Weathering a perfect storm

2020 proved to be one of the most eventful years for commodity trade finance in recent history with some of the largest players facing significant losses and being forced to exit the business. Covid-19 and market volatility further complicated matters, however in the rubble the financing houses left, opportunities have emerged for new players.

What went wrong?
Commodities trade finance had always been an extremely complicated business due to the large number of participants, from producers and consumers to shippers and traders – with each group having their own agendas, liabilities and ways of working.

Due to the complexity and the sheer global scale of the business, over the last decade or so, many banks and financing houses have created increasingly more specialized units to deal with even more specific portions of the ‘trade finance chain’. While all of this was happening, the ‘big picture’ of how these elements all link together and what is happening in the real world was lost. Many banks refused to carry out, or discontinued, their physical trading operations, thus becoming pure financial intermediaries. They lost the knowledge and expertise of how to work with the title and the commodity. More importantly, they began to rely on papers and, as such, the danger of fraud or material mispricing of risk dramatically increased.

In addition to this compartmentalization of duties and losing sight of the full chain of commodity finance, competition for business caused banks to accept material margin reductions in the trades they were financing. Over the past 20 years the cost of trade finance has drastically decreased. In a situation such as this, banks have had to increase volumes in order to generate commensurate revenues, resulting in material mispricing of underlying risk. Eventually risk exceeded margin and caught up with those capital providers. Low margin, sizeable risk positions became so concentrated that one, or several, potential defaults could destroy a financing bank’s profit and loss for an entire year.

What lies ahead
2021 will undoubtedly be a year of transition – moving away from some of the practices of the past in controlling risk, concentration and fraud towards a strong bull market in commodities on the back of global Covid-19 recovery and large stimulus programs.

Industry players with full trade finance chain expertise will benefit from the situation and fill the void left by the retrenching traditional financing houses. For example, trading houses which provide financing, such as VTB Commodity Trading, will benefit.

Repricing will take place as the cost of risk balances with underlying risk exposure in a more coherent manner.

We anticipate that operations, compliance, controls, fraud identification and elimination will all improve following the lessons of 2020 where a few large bankruptcies (the result of many operational and risk control missteps) started the industry shake-up, later compounded by the Covid-19 freeze.

Reduction in risk appetite for crediting small and middle trading companies is already happening now. It will lead to concentration of business in the hands of players having large capital and able to fully understand the intricacies of physical operations.

As is often the case for business, in order to thrive, you must stand out. Commodities trade financing is a complex matter and ensuring full synergy across businesses and specialties is key to growth. At VTB, we have chosen not to replicate the business operations that have been abandoned by international predecessors, but to follow a unique route – utilizing the synergies of the bank’s balance sheet and credit analysis with our full trading house capabilities to manage market risks, operating security and controls along the physical commodity chain.

Atanas Djumaliev is Head of Global Commodities at VTB Capital. VTB Capital, VTB Group’s investment banking business, is the leading international investment bank in Russia. VTB Capital offers a full range of investment banking products and services relating to, among others, trading operations, debt and equity placements, M&A transactions and consulting services, private equity, asset management, FX and interest-rate products, hedging strategies, and global commodities.
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