When Credit Suisse announced in July that it would be exiting its small commodities trading business, it added its name to a growing list of investment banking firms winding down their participation in the trading of wheat, sugar, gold and oil.
In the spring, Barclays announced its withdrawal from most commodities with the exception of precious metals, commodities indexes and derivatives tied to oil and gas. That announcement came after the British multinational bank had already cut back raw materials trading in January. Deutsche Bank, which had been a top five financial player in commodities, announced at the end of last year that it was exiting most raw materials markets while retaining its $9 billion commodities index fund trading. UBS has slimmed down much of its commodities, retaining its commodities index business and JPMorgan announced plans to sell its physical commodities unit to Swiss trading firm Mercuria.
Finally, Morgan Stanley, long a leader in commodities, sold its oil storage and transport business TransMontaigne to NGL and is in the process of selling its physical oil trading business to Russian oil giant Rosneft. But as the sale of that business is underway, news has emerged that the firm plans to build and operate a natural gas compression and container loading facility. The construction of the facility will take time, but the news implies that Morgan Stanley is already beginning to lay the groundwork for a future push into the commodities market even as it proceeds with its exit from oil trading.
Under Pressure
When Credit Suisse revealed plans to exit most commodities during its second quarterly earnings call, chief financial officer David Mathers said that the banks macro business, which includes commodities, is being affected by a list of factors including the low interest rate environment, regulatory changes such as new leverage rules, and the introduction of different trading platforms and pricing requirements.
It is this combination of pressures that has forced several in the industry to rethink the market, experts say. I just dont think the returns are there to offset the risks, and when I talk about the risks, Im not strictly talking about market risk, Im also talking about regulatory risk, shareholder risk, said Patrick Reames, founder and managing partner of Commodity Technology Advisory, and a former energy commodity trader. I think they feel the capital that has been deployed in these businesses could be better leveraged somewhere else.
In Credit Suisses case, the bank is freeing up capital to divert it to higher returning private banking and wealth management, CEO Bradley Dogan said in the conference call.
Timing Is Key
On the other hand, the market conditions that have made it harder to find profit in commodities trading tend to be somewhat cyclical, said Dennis Gartman, a veteran trader and editor of the Gartman Letter, a newsletter dedicated to the global capital markets. He sees the recent exodus of banks for the commodities market as a classic case of banks being behind the curve.
Banks get into businesses almost always at the wrong time, and they get out of businesses almost always at the wrong time. The prime example of that is Bank of America buying Countrywide Mortgage right at the top of the mortgage market, said Gartman. They got into the commodities business aggressively in 2007, 2008 when the grain market, cotton markets, oil markets were all on fire. Now they are getting out when you have had a bear market in grain, oil prices have fallen and interest in the commodity markets has waned.
Garment added, This is the time you should be getting in; instead they are getting out.
An Evolving Marketplace
Others in the commodities market view the mixture of pressures facing commodities trading as even more multifaceted than market conditions and regulations.
Ron Lawson formerly ran Merrill Lynchs commodities trading operations west of the Mississippi, overseeing 126 commodity brokers in 26 western states. In 2003, he joined with Bill ONeill, a former global head of commodities at Merrill Lynch, to form Lawson/ONeill Global Institutional Commodity Advisors, or LOGIC for short.
Lawson says that the low volatility and low interest rates that have made it harder to find profit in other markets are attracting new types of traders to commodities. Automated and even high frequency traders are looking at commodities as yet another place to find alpha. Meanwhile, exchanges, which used to count on the interest they earned from the margin money they held, have found that with interest rates approaching zero, that revenue stream is dwindling.
Right now we are at zero percent interest and exchanges used to make most of their money on the margin money they had sitting at the exchange, Lawson said. If an exchange is sitting with $250 billion earning seven percent interest, great. At zero percent interest – not great.
As exchanges are now public companies with fiscal obligations to shareholders, the loss of margin interest revenue has made high volume traders who pay fees to exchanges based on their level of activity a more attractive proposition. The problem is, Lawson told Traders, algorithmic trading looking for alpha skews the market for commodity traders who are looking to trade or hedge an underlying commodity.
Essentially, when the speculators run in and push the futures market in non-correlated moves to the underlying cash, you lose your ability to spread the risk into the futures, Lawson said. Why would I take on more risk with futures? Futures are supposed to reduce my risk.
Lawson noted that some bona fide commodity clients have stopped trading futures and only trade cash to avoid the aggravation of the current market. Banks are facing the same issue.
If Im a bank and I have a cash business that I cant offset in futures, the first thing Im going to do is stop trading futures, he said. Then Im going to say this is too risky if I cant hedge it with futures, so Im getting out of this too.
Filling The Void
The question that remains for the market is how strongly the departure of a significant number of investment banks will be felt.
In the short to medium term there will be an absolute impact in market quality and trading volumes, said Andy Nybo, principal and head of derivatives research with Tabb Group. Over the longer term however, as the spreads widen and as the liquidity decreases, there is more opportunity for firms that have the balance sheet and the capabilities to participate in these markets.
Some suggest that large commodity trading firms, like Cargill and Glencore, could easily fill a void left by investment banks, but replacing banks with large commodity players might change the motivations behind trading.
Megabank A has clients on both sides of the market. It might have an energy oil producer who has to hedge on the short side of crude oil, and it may have a chemical company who needs to be long on crude, said Gartman.
A large commodity firm would represent only one side of a trade, but Gartman noted that commodity firms can often be aggressive traders. They tend to be short and long, long and short, where banks tend not to be aggressive in and out traders, he said. Banks might speculate, but theyre not big punters.
The Return of Interest and Volatility
At some point, interest rates will climb again and volatility will return to the markets. When that happens Lawson predicts several of the markets current issues will self-correct.
Lets say everything returns to normal and interest rates go back up to 7.5 or 8 percent. Then it becomes open interest that the exchanges want, not just volume. High frequency traders wont help them anymore, Lawson said. Then you may see things change. They may try to draw the other guys back into the market.
A return of volatility might bring other new changes to the market as well. Reames of Commodity Technology Advisory expects the return of volatility will spur demand for real time analytics to keep pace with a rapidly moving market.
With the increasing globalization of the marketplace, there are more opportunities for arbitrage. The problem is seeing those opportunities and trying to take advantage of them requires a very broad and holistic view of the marketplace, Reames said.
He added that technology is playing a larger role in consolidating those views. Right now the exposures associated with volatility are not as great as they could be, Reames concluded. As those increase, managing the volatility becomes more important so youll see more capital deployed in trying to find technology to help address those risks.
