Commodity traders need to embrace a digital future

The collapse of Agritrade International, Hin Leong Trading, Phoenix Commodities or ZenRock Commodites Trading — commodity trading firms seem to be failing with some regularity over recent months.

Superficially, commodity traders share some features of the lightly regulated investment banks that existed before the 2008 financial crisis. They have leveraged balance sheets; they extend credit to suppliers; and they transact in derivatives executed on regulated exchanges.

Most independent trading houses are private, with some that have grown very large over the past two decades by moving, storing and transforming ever increasing volumes of crude oil, soyabeans or liquefied natural gas.

With each new failure, the calls have been growing louder for financial regulators to step in and impose capital adequacy rules upon them. What is missing from the debate is the repeated fraud that has been behind their problems.

Even if financial authorities did step in today, the lack of digitisation of the underlying markets is likely to hamper effective regulation. What commodity trading needs is a digital platform that tracks the entire logistics lifecycle of a transaction which validates invoices against the physical products.

Fraud can take many forms in commodity trading. Hedging of physical positions with derivatives can be pushed out of balance and turned speculative; inventories can be pledged multiple times to financiers by forging warehouse receipts; receivables can be manufactured. It is usually the trade finance banks that are left holding the bag.

Unlike derivatives transactions, which are settled through clearing houses, the physical commodity market lacks a digital confirmation facility where the pricing, payment and delivery terms booked by the buyer and the seller can be reconciled — automatically and in real time.

Historically, traders were very reluctant to send their transactions to a centralised database as they contain the most commercially sensitive details of their business dealings.

With the advent of blockchain technology, the preservation of privacy has become algorithmically guaranteed: commercial data is encrypted end to end, and the platform operator cannot hope to access — and resell — the intelligence gathered from the observation of commodity flows.

The fraud risk assumed by trade finance banks would be considerably lowered if the whole industry made a systematic use of digital confirmation facilities: banks would be able to check with their clients’ counterparties the existence and details of transactions they are asked to finance — a welcome departure from the current practice of requesting letters of credit by email with documents not authenticated by a third party.

By the same token, invoice fraud in commodity trading is made possible by the weak link between the actual value of the invoice and the transaction that generated that invoice. In real life, loaded quantities differ from agreed quantities; qualities vary; and ships are late.

Frauds associated with loans collateralised by inventories have been more common than they should. In 2014, Dezheng Resources was accused, and ultimately convicted, of pledging to trade finance banks’ warehouse receipts representing metal stocks at the Chinese port of Qingdao multiple times; the losses to the lenders totalled more than $3bn. More recently, the founder of Hin Leong admitted to selling inventories pledged to bankers to raise cash and meet margin calls.

One would expect a fraud involving inventories to be difficult to carry out in 2020: the terminal operators — which effectively act as custodians for the physical goods — could easily report stock levels held by their clients directly to the banks on a digital platform and certify their presence.

But in commodity trading, traders self-report to the lenders via email. In future, one will expect this separation of duties to be enforced more thoroughly; and when the terminals are operated by the traders themselves, the lenders will probably use the considerable arsenal of cargo tracking now available to carefully monitor the movement of ships and reconcile them with the stock levels submitted by their clients.

Like modern commodity analysts, the trade finance bankers of the future are probably going to be python coders.

There is no doubt that the commodity trading industry is highly sophisticated and generally well managed. In an environment where the visibility of trade flows has been enhanced by satellite technology and big data, it relies heavily on large volumes of trade finance loans to operate profitably.

If they don’t want the party to stop, it is high time that the better run traders and their bankers start emulating their financial brethren and embrace the use of digital platforms.

Etienne Amic is the chief executive of VAKT Global, a blockchain-based trading platform

The Commodities Note is an online commentary on the industry from the Financial Times