Despite the near-record scream higher in Chinese stocks over the last few months, under the surface China is rattled and nowhere is that more evident than in the collapse of its commodity-backed ponzi-financing deals. Since we first uncovered the fraud at the port of Qingdao [7], another has appeared that is just as fraud-ridden - Penglai [8]; and Citi and Mercuria Energy are arguing over who pays. According to Mercuria's lawyer Graham Dunning, Citi was "in a state of panic," when they uncovered the fraud. As Bloomberg reports [9], Dunning exclaimed "it appears that substantial quantities may be missing from the warehouses or may be the subject of multiple pledges," and the bank says it is owed at least $270 million. Other 'banks' have been less forthcoming about their potential losses, but the government probe has so far uncovered almost $10 billion in fraudulent trade, including irregularities at Qingdao, according to the country’s currency regulator.
Suspected metals fraud in China sparked claims of betrayal by both U.S. bank Citigroup and trade house Mercuria over who would absorb about $270 million in exposure to financing deals, a London court heard this week.
The dispute:
Mercuria held copper and aluminium in Chinese warehouses and agreed a series of deals that were effective loans from Citi using the metal as collateral.
Under the repurchasing agreements, or repos, Citi agreed to purchase metal from Mercuria before selling it back at a slightly higher price to include interest on the effective loans.
The two groups were in the midst of several repo deals when the potential fraud in China was uncovered in warehouses in both Qingdao and Penglai. Citi demanded early repayment of the repos and Mercuria refused.
As Bloomberg reports [9],
Citigroup was in a “state of panic” when alleged fraud was uncovered in two Chinese ports, Mercuria Energy Group Ltd.’s lawyer said as a London trial over disputed metal finance deals got under way.
“The discovery of the fraud was a massive problem for Citi as it was their metal and it was at their risk,” Mercuria lawyer Graham Dunning told a London judge. “There was a state of panic.”
The disputed copper and aluminum is under lockdown in the ports of Qingdao and Penglai, where Chinese authorities are investigating an alleged fraud. Neither side can get access and they don’t know how much of the metal is there, Dunning said at a pre-trial hearing in August.
Citigroup argues that it effectively delivered the metal to Mercuria under the terms of a sale-and-repurchase agreement by handing over warehouse receipts. The bank says it is owed about $270 million. Mercuria, a Cyprus-based firm with major trading operations in Geneva, argues the products were never properly delivered.
“It appears that substantial quantities may be missing from the warehouses or may be the subject of multiple pledges,” Dunning said today.
...
The probe at Qingdao, China’s third-largest port, is examining companies owned by a Chinese-Singaporean metals trader, Chen Jihong, who is alleged to have pledged the same metal inventories multiple times for collateral on loans. Chinese authorities have uncovered almost $10 billion in fraudulent trade, including irregularities at Qingdao, according to the country’s currency regulator.
But as Reuters adds, [10]
Citi was worried about reporting a potential "hole" in its balance sheet to regulators while Mercuria was in the process of arranging a huge acquisition of the physical commodities business of bank JP Morgan Chase, lawyers said.
...
But the Chinese authorities imposed a lockdown on parts of the two ports where the metal is held, preventing anyone, including Citi, Mercuria and the warehouse operators, from accessing the material, court documents said.
"We expect them (Mercuria) to keep us out of a potential messy situation," according to an email from John Young, Citi's managing director of commodities business development, cited in court documents.
Mercuria's Chief Financial Officer Guillaume Vermersch promised Citi that "Mercuria would make Citi whole if there were issues concerning the underlying metal"
So Citi went for Blackmail...
Young suggested that Mercuria be reminded that it had extensive financial arrangements with Citi, including $4 billion in credit and borrowing facilities and over $14 billion of bilateral trade facilities, plus potential help in financing the purchase from JP Morgan.
But Mercuria resisted what it regarded as unfair pressure...
"Citi hoped that...it could force Mercuria to agree on its quick exit from a difficult position and hence enable Citi to fill the potential hole in its balance sheet... which was concerning the regulators in London and New York,"
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The precedent in this case is important as dozens of trading intermediaries will be on the hook if Citi's claims are upheld and the smaller trading units are severely under-capitalized to cope with any forced deliveries.
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Addenda: since, we suspect, commodity funding deals, the transactions at the basis of the broken Chinese repo/rehypothecation pathway will once again become a prominent feature of the mainstream media circuit as soon as journos figure out the losses are mounting, here is a reminder of the key basics involved , as we posted over a year ago [7].
An example of a typical, simplified, CCFD
In this section we present an example of how a typical Chinese Copper Financing Deal (CCFD) works, and then discuss how the various parties involved are affected if the deals are forced to unwind. Exhibit 3 is a ‘simplified’ example of a CCFD, including specific reference to how the process places upward pressure on the RMB/USD. We believe this is the predominant structure of CCFDs, with other forms of Chinese copper financing deals much less profitable and likely only a small proportion of total deal volumes.
A typical CCFD involves 4 parties and 4 steps:
- Party A – Typically an offshore trading house
- Party B – Typically an onshore trading house, consumers
- Party C – Typically offshore subsidiary of B
- Party D – Onshore or offshore banks registered onshore serving B as a client
Step 1) offshore trader A sells warrant of bonded copper (copper in China’s bonded warehouse that is exempted from VAT payment before customs declaration) or inbound copper (i.e. copper on ship in transit to bonded) to onshore party B at price X (i.e. B imports copper from A), and A is paid USD LC, issued by onshore bank D. The LC issuance is a key step that SAFE’s new policies target.
[11]
Step 2) onshore entity B sells and re-exports the copper by sending the warrant documentation (not the physical copper which stays in bonded warehouse ‘offshore’) to the offshore subsidiary C (N.B. B owns C), and C pays B USD or CNH cash (CNH = offshore CNY). Using the cash from C, B gets bank D to convert the USD or CNH into onshore CNY, and trader B can then use CNY as it sees fit.
The conversion of the USD or CNH into onshore CNY is another key step that SAFE’s new policies target. This conversion was previously allowed by SAFE because it was expected that the re-export process was a trade-related activity through China’s current account. Now that it has become apparent that CCFDs and other similar deals do not involve actual shipments of physical material, SAFE appears to be moving to halt them.
Step 3) Offshore subsidiary C sells the warrant back to A (again, no move in physical copper which stays in bonded warehouse ‘offshore’), and A pays C USD or CNH cash with a price of X minus $10-20/t, i.e. a discount to the price sold by A to B in Step 1.
Step 4) Repeat Step 1-Step 3 as many times as possible, during the period of LC (usually 6 months, with range of 3-12 months). This could be 10-30 times over the course of the 6 month LC, with the limitation being the amount of time it takes to clear the paperwork. In this way, the total notional LCs issued over a particular tonne of bonded or inbound copper over the course of a year would be 10-30 times the value of the physical copper involved, depending on the LC duration.
Copper ownership and hedging: Through the whole process each tonne of copper involved in CCFDs is hedged by selling futures on LME futures curve (deals typically involve a long physical position and short futures position over the life of the CCFDs, unless the owner of the copper wants to speculate on the price).
Though typically owned and hedged by Party A, the hedger can be Party A, B, C and D, depending on the ownership of the copper warrant.
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Please note the bolded, underlined text above. That's more or less the whole story here... and consider every commodity that has been used for the purpose of collateral has been utterly devastated in price considerably exaggerating the problem.
