Banking on Global Scams

There is this interesting piece of journalism from NY Times. It talks about how a handful of banks are keeping the multi-trillion dollar derivatives trading to themselves, especially in Commodities markets.This is really interesting, and it exposes us to a world which is widely spread, but little is spoken and written about it...(and even lesser blogged!)... the world of commodities trading and hedging. Let me first start by explaining how and why Commodity companies use derivatives for hedging.



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Hedging using Derivatives:

Recall the company whose wheat flour you use for bread. Imagine how that company procures this wheat...probably some is grown in fields owned and operated by the company, but most will come from farmers who sell their produce to this company at wholesale rates. Now, if the demand of wheat increases, the prices will go up...so the procurement / purchase costs of this company go up. It can't however, increase its flour prices so easily and quickly because pricing of such mass retail items is a well researched and planned strategy in itself. Besides, pricing will also determine the market share for this company. On the other hand, if it does not increase the prices, its margins are squeezed. For example, if the company bought wheat for 1$ / kg, processed into flour at 0.2$ / kg, and sold for 1.5$ / kg, it made 0.3$ / kg margins. But if wheat prices moved up to 1.2$ / kg, the margins get squeezed to 0.1$ / kg. If you look at it in percentage terms, its a 20% increase in input costs, but a 67% reduction in Net profits ! So what does the company do?

At the beginning of the financial year, the company goes and buys wheat futures in an exchange...which will expire around the time when it plans to purchase physical wheat. Now, since futures prices move along with the physical commodity's prices, when the company actually goes to buy wheat in the physical market, if the price of wheat has gone up, it'll make that profit on futures prices and set it off against the higher procurement / purchase prices. Alternatively, if the prices went down, the company make a loss on its futures trade, but it is able to procure wheat cheaper as well. In either case, the company is able to "lock-in" the price of wheat right at the beginning of the year for all its purchases throughout the year. This act of locking-in the price is known as Hedging, and derivative like Futures, options, swaps are useful instruments available in the market to hedge.

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The Derivatives Trading Scam:

Coming back to the topic, according to the article, in the wake of the 2008 crisis exchanges like ICE (Intercontinental Exchange) and CME (Chicago Mercantile Exchange), two leading exchanges for trading commodities, opened clearing houses (a clearing house takes on the role of a counter-party in a trade, so you are assured that for that 1 lot of wheat futures that you've bought / sold, ICE / CME is taking the responsibility of giving you the cash / futures allocation...so you don't have to worry about the counter-party risk). For this, they needed big banks to join this effort and use these clearing houses, as they had most of the volumes. Some 9 banks (including BofA, Citi, JP Morgan, Goldman Sachs, Barclays, Credit Suisse, Deutsche Bank, etc.) joined these clearing houses, and formed a cartel...they now decide who else joins and who doesn't, what rules are created, and of course, what brokerage to charge.

They have practically blocked anyone else from coming into this "Elite" group so that the broking fees doesn't come down, the rules of the game don't change. The fees charged for such derivatives transactions (especially the structured products) is the biggest fee earner for these banks...in billions of dollars !

What are Structured Products?

This is actually true...from my talks with various commodity trading and processing companies in countries in South-East Asian and European regions, I can say that it's nearly impossible to get a bank outside this group to offer a structured product for hedging. For example, if you take a simple structured product like an Asian Collar option or say, an Asian Swap...instruments which combine multiple call and put options or swaps, expiring at the end of each month for the next 2 / 3 years...priced on the basis of Asian pricing (average of last 1 or 2 month's prices). These instruments meet the requirements of commodity firms much better than just a simple futures / options contract., because they  give a different profit profile to these firms. Its not important to understand these instruments, the point here is that these deals / contracts are, most of the times, custom-built for each customer and contract...which pushes their cost of transaction higher. Hmmmm...

....And hmmmm again 'coz banks are charging much higher for creating and offering these instruments than what it can possibly cost them...and making huge margins on these. The loser here is the commodity firm, which, due to higher transaction costs, was not able to cover itself completely from the rise / fall of the commodity price...and it'll eventually show in both, their margins (and therefore their share prices) and the prices of their products...in the wheat flour that you and I buy...! As if the governments weren't doing enough already to push the prices up...I guess everyone can use a li'l bloody bit of help once in a while.

And as an icing on the cake, here's another one... 

Banks get Basel to dilute norms

According to a report by Bloomberg, Banks have gotten the Basel committee to bend rules to suit their requirements. For one, the increased amount of capital the Banks were supposed to hold (to reduce risk on defaults exceeding capital), has been pushed beyond eight years...(like they'll shore up money to set aside more capital in that much time...optimistic bankers are the most dangerous breed of humans around...!). The lobbying effort towards this effect was led by, well, Deutsche Bank (again)!

Another proposal which was rejected by the bankers was a "Leverage Ratio", a ratio of Equity / Liabilities, to prevent banks from becoming too indebted. Majority of the 27 EU nations opposed this. The bankers apparently said that this will "restrict their borrowing capacity" and "inhibit lending"...!!!! Wasn't that the point to start with?

Both the examples above show the ability of banks to "write their own pay-checks". (both literally and metaphorically)..something that is an absolute no-no in Risk Management parlance. They demonstrate how far away we are from having a stable banking system and honest bankers.

As an end note, I'd like to tell you that while giving a title to this post, I swayed a bit between "Banking on Global Scams" and "Scams on Global Banking"...and I deliberated....before realizing it doesn't matter...both mean almost exactly the same! 

Happy banking...and yes, the next time you buy that pack of wheat flour (or your bottle of cooking oil), remember its not really the rising commodity prices which have pushed the prices of these products up...that could have been countered...what couldn't have been is a nexus between governments, regulators and bankers.

Have a Merry Christmas !

PS: By the way, Wikileaks founder Assange has revealed the name of the bank his company is going to expose in early January next year...its Bank of America. Check my earlier post in which I had mentioned this, though the name of the bank was not known then.