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More On China’s “Missing Commodity” Scandal: Fallout Spreads As Banks Get Involved

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  • Jun 7, 2014
  • theunhivedmind

    More On China’s “Missing Commodity” Scandal: Fallout Spreads As Banks Get Involved

    Tyler Durden’s pictureSubmitted by Tyler Durden on 06/05/2014 15:53 -0400

    While we have warned about the problem with near-infinitely rehypothecated physical/funding commodities/metals, be they gold or copper, many times in the past, and most recently here, it was only yesterday that China finally admitted it has a major problem involving not just the commodities participating in funding deals – in this case copper and aluminum – but specifically their infinite rehypothecation, which usually results in the actual underlying metal mysteriously “disappearing”, as in it never was there to begin with.

    And disappearing commodities is exactly what we reported yesterday the third largest Chinese port of Qingdao is being investigated for after a source at a local warehouse said that “it appears there is a discrepancy in metal that should be there and metal that is actually there… We hear the discrepancy is 80,000 tonnes of aluminium and 20,000 tonnes of copper, but we hear that the volumes will actually be higher. It’s either missing or it was never there – there have been triple issuing of documentation.”

    This has resulted in a prompt and acute selloff of copper and other commodities as we further documents, but the problems may only now be starting and the banks, those which stand to lose the most if their “collateral” is uncovered to have never existed, are finally getting involved. As Reuters reports, worries over a probe into commodity stockpile financing at China’s Qingdao port appeared to deepen on Wednesday as Standard Bank Group and a part-owned unit of Louis Dreyfus Corp warned of potential losses and copper prices fell further.”

    Responding to queries about the probe at Qingdao, which has not been officially confirmed, South Africa-based Standard Bank said it was “working with local authorities” to investigate potential irregularities at China’s third-largest port, a major source for metal and iron ore imports.

    “Standard Bank Group is not yet in a position to quantify any potential loss arising from these circumstances,” the bank, whose Standard Bank Plc subsidiary conducts commodities trading, said in a statement.

    Standard Bank is not the only one that may suffer major losses should the disappearance of rehypothecated collateral be confirmed:

    Singapore-based logistics provider GKE Corporation Ltd warned shareholders that it was “assessing the potential impact” of the investigation on its GKE Metal Logistics Pte Ltd unit, a joint-venture 51 percent owned by global commodities merchant Louis Dreyfus.

    While we expect many other banks to step up, for now these two are the first companies to publicly discuss the issue since the inquiry came to light on Monday, when Reuters reported the port in northeastern China had halted shipments of copper and aluminum as it launched an investigation into metal stockpiles used for collateral on loans.

    To be sure Chinese authorities are in a bind: while they can’t ignore the problem, a very aggressive investigation into the disappearance of collateral may result in a collapse of the entire rehypothecated house of cards, and they know it: according to Reuters, authorities at the port in northeast China have not officially confirmed an investigation, and have said exports and operations are running normally.

    But earlier on Wednesday, Xinhua news agency reported that the port had said it was investigating whether iron ore warehouse receipts were fraudulently used multiple times to raise finance by different banks.

    And while we have been warning about this problem for years, only now – when there is a documented case of alleged fraud – are the players finally starting to panic:

    According to traders and warehousing sources, port authorities at Qingdao’s Dagang wharfs have been examining whether there had been multiple issuing of receipts for single cargoes of metal tied to a trading company and linked companies.

    The tumult has revived concerns that first surfaced in March, when China’s first domestic bond default fuelled fears of further financing woes and triggered one of copper’s steepest drops in years, with prices tumbling 8 percent in three days.

    The immediate impact on pricing is clear, and just as we warned in March: lower.

    “I think it’s (copper) got more downside to go,” said analyst Vivienne Lloyd at Macquarie. “That (the probe) will have the effect of making the banks extremely cautious about to whom they will issue letters of credit.”

    So while we are gratified that yet another event we have warned about has come to pass, what happens next is unclear.

    Recall what we said in March, when we looked at the possible aftermath of a wholesale unwind of commodity funding deals:

    From a commodity market perspective, financing deals create excess physical demand and tighten the physical markets, using part of the profits from the CNY/USD interest rate differential to pay to hold the physical commodity. While commodity financing deals are usually neutral in terms of their commodity position owing to an offsetting commodity futures hedge, the impact of the purchasing of the physical commodity on the physical market is likely to be larger than the impact of the selling of the commodity futures on the futures market. This reflects the fact that physical inventory is much smaller than the open interest in the futures market. As well as placing upward pressure on the physical price, Chinese commodity financing deals ‘tighten’ the spread between the physical commodity price and the futures price.

    … an unwind of Chinese commodity financing deals would likely result in an increase in availability of physical inventory (physical selling), and an increase in futures buying (buying back the hedge) – thereby resulting in a lower physical price than futures price, as well as resulting in a lower overall price curve (or full carry).” In other words, it would send the price of the underlying commodity lower.