By John Kemp
LONDON, Jan 16 (Reuters) - The sale of the base metals, oil and North American power and gas trading businesses of UBS to Barclays Capital, announced on Friday morning, marks a further step towards consolidation of the commodity trading industry around three large investment banks (Goldman Sachs, Morgan Stanley and Barclays) and a handful of large physical trading firms (Cargill, Archer Daniels Midland, Koch Industries and Glencore, as well as oil majors such as BP and Shell).
As expected, the commodity trading business is polarising. At one end, business is consolidating around large institutions with sufficient capital and access to liquidity to offer a full range of customer services -- from simple index products and exchange-traded funds to futures and options execution, physical trading, inventory financing and more complex bespoke hedging and risk-management strategies.
Most will also use the liquidity and information advantages provided by customer flow to run successful proprietary trading activities alongside their customer-focused operations. At the other end, banks able to offer access to fairly simple products such as indexes and exchange-traded funds to their customers from a small desk at much lower cost will survive, as will small niche players able to run proprietary trading operations in one or two commodity markets where they have detailed knowledge and unique advantages.
The mid-tier of banks and trading firms, running relatively high-cost trading businesses and trying to operate across multiple commodity markets where they have no clear information advantage, is already disappearing.
The space they inhabit is being squeezed from above by the greater risk appetite and liquidity the top tier firms are able to provide to their customers, and from below by the lower cost of small-scale execution-only businesses.
As the middle ground vanishes, the challenge for mid-tier players is to bulk up to become one of the handful of large and dominant players, or scale down and focus on low-cost execution. The number of mid-tier traders has already been shrinking for more than a year. Bank of America and BNP Paribas have both withdrawn from some commodity activities. The commodity businesses of Bear Stearns were consolidated into those of fellow-trader JPMorganChase following Bear's failure in early 2008. The commodity trading business of Lehman Brothers was consolidated into Barclays after Lehman failed in the autumn.
Now UBS is quitting most of the commodity businesses other than precious metals (which trade like foreign exchange), as well as plain vanilla commodity indices and ETFs that can be offered a low cost and minimal risk.
Of all the players in the industry, Barclays has made the most determined effort to break into the top tier previously dominated by Goldman Sachs and Morgan Stanley. Between 2002 and H1 2008, Barclays increased its appetite for commodity trading risk (measured by average daily value-at-risk) from
1.8 million pounds to 23.7 million pounds. By the first half of last year, the average amount of risk being carried in Barclays' commodity trading book was comparable to Goldman Sachs ($48 million average daily VaR in Q2
2008) and Morgan Stanley ($39 million); the investment bank was on the brink of joining the top table. Barclays' subsequent acquisition of the commodity trading businesses from Lehman Brothers and UBS will ensure it is one of the top three commodity banks in the world.
INDUSTRY RESTRUCTURING
Consolidation and polarisation of the commodity trading business is being driven by both cyclical and structural factors:
(1) Like other parts of the financial services industry, commodity trading has experienced a massive expansion over the last five years, and now faces a period of cyclical consolidation as the boom ends. Like other financial businesses, commodity trading is showing signs of excess capacity. Much of the new volume over the past half-decade has come from a dramatic increase in the amount of investment money allocated to passive commodity indices and more actively hedge funds. The amount of underlying business tied to physical trading activity has grown much more slowly. There are now too many banks and traders chasing too little underlying flow. So far, traders have been protected by the increased investment business from hedge funds and pension funds. But as the hedge fund sector retrenches, and pension funds come under pressure to adopt more conservative investment strategies, the commodity trading sector's overcapacity will become increasingly apparent.
(2) Enron's implosion in October and November 2001 demonstrated the inherent limitations suffered by stand-alone trading firms. The model's basic problem has been over-reliance on short-term funding from the money markets -- or investors with relatively short monthly or quarterly lock-ins
-- to fund investments which are much more long term and less liquid. Like a commercial bank borrowing short and lending long, prop shops have been vulnerable to maturity mismatch and liquidity risks. Proprietary trading operations located with major commercial and investment banks have been more secure because they have access to a wider range of funding sources, and the parent company can ultimately call upon the central bank as lender of last resort. But as the financial crisis has intensified since summer 2008, bank leaders and central bank officials have begun asking hard questions about the risk-adjusted returns from all proprietary trading operations, including commodities, and the implicit risk subsidy from the depositor-base as well as the taxpayer.
Banks which have been able to survive while largely or completely declining taxpayer-funded rescues (Barclays, Goldman and Morgan Stanley) are in a much stronger position to preserve or aggressively expand commodity trading and other proprietary activities. Rivals that have been forced to accept state-funding are under pressure to demonstrate proprietary trading profits are not being subsidised by the rest of the bank at ultimate risk to the taxpayer. Pressure on state-rescued banks to prioritise real-economy lending rather than financial-side trading businesses is accelerating the flow of business towards the big three, none of which was explicitly rescued by government.
(3) The quest for consistent profits ("alpha") from proprietary trading is largely based on a misconception. Not everyone can beat the market. By definition, for every dollar of positive, there must be a dollar of negative alpha somewhere else, since the average is by definition just that. It would be nice to think alpha would accrue to the brightest and best intellects. Unfortunately, the financial services industry is populated by brilliant talents. The chances of being smarter than everyone else are not that high, and intellectual brilliance alone does not guarantee long-term profitability. Very few prop traders can consistently outperform the market in the long run for reasonable risk.
As noted in a previous column there are only four sustainable sources of alpha-generating advantage:
(a) Superior access to information (both from greater proximity to the market and other players, as well as the type of "inside information" that the regulators frown upon but which has proved the lifeblood of markets and impossible to eradicate).
(b) The ability to dominate pricing by running large positions relative to the size of the overall market and therefore move the market in the traders' own direction (either taking big enough prop positions, or drawing a large volume of customers into reinforcing trades).
(c) The ability to run complementary and reinforcing positions in related markets (eg cash, physical and derivatives) so positions in one can be used to support positions in another.
(d) Using significant leverage to magnify marginal trading advantages on thousands of trades (the strategy of picking up nickels in front of steamrollers).
For the time being the use of leverage to juice up returns is not an option. So successful prop trading strategies will be based around superior access to information, ability to run large positions, and presence in related markets. All these advantages will favour the top tier firms which can consolidate the market, grab the largest share of customer flow and maintain a presence in all elements of the industry.
((john.kemp@thomsonreuters.com; reuters messaging: john.kemp.reuters.com@reuters.net; +44 207 542 9726))
Keywords: COLUMN KEMP/ =2 LONDON Friday, 16 January 2009 12:32:44[nLG589410]
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