Bronze Swan Lands: Goldman Explains How The China Commodity Unwind Will Happen

Over a year ago we were the first to bring the topic of China's shadow banking system's problematic rehypothecation issues to the general trading public. In "The Bronze Swan Arrives: Is The End Of Copper Financing China's "Lehman Event"?" we explained how the Chinese commodity financing deals (CCFDs) worked and how they would inevitably be a systemic event for the nation so dependent on the shadow banking system for its credit (and its "growth"). The day has arrived when the Bronze Swan is landing (and it's unlikely to be soft). As we have discussed recently, the probe into 'missing' collateral (or multiple-used collateral) at China's Qingdao warehouse is a major problem... and now Goldman confirms, the Qingdao situation likely to continue ongoing CCFD unwind and has the potential to leave foreign banks with undercollateralized loans and/or losses.

Via Goldman Sachs,

Qingdao situation and the copper market outlook

According to reports, an onshore trading company is being investigated for allegedly pledging commodities (aluminium and copper) multiple times with different banks in order to gain access to cheap FX funding (specifically via repurchase agreements, or “repo” business). This has the potential to leave foreign banks with undercollateralized loans and/or losses.

Given this, a number of foreign banks may suspend their repo business in China, as well as shrink their commodity financing positions in China in general.

The Qingdao issue could be a catalyst for further CCFD unwinding

In our view the developments in Qingdao are likely to continue the significant scaling back of FX inflows from foreign banks into China via commodity financing business. This would disincentivize the physical holding of commodities in bonded warehouses, increasing ‘visible’ inventories and placing more downward pressure on physical (cash prices) than upward pressure on futures prices. As foreign banks reduce their exposure to Chinese commodity financing deals (CCFDs), the profitability of these could be reduced meaningfully (via an increase of US rates and/or a lower FX loan quota to CCFD participants), more physical metal previously tied up in financing deals would be freed up for the physical market, helping ease the current temporary regional tightness.

With respect to copper in particular, we expect more copper will either flow back to China or LME, depending on which market is relatively stronger. Indeed, there are signs of unwinding in near-dated tightness in the market recently, as indicated by the significant easing of both Shanghai premia and LME time spreads (Exhibits 2).

To explain in more detail, we expect this could result in:

Copper refiners having less incentive to export cathodes to bonded warehouses (since funding from repo business could be ceased).


Copper inventory holders finding it more reasonable to move copper out of bonded warehouses and place it in LME warehouses, both for funding availability and profitability considerations.


Importers may redirect their cargoes to other locations where premia trade at higher levels.

We remain bearish on copper for 2014

These factors, together with copper’s particularly high exposure to CCFDs, as well copper’s significant leverage to China’s weak property market, have seen cash copper prices fall 5% over the past week (now down more than 10% ytd). These developments are in line with our views expressed in Days are Numbered for Chinese Commodity Financing Deals (published March 18, 2014) and Concerned about Chinese property, still bearish on copper (published May 7, 2014).

We reiterate our year-end copper forecast of $6,200/t (we had already assumed a gradual unwinding of Chinese copper financing deals). Given the potential we see for the Qingdao situation to lead to a rapid unwind in financing deals, there is a risk our target is reached earlier than the end of the year. Further, we expect more refining capacity will be delivered in 2H14 to convert a concentrate surplus into a cathode surplus.

What is the “repo” business in China’s commodity industry?

The “repo” business in commodities in China is similar to any other “repo” business in the financial markets. Generally speaking, the repo is a short-term FX funding vehicle, whereby a commodity owner first sells the commodity warrants issued by bonded warehouses (paired with an equal amount of short positions) to banks, then buys the package back from the banks in 3 to 6 months. It is a way for commodity traders/refiners to gain access to foreign banks’ balance sheets and improve liquidity efficiently.

The Qingdao situation alleges the issuance and pledging of more warrants than the underlying physical commodity. Were this to have occurred, foreign banks may be exposed to asset write-offs due to potential collateral shortages and/or losses. As a result, some foreign banks may have reduced or suspended their commodities repo business in China, and could be undertaking further investigation as to whether to make any suspension permanent.

Likely reaction of foreign banks to the Qingdao issue

The initial reaction is likely to be to significantly reduce the exposure to different repo businesses and investigate whether there are any other multi-pledge issues in other deals. This is already happening in the market.

A further potential reaction, in our view, is for the banks to investigate the broader spectrum of their Chinese commodity financing deals (i.e. not just the repos or CCFDs, but the whole book) in order to clarify:

  • whether these deals are exposed to substantial underpriced risks;
  • whether the banks as a whole still want to continue the business;
  • if they choose to continue, what rules could be established and enforced.

Our base case is that, even if banks do not find any further cases during the investigation periods, they are likely to raise the bar for Chinese commodity financing deals in general, in order to broadly lower the exposure to this sector. This would occur via higher funding costs for the arbitrageurs, thereby slowly disincentivising repurchase deals and CCFDs, and resulting FX inflows. However, if there are further similar cases to be found, the whole exposure could be reduced sharply, which would lead to a disorderly unwind of repo and CCFD business in general.

However, the problem goes a lot deeper and has the potential to impact shadow banking systems around the world...

What do “repos” have to do with CCFDs? (see here for details)

If foreign banks try to reduce their broad exposure to Chinese commodity financing business via cutting commodity clients’ loan quotas and/or raising funding costs, this could reduce CCFDs’ ability to access cheap foreign funding and could potentially raise FX financing costs in future, thus affecting the profitability of CCFDs.

As illustrated in step 3 of the Exhibit 4, USD cash raised from repo business is an important link in CCFD funding. If we assume most of the copper in bonded warehouses is tied to both repo and CCFD business and the circulation of CCFDs are around 5 times, the FX funding from repo could be c.20% of total FX borrowings from Chinese copper financing deals. Thus, the suspension of repo business since last week by many foreign banks does directly impact the funding for CCFDs and reduces the incentive to hold physical inventories.

Another channel to access cheap FX funding is onshore banks’ funding of LC which is eventually funded by the interbank market (Exhibit 4). Thus, this channel would also be affected if the foreign banks try to lower exposure to China’s commodity business, because it would either raise the cost of LC funding or limit the LC funding quota for CCFDs, which would disincentivise CCFDs in both cases.



Even before the reporting of the Qingdao issues, the profitability of CCFDs in copper had been declining sharply since March 2014, due to:

  • lower CNY/USD rate differentials;
  • higher CNY volatilities against USD
  • higher LME rolling costs.




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This leaves us with two significant questions:

1) how much physical copper/aluminum tied in to these deals will suddenly hit the market (for sale) - thus sending the price sliding (and contagiously spreading to numerous banks and trading shops around the world - as we discussed here); and

2) if we are right that somehow China managed to push gold lower via gold CFDs, then the unwind pushes gold higher:

Here's how that might work:

In the gold markets, the paper or synthetic 'demand/supply' dominates pricing as opposed to the non-precious metals which have at least a grain of fundamental sense to them still


Throughout 2012/2013 - as the gold CFDs were booming, Chinese demand for physical gold was soaring as the price plunged (due to the forward hedging required in the CFD transactions which pressured gold swaps/futures lower and thus dominated pricing)


As CFD unwinds hit en masse, these flows must unwind (cover hedges and ensure the underlying physical is there... and if not buy it)


This will pressure gold futures prices higher and because unlike in non-precious commodities where spot markets wag the tail of the futures markets - spot gold will likely be dragged higher also (as we know the demand for the physical has been high).

As the renowned Dennis Gartman might say, being short of commodities in precious metals terms may be the cleanest way to trade the coming CFD unwinds. Especially since Gartman himself is long of said commodities.

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Finally, we noted previously, in brief (pun intended):

a complete, unpredictable clusterfuck accompanied by wholesale liquidations of "liquid assets", deleveraging and potentially a waterfall effect that finally bursts China's bubble, all due to a simple black swan. Although, in reality, nobody knows. Just like nobody knew what would happen when the government decided to let Lehman fail.

So is this China's Lehman? Sure looks like someone just hit the "oh, shit" button at the PBOC.