ECONOMICS SEPTEMBER 11, 2013
In July, the public learned that Goldman Sachs and several other large banks have morphed into giant merchants of physical goods, routinely shipping oil, running power plants, and amassing stocks of metals so large that Coca Cola accused them of hoarding. It was a disconcerting moment, as regulators realized that firms so recently known for their explosive mortgage-backed securities also deal in goods that can literally explode. These activities mean that banks supplying credit to businesses in the real economy were now also competing with them, opening up a Pandora’s box of perverse incentives and risks. Since the revelations, officials have cracked down, and the banks say they have moved to discard some of these mines and warehouses, returning to more traditional forms of banking.
But that was only half the story. What lawmakers and regulators missed is that it isn’t only the banks that have shifted shape. Over the last decade, some of the world’s biggest traditional traders in grains, oil, and metals have quietly taken on many attributes of banks—running billion-dollar hedge funds, launching private equity arms, and selling derivatives to clients. These businesses enable trading firms to tie up large sums of money in bets and profit off insider information. Unlike the banks, these companies have escaped regulatory scrutiny—even though experts say they present similar hazards.
Take the grain titan Cargill. The largest private company in the U.S., Cargill has gathered and shipped a bulk of the world’s supply of wheat and corn for more than 100 years. Nowadays, however, Cargill also sells billions in derivatives to food companies, and runs two massive hedge funds, managing more than $14 billion for investors. Or take Louis Dreyfus, another major grain trader. In 2008, Dreyfus launched its own fund enabling investors to bet on food prices. By 2011, the fund had grown so fast it stopped accepting new money.
Trafigura, the third largest global trader of energy and metals, runs nine funds that together manage approximately $2.5 billion. Last year Glencore, a metals and mining giant, and Vitol, the world’s largest independent oil trader, financed a $10 billion loan for a Russian oil company. As businesses struggle to secure large sums from traditional banks, analysts say these companies could continue filling in for banks as a source of capital. Recently, some experts have also noted that extensive interlinkages between commodity markets and the financial system could pose systemic risks to the global economy.
"To the extent these companies [are] trading commodity contracts and selling investment products, they seem virtually identical in their scope of activities to the banks," said Marcus Stanley, policy director at Americans for Financial Reform.
Unlike the banks, though, most trading companies are privately owned, release scant information, and escape most regulation. Goldman Sachs and J.P. Morgan might obscure their commodity activities to the public, but they are still obliged to privately disclose them to the Federal Reserve. Firms like Vitol and Cargill, meanwhile, operate in near secrecy. They must register their hedge funds with the Securities and Exchange Commission, but no regulator sees the full stable of their businesses. The lack of rules around “insider trading” in commodity markets also opens a backdoor to manipulation.
It’s a glaring yet untouched disparity that experts say exposes our markets for essential goods to price manipulation, and weakens recent efforts by officials to rein in similar games by Wall Street. While the Dodd-Frank Act has shed some light on arcane and exotic financial instruments, physical trades in energy, food, and metal largely continue in darkness.
“There is no regulation of physical [commodity] markets,” said Mike Masters, founder of Better Markets and a hedge fund manager in Atlanta. “It’s the Wild West, they can do whatever they want and nobody knows.”
The lack of transparency makes markets more vulnerable to manipulation. Though commodity trading has always been notoriously secretive and rife with rumors of foul play, the actors today are bigger and more formidable than ever before. They have grown spectacularly over the last decade, collectively netting $33.5 billion in profits in 2012, up from $2.1 billion in 2000. (No company discloses how much it earns from speculative trading.)
They have also amassed substantial new influence over the goods they trade, by embedding themselves deeper along the supply chain. Glencore, for example, is a major trader of metal, controlling more than 50 percent of some markets; since purchasing mining company Xstrata for $29 billion last year, it is now also a major producer. In addition to transporting sugar and soybeans, Cargill works closely with farmers to decide what they should grow. This year Trafigura launched a private equity fund to invest in small- and mid-sized mining companies. By expanding their involvement, companies win greater opportunity to directly affect the supply and movement of goods—which they can then use to benefit their financial activities, which are linked to those goods. This kind of manipulation is illegal, but hard to catch and even harder to prove.
Experts warn that this degree of involvement across the entire production cycle gives a handful of sizable firms even greater unchecked power over our most basic goods. “Clearly if you control the physical stock and stand to gain from managing the release of that stock, it would be foolish to expect companies not to take advantage of that,” said Sophia Murphy, senior adviser at the Institute for Agriculture and Trade Policy and author of “Cereal Secrets,” a report on the major grain traders.
Part of the trouble is that no public body oversees global physical stocks. Andres Missbach, co-author of Commodities: Switzerland’s Most Dangerous Business, said the vast storage capacity these companies have amassed equips them to create artificial shortages in the short-term if they wish. "We have no idea if they are manipulating,” he said. “We can only say they have the capacity to, and that there is no regulator ensuring that they are not.”
Even the activities of Glencore, one of the few commodity trading houses that is publicly traded, remain opaque. “No regulator in the world knows [the full scope of] what they are up to,” said Daniel Rohr, a metals analyst with Morningstar.
