Wednesday, July 24, 2013

Why Banks Are Storing Physical Commodities, and Why it May Matter

By Tim Dulaney, PhD and Tim Husson, PhD

Physical commodities -- barrels of oil, bars of gold, bushels of wheet, etc. -- are used for a variety of industrial purposes, but can also be bought and sold in financial markets.  Most commodities trading involves futures contracts, as trading the physical commodity itself involves transportation and storage costs.  Traditionally, banks who traded commodities were only allowed to deal in derivatives such as futures contracts, rather than dealing in the physical commodity itself.

But since the 1990s, several banks have been approved by the Federal Reserve to buy warehouses, pipelines, and other assets related to the storage or transportation of physical commodities.  And according to a recent investigation by the New York Times, banks have used their control over physical commodities to increase prices and their own trading profits:
By controlling warehouses, pipelines and ports, banks gain valuable market intelligence, investment analysts say. That, in turn, can give them an edge when trading commodities. In the stock market, such an arrangement might be seen as a conflict of interest — or even insider trading. But in the commodities market, it is perfectly legal.        
The example highlighted by the New York Times involved 27 aluminum warehouses in Detroit owned and operated by a subsidiary of the investment bank Goldman Sachs.  Goldman allegedly moved aluminum ingots between these warehouses in order to delay shipments, effectively reducing world aluminum supply and thereby increasing prices.  As banks' stockpiles of physical commodities have grown, their ability to control supply and demand (and therefore price) has increased.

These and other practices are now under intense scrutiny, and the Federal Reserve is reportedly reconsidering its relaxation of restrictions on banks.  Interestingly, similar concerns have been raised about proposed exchange-traded funds (ETFs) that will own physical copper.  In that case, if an ETF amassed a large stockpile of physical copper, then physical copper prices might increase (due to decreased supply), increasing the cost of industrial uses of the metal.

It will be interesting to see how regulators deal with banks' increasing presence in commodities markets, and how they might prevent anti-competitive behavior.

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