Banks Retreat From Commodity Trade Finance
With extreme market volatility and higher interest rates, London-based hedge funds have increased their financing of trading in commodities including oil, gas, cocoa, and copper as banks have reached their risk ceiling.
The term “commodity trade financing” refers to a variety of loans, usually from banks, that support the international trading of goods, from wheat to gasoline. The loans enable counterparties to manage various transactions while lowering their risk. Most loans for trade finance are of a short duration—less than a year.
When natural gas prices spiked in the fourth quarter of last year, traders’ credit lines started to feel the strain. After Russia invaded Ukraine in February, the situation deteriorated further, driving up the cost of physical trading as commodity and energy prices rose dramatically around the world.
In what has been an unparalleled era of market volatility, historically large margin calls on gas, power, and industrial metals forced many traders to reduce the amount of their transactions because they were unable to obtain the additional credit required to meet those demands.
Early in the year, banks’ liquidity and counter-party risk limits in the financing of commodities and energy trades had been reached or were about to be reached, leaving small and mid-sized businesses in particular scrambling for financing.
With banks retreating from commodities and inventory financing, hedge funds and other non-bank financial institutions have stepped in to fill the funding gap.
Non-Bank Financial Institutions Step In
Non-bank financial institutions (NBFI), including venture capital, private equity, hedge funds, insurance funds and even other commodity merchants, have since shown interest in increasing their exposure to commodity trade finance.
According to Novum, a mid-sized U.S.-based oil trader, NBFIs now account for 20% of their credit lines, up from zero a year ago.
Mid-sized base metals dealer Ocean Partners, based in the UK, used to rely heavily on banks, but today funds make up about 3% of their credit lines.
The underlying problem was that major banks were pulling back from financing commodities following some defaults in the sector in 2020, while Russian banks that were planning to expand were now barred from entering Europe.
According to funds like Scipion Capital, demand for commodity trade financing has increased since last year, particularly after Russia’s invasion of Ukraine drove up global product prices.
-BBB investment grade commodity traders presently provide the most alluring risk-adjusted return of roughly LIBOR + 2% to 8%, according to Kimura’s Tremaine.