Many of these companies have also built formidable intelligence networks made up of everything from satellites to on-the-ground agents. Commodity houses traditionally have collected information about world supplies and local conditions as a central part of how they distribute goods. In recent years, however, they have parlayed it into a new business, marketing it to outsiders.
In describing its financial arm Galena, Trafigura boasts of “unparalleled insight" into physical markets, effectively selling investors inside knowledge of when, say, it plans to deliver a barge of oil or release a huge stock of aluminum. This advantage has paid off: in 2012, funds owned by commodity traders notched positive returns of up to 9 percent, while the average fund posted a 3 percent loss.
A spokesperson for Cargill said its hedge funds are overseen by the appropriate regulatory authorities in the countries in which they do business. Trafigura and Louis Dreyfus declined to comment on their funds.
Food and oil markets are a smart place to park these investment vehicles. Trading on "inside information" is illegal in the stock market, but no rules prohibit it in commodities. Originally created as a way for producers and consumers of volatile goods to hedge the risk of dramatic price swings, commodity markets have traditionally been used primarily by these "end-users," like farmers, bakers, miners, and steel producers. Over the last decade, big investor money has flooded markets for oil and grains, making them attractive for everyone from pension funds to college endowments.
Banks bought up warehouses, terminals, and mines to win this same sort of informational edge, as on-the-ground knowledge creates an opportunity to profit big and twice over through financial trades. If you control a big enough share, you can also use the double presence to manipulate markets. The Federal Energy Regulatory Commission (FERC), for example, recently fined traders at Barclays and Deutsch Bank for trading physical supplies in order to benefit their derivatives transactions. The Commodities Futures Trading Commission (CFTC) and Justice Department are currently investigating whether Goldman Sachs and others used metals warehouses to manipulate prices.
Since no regulator tracks physical trades of grain, metal, or oil, officials who suspect misdoing are left scrambling to trace steps after the fact. (The one exception is FERC, which does see physical trades of electricity; it has also brought more manipulations actions than any other commodity regulator.) CFTC, which regulates futures contracts, technically can request information on physical trades if it detects suspicious activity. But Bart Chilton, a commissioner at CFTC, acknowledged that proving manipulation is still tough. "The fact that we've only won one manipulation case in 36 years shows that the standard is too onerous right now,” he said. “It's too high a hurdle for regulators to prove.”
As the crackdown by regulators pushes banks to sell their physical assets, experts say commodity houses could further expand. "The trading companies are the main beneficiaries from the exit of competitor financial institutions,” said Craig Pirrong, finance professor and commodities expert at University of Houston.
If the trading houses grow, they will push greater swaths of our commodity markets into the dark—in fact, they’ve fought to keep it that way. Several new rules under Dodd-Frank—the mammoth financial reform legislation Congress passed in 2010—threatened to shed light on commodity houses, which trade massive amounts of derivatives right alongside Wall Street. The trading companies lobbied aggressively for exemptions, claiming that the new rules would impose crippling costs on financial trades they use primarily to hedge the risks they take when transporting physical goods to customers. But experience shows that firms can use their old-school businesses to veil vast financial activity. In 2008, CFTC discovered that Vitol was taking huge positions in the oil market not because it planned to deliver oil, but as a speculative bet, a profit-making investment.
Regulators have conceded to their demands for more forgiving rules. In one instance, CFTC had initially proposed subjecting all companies that trade more than $100 million worth of swaps (a type of derivative) to new requirements, a threshold that would have included many of the big commodity trading houses. But after fierce resistance from companies like Vitol and Shell Energy, regulators raised the threshold to a whopping $8 billion, with the possibility of later lowering it to $3 billion. Now, Cargill is the only trading company to have registered as a swap dealer. The only other commodity-dealing firm that signed up is BP.
If there’s good news for the public, it’s that banks envy these special privileges and are actually supporting a push for more regulation. Last year, the Global Financial Markets Association, a lobby group for banks, commissioned a study on whether trading houses are “too-big-to-fail.” Hoping it might convince officials to regulate these companies like banks, GFMA abandoned the study after Pirrong, its author, reached a different conclusion. The tussle highlights how banks and commodity trading houses have become curious rivals, though the latter still roam entirely unpoliced.
In July, the Center for European Policy Studies (CEPS) made a case that the commodity trading houses may in fact be “systemically important,” a term officials use for firms whose collapse could threaten economic stability. In recent months, watchdogs have designated insurance giant AIG and General Electric Capital systemically important, alongside big banks and financial institutions, subjecting them to stricter standards.
The argument that commodity trading houses might be “too-physical-to-fail” has not yet won much traction, and skeptics note that the amount of risky debt banks can hold still dwarfs what traders can manage. Still, Diego Valiante, one of the authors of the CEPS report, says the possibility isn’t one we can afford to leave as unknown. “Without more transparency, we have no idea what the systemic implications could be,” he said.
As part of its investigation into potential price manipulation by the banks, CFTC has subpoenaed at least one commodity trading house that also owns warehouses. But the issue remains peripheral to their work, and there’s no sign of U.S. officials even registering that we are blind. 2008 taught us the perils of letting complex, esoteric financial trades run amok—but it turns out it’s our most essential physical markets we’ve now left unguarded.
Lina Khan is a policy analyst for the Markets, Enterprise, and Resiliency Initiative at the New America Foundation.