Starting back in May of 2013, we first predicted that China's "Lehman event", even more troubling than the recent advent of Chinese corporate bankruptcies and perhaps even its housing crisis, namely the "discovery" that behind China's virtually-infinite rehypothecation machine - the backbone of its shadow funding markets - the amount of actual physical commodities is severely limited and misrepresented, meaning that for every paper claim on an underlying "funding" metal, there are pennies on the dollar, or renminbi as the case may be, of actual underlying collateral. Or, as MF Global's Jon Corzine may say, "it evaporated." A year later, this too prediction has come true, and overnight none other than Goldman laid out a checklist of just how the recent revelation that not all bonded warehouses at the port of Qingdao, China's third largest, will become the catalyst to further CCFD unwinding.
And while this story is very slow to gain prominent media coverage for obvious reasons, the few outlets that have been keeping up, continue to disclose ever more troubling details, of which the latest and greatest one is not that China's key bank, state-owned Citic Resources has moved to secure the metals (it hopes) it has possession of at Qingdao: this was perfectly expected and the only question was who would be the first counterparty to admit there is a massive rehypothecation problem, and will be the second leg in the crisis, as one claimant after another rushed for their physical only to find that it has been pledged a countless number of times to other counterparties.
No, the biggest news was that the troubles at Qingdao, which as noted is merely the 3rd largest Chinese port, have now spread to a second Chinese port: Penglai, which is also located in the Shandong province. Putting some size numbers for context: Qingdao's copper inventory is about 50,000 tons, compared to 800,000 tons in Shanghai, analysts say. There's "little evidence" for now that traders in Shanghai fraudulently have pledged collateral to banks, said Sijin Cheng, an analyst with Barclays Research in Singapore. Little evidence will become "lots" in the coming days when we expect more "discoveries" at all other bonded warehouses as the relentless inflow of commodities finally reverses and the beneficiaries finally demand possession. As everyone who has followed even the simplest Ponzi schemes knows, this is the part of the lifecycle when many tears are shed by most.
Here is what else the WSJ had to say on this topic:
The trading firms hold the deed to the metal, which can be used to secure financing, but the metal stays in a warehouse. Banks fear a private Chinese company may have used the metal as collateral to get multiple loans, potentially defrauding the lenders and trading firms.
These banks have not been able to get access to the collateral, stored at Qingdao Port, which administers the warehouses.
In an announcement to the Hong Kong stock exchange, Citic Resources said it has applied to courts in Qingdao for "sequestration orders in respect of the Group's alumina and copper." It said it owns alumina and copper stored in bonded warehouses at the port.
A number of Western and Chinese banks have sought similar court orders in an effort to secure their collateral, according to one person familiar with the matter. But the court orders won't alleviate the problem of multiple lenders claiming the same piece of collateral that had been promised to them by the borrower, this person said.
Meanwhile, the infinite rehypothecation bug has gone airborne:
Western lenders are also concerned that the potential fraud may also have occurred at Penglai port, located about 150 miles south of Qingdao, according to people familiar with the matter. Inspectors have been unable to again access to collateral stored at Penglai port, one of the people said.
One executive at a Western bank said the development is a worrying signal that the possible fraud first uncovered at Qingdao may be more widespread than anticipated.
The banks involved:
The Western lenders involved include Citigroup Inc., Standard Chartered PLC, Standard Bank PLC, ABN Amro Bank NV, BNP Paribas SA and Natixis.
Not surprisingly, Citic, which as noted above was the first bank to defect from the group of ostriches with their heads in the sand is quiet about what it finds: the last thing it wants is other banks to scramble and obtain their collateral at a time when Citic is doing the same. Good luck getting your copper, aluminum... or gold... after the first one or two banks have recovered their deliverables: there will be nothing left for anyone.
Citic said the status of the investigation by authorities is "unknown" to the company and that it cannot provide further information on the effect of the investigation on its alumina and copper assets.
For about a decade, Chinese and Western banks have facilitated the flow of capital into China backed by imported commodities. More recently there has been concern that Chinese merchants were carrying out an arbitrage by borrowing against the commodity in dollars at low offshore rates and investing onshore at a higher interest rate. The merchant later pays back the dollar loan.
Chinese