COMMODITY RISK MANAGEMENT
they have a limited understanding and literally no control. Banks have therefore sought a stronger insurance against price / differential variation and counterparty default by entering into ownership based finance deals – also called cash and carries. Such deals are effectively fully protective of credit / counterparty and market risks … as long as they remain in their most basic version. In a plain vanilla cash and carry, the bank buys a
stored physical commodity with a hedge reflecting the tenor of the agreement and the relevant market contango. The contango can be construed as the addition of the warehousing, insurance and interest costs. The lender will give to his counterparty
“... I am campaigning for a more systemic and transparent evaluation of differentials”
their clients requirements. The client will accept all haircuts as long as the deal beats the pricing of pledged lending. This type of deal is imperfect as the banker tacitly accepts to run a differential risk. You will have understood that straight pledged lending or repos equally expose the banker to differential risk. Now you may tell me that while bankers have
a limited grasp of differential trading, auditors are fully conversant with the practice. The answer as usual is yes and no. Yes, they understand that buying physical goods under the referenced future and selling it above generates a profit. Yes, they perfectly assess the profit and loss of a closed deal. But no, they have very limited means to assess the differential value of an open book. An open book is the aggregation of unmatchable deals by reason of grade, quality and position. In other words, the price of unsold goods – whether bought forward or in store – is hard to assess, as are sold forward goods but not yet bought back. So how can
the right – but not the obligation – to repurchase the goods. Why would he grant such an option? The answer is simple: if the merchant does not retake the goods, the lender will tender the commodity on the relevant exchange. And yes, I agree that this type
of deal perfectly Jean-Michel Boehm
protects the lender, but such deals are, unfortunately nowadays, rarer. Commodity traders now need more refined (I believe the word exotic
is appropriate) cash and carry arrangements. The tenderability of the goods is an impediment to most deals as location, quality and differential create an insurmountable obstacle. Location: the warehouse where the goods are
stored is not exchange registered. Quality: the quality of the goods is either too bad
or too good to be tendered. Differential: the commodity premiums or discounts make the tendering uneconomic. So the bankers have turned themselves into barbers: they haircut here and there in order to fit
30 March 2014
they sign off on accounts where there is no objective instrument to value open differentials? Well, the open book is the subject of a negotiation
between the merchant and the auditors. This can lead, as seen in the past, to firms known as having suffered substantial losses publicising unchanged year-end accounts. How come? The answer is in the evaluation of the differential … and as they say “they kept a bit of fat in the differential”. The opposite has also been known to be true.
Such practices can also, depending on the country, create serious tax issues. As said, the differential is a rather complex equation and I would like to add an additional unknown to the formula. The regulators across the world have, rightly so, declared war on money laundering. Most regulated financial institutions have set up stringent and effective money
laundering practices. Suspicious on-
exchange trades or cleared trades are systematically reported. But what about physical commodity trades? If you can hide “fat” in a differential, what else can you hide? I am not suggesting that bankers are the blind
of the financial world or that auditors are clueless in assessing open physical positions. Nor am I advocating that merchants are mere pilferers … far from it. But I am promoting the concept of Physical Commodity Differential Risk Management which should lift the opacity surrounding differential
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