Commodity trading sheds light on how Wall Street gains proprietary trading edge

Reuters ran an interesting article discussing the struggle between Wall Street's biggest banks and the Federal Reserve over Wall Street being able to retain their investment in warehouses, storage tanks and other hard assets.

Why is Wall Street fighting so hard to retain and expand their physical commodity operations?

For the same reason that they purchased mortgage origination and servicing operations in the years leading up to the financial crisis -- information.

Not just any type of information, but information that is the equivalent of having tomorrow's news today.

For example, mortgage originators provide information on both the mortgages they fund and the mortgages they decline and someone else funds.  It is useful to know who funded loans that did not meet your credit standards if you would like to short the market and not use mortgages you originated.

For example, mortgage servicers provide current information on mortgages because their data reflects all observable events that have occurred with the mortgages through the close of business yesterday.  This data provides an informational advantage when investors access to this same data lags by several days.

"The truth of it is that having access to the physical markets is about optimization and knowledge - it gives you the visibility of the market to make far more successful proprietary trading decisions in both physical and financial markets," said Jason Schenker, President and Chief Economist at Prestige Economics in Austin, Texas. 

"That's why for many years the most successful traders had access to both markets, and why we've seen little sign they're moving quickly to divest these assets now. It's trading with material non-public information - the difference compared with equity markets is that it's perfectly legal."

Mr. Schenker's point bears repeating.  There are markets like structured finance securities and commodities where it is legal for Wall Street to trade with material non-public information.

In the case of structured finance, there is a simple solution for leveling the playing field.  The solution is to require all structured finance securities to disclose all observable events involving their underlying collateral  one hour before the beginning of the business day following the business day on which the observable event occurred.

In the case of commodities, there is a simple solution for leveling the playing field.  The solution is to require the banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  This way, market participants could see what these firm's trading positions are and adjust their exposures based on their assessment of these trading positions.

Borrowing a page from the sub-prime mortgage playbook, Wall Street buys commodity servicers

The Wall Street Journal ran an article on how Wall Street has moved into the commodity storage business.  The parallels between Wall Street's activities in servicing commodities and servicing sub-prime mortgage securities are unmistakable.

About 600 miles from Wall Street, Goldman Sachs Group Inc. employees are busy doing deals.  But instead of a sleek office tower, they work in a rundown warehouse deep in an industrial section of Detroit. And rather than trading in stocks or bonds, they move metal—lots of metal. 

Goldman's warehouse on the banks of the Detroit River is one of more than 100 storage facilities controlled by the giant securities firm around the world. The warehouses are part of Wall Street's effort to forge a new frontier in the commodities markets: warehousing metal. 

In the past 18 months, Goldman, J.P. Morgan Chase & Co. and trading firms Glencore International PLC and Trafigura Beheer BV have snapped up warehouse operators, all of them accredited to house metal traded through the London Metal Exchange, or LME. The buying binge means the four firms now are landlords to about two-thirds of the LME's entire metal stocks, from aluminum to copper to zinc. 

LME metal stocks represent a small portion of the global supply. For example, LME's total aluminum stocks are about 4.5 million tons, or about 10% of the world's annual supply. 

For Wall Street, warehouses are a way to earn extra income, especially as core businesses like trading are suffering. The facilities represent a relatively small but profitable way to bet on commodities markets without actually trading, the firms said. 

The investment in sub-prime mortgage servicers were also a small but profitable way to bet on the mortgage markets without actually trading.

But the growing muscle of securities firms in the metal-storage business is riling users and traders, who say the firms have both a bird's-eye view of supply and demand and the ability to control what goes in and out of their warehouses. These traders worry the firms could exploit their knowledge.

The investment in sub-prime mortgage servicers also provided Wall Street with a bird's-eye view of the supply and demand for sub-prime mortgages as well as their performance (equivalent to what goes in and out of a warehouse).  It is well documented that the Wall Street firms did exploit this informational advantage.

The new owners say they keep their trading arms and warehouse operations separate, and there is no evidence to suggest they share information. 

In the case of sub-prime mortgage servicers, there was plenty of evidence of information sharing.  For example, at Goldman Sachs, Dan Sparks, a senior member of the mortgage trading team, sat on the Board of Directors for Senderra, a national sub-prime mortgage originator and servicer.

In the case of commodities, one of Wall Street's famous Chinese Walls must be preventing information sharing.

Traders and metal users have complained to the U.K.'s competition watchdog and the LME about companies acting as both trader and warehouse keeper.

Apparently traders and metal users think that allowing companies to act as both trader and warehouse keeper unnecessarily tilts what would be a level playing field for no apparent improvement in the market.

On Thursday, the Office of Fair Trade said the complaints lacked substance, and the agency won't investigate. The LME says it has no evidence to support claims the warehouses are used to gain an unfair advantage. 

The SEC also did not have a problem with Wall Street owning the sub-prime servicers even though these servicers provided the trading areas with the equivalent of inside information.

It is interesting that regulators consistently allow Wall Street to be in a position where, should its Chinese walls fail, it can tilt the playing field.  Why are regulators willing to run this risk?

Goldman's operations in Detroit are at the center of the controversy, because aluminum prices are higher in that area than the trading price in London, and Goldman controls most of the warehouses in Detroit. Warehouses like the one along the Detroit River hold about one million tons of aluminum, or almost 25% of the LME's stocks. 

Metal users such as beverage giant Coca-Cola Co. and can maker Novelis Inc. have expressed concern to the LME that the Detroit warehouses send out too little of the commodities they need. The LME has responded by instructing warehouse to release more commodities. 

"This is inappropriate," says Nick Madden, chief procurement officer at Novelis, referring to the release limits and the wait to receive aluminum. Warehouses in Detroit owned by Goldman are only required to release 1,500 metric tons of metals a day. The warehouse only rarely surpasses this limit, according to LME data. 

Novelis, a beverage-can maker, is the largest user of aluminum in the U.S. "We see it as very unhealthy for the market," he says. "The ultimate bill goes to the consumers." 

Procurement officers at Coke and Novelis have said the limited releases are driving metal costs higher. A Goldman spokesman says its warehouse unit "is fulfilling the LME's requirements." 

With record levels of commodities piling up, companies that own the warehouses are raking in nearly $1 billion in rental revenue each year, according to LME data. 

Here is how it works: If a producer or merchant needs to store some aluminum, for example, it sends the metal to a warehouse, paying rent every day. In Detroit, Goldman charges 41 cents per metric ton of aluminum per day, or about $150 a year, according to LME data. The rent is offset by big cash incentives warehouses pay to attract metal. But with millions of tons in storage, even a difference of a few dollars of income per ton can quickly add up.

The business was a backwater in the commodities markets for decades, dominated by small, independent operators. Then the financial crisis put the industry on the radar screens of Wall Street firms looking for new ways to make money. The firms correctly predicted a slump in metal demand during the recession, increasing the need for storage. 

In 2010, J.P. Morgan acquired Henry Bath & Son as part of the New York bank's purchase of RBS Sempra Commodities. Goldman bought Metro International Trade Services LLC, a Romulus, Mich., warehousing company, for an undisclosed sum. Trafigura, the world's second-largest metal trader after Glencore, purchased U.K.-based NEMS Ltd. Glencore paid $209 million for Pacorini Metals, the metal-storage business of Pacorini Group, an Italian, family-run firm. 

"The warehouses give the banks exposure to commodities without them having to be involved in price volatility," said Clare Eilbeck, a metals researcher at Brook Hunt, a subsidiary of commodities consulting firm Wood Mackenzie. 

Simon Collins, a director at Trafigura, says the Amsterdam-based firm sees its warehouses as a "recession hedge" when other businesses slow. 

So far, the frenzy of warehouse buying is paying off. Glencore's Pacorini earned profits of $31 million in 2010 on revenue of $220 million, according to its recent initial-public-offering prospectus. Henry Bath was one of the biggest contributors to J.P. Morgan's base-metal business in the first five months of this year, according to people familiar with the matter. A J.P. Morgan spokeswoman declined to comment. A Glencore spokesman also declined to comment. 

In Detroit, Goldman often offers a discount to attract customers to its warehouses but sometimes forces buyers to wait seven months or longer to get their inventory back, according to some users and LME data. 

As a result of recent complaints, the LME will require most warehouses to release more metal on a daily basis starting next April. But analysts say the exchange's move isn't enough to alleviate the delays.