaping the market. Regulatory pressures from Basel III on liquidity for L/C-based trades and Volcker-type regulations that will restrict banks' operations in speculative activities are shaping the market too.

New players will step in to fill the voids left by traditional financiers, and some innovative commodity trading solutions that obviate the need for L/Cs may be needed.

Eurozone catalyst

The eurozone crisis was initially the catalyst for French banks to upset the equilibrium of commodity financing markets at the end of 2011. BNP Paribas said it would reduce its exposure in commodity financing. Crédit Agricole did as well, and announced that it would stop trading commodities. Société Générale said it would close its US energy trading unit. BNP Paribas sold its North American energy division - which also provided commodity financing - to Wells Fargo. The three banks have historically loaned around half of the trade finance borrowed by the world's biggest commodities trading houses.

Spanish banks Santander and BBVA - albeit with quite modest commodities operations - have closed their commodity derivative trading units. Nomura, Barclays Capital and UBS are amongst those also to have cut back on staff or limited the range of their commodity offerings.

Market retrenchment continues. In February of this year, French investment bank Natixis said it planned to significantly reduce its commodities trading activities - though not its commodity financing operations - as part of its efforts to scale back its overall exposure, even though this implies more focus on less profitable activities.

The role of the ECB

In commodity financing, ECB measures appear to have taken the sting out of the crisis. In the bank's efforts to support the liquidity situation of eurozone banks, it decided in December to adopt nonstandard measures with the aim of improving the banking sector's access to liquidity and facilitate the functioning of the eurozone's money market.

The ECB said it would conduct two longer-term refinancing operations (LTROs) and reduce the reserve ratio from 2 per cent to 1 per cent. According to bankers canvassed by DCInsight, the LTRO provisions have had a particular impact by increasing liquidity and improving the conditions for L/C-based commodity trade financing.

While the ECB measures may have helped, they have not restored Europe's banks - which still find it tough raise the US dollars needed to finance global commodity trades - to their dominant position. Funding costs, particularly in the US currency, remain high despite the ECB's liquidity injection.

All of this means a change of players, perhaps most noticeable in the financing of the giant Swiss commodity trading houses, whose forays into the market signal the changing cast of suppliers in commodity financing. When Trafigura went to market earlier this year to refinance and extend US$3.1 billion in loans, it found its existing financiers apparently short of the US dollars required. The independent commodity trader pegged its pricing at 2011 levels, thereby pricing its lead financiers last year out of the financing exercise this year and allowing new entrants into the market.

Lead financers for Trafigura's US$600 million one-year loan this year included Citigroup, Standard Chartered, Commonwealth Bank of Australia, Development Bank of Singapore, JP Morgan, UBS and UniCredit. Last year's loans for Trafigura were led by BNP Paribas, ING Bank, Lloyds Bank Corporate Markets, Royal Bank of Scotland, Société Générale and Standard Chartered Bank.

Other forces

Regulatory conditions are also shaping the market. These include increased capital requirements, largely driven by Basel III regulations, increased collateral requirements and the increased compliance costs associated with new regulations.

Factors outside the banking sector are shaping the market too. One commodity trader told DCInsight that the boom years in commodities are over, at least for the time being, and said it's prudent for banks to retrench or withdraw from the market rather than wait for commodity prices to fall.

One impact of this is that as the banks close their trading desks, some of the giant Swiss trading houses are seizing the opportunity to recruit their staff. Both Glencore and Trafigura have taken on commodity derivative traders previously employed by banks. Interestingly, since the commodity houses are not so subject to regulations such as Basel III or the Volcker-type rules that make it difficult for banks to practice in certain speculative types of investment activities, trading houses could be set to play a more active role in commodity markets.

Future prospects

Specialist market intelligence provider Tricumen reckons that, barring major calamities, four main trends will emerge in the commodities market during 2012. Asia will continue to grow in importance, propelled by demand from financing clients building new infrastructure, especially in Australia and Indonesia, and from investor clients such as pension funds, sovereign wealth funds and private clients.

Tricumen's second prediction is that metals and agriculture will continue to fare better than energy, especially in physical trading, and JP Morgan will be the key beneficiary of this trend. The Cambridge-based research company also expects to see more highly customized hedging solutions with the corporate market remaining highly competitive. The fourth trend may see second-tier trading houses struggle to raise funds - a direct result of the end-2011 reduction of L/C and other trading financing activity at Europe's banks.

Some analysts reckon some of the main beneficiaries will be the larger US based or global banks such as JP Morgan, Goldman Sachs, Citigroup, HSBC and Merrill Lynch, which are expected to become stronger players as Europe's banks retreat from the market. But in some areas, it will probably take more than a change in suppliers of finance to keep commodities flowing.

Refining is one of the commodity market segments hardest hit by the shortage of traditional L/C financing. In January, Europe's largest independent refiner, Petroplus, filed for bankruptcy, and several refineries in the US are reportedly either mothballed or due to shut down. Poor market conditions - which include poor margins and strong oil feedstock prices as well as tight credit conditions - are prompting refiners and their bankers to look for financing solutions that bypass the need for L//Cs .

Mark Ford's e-mail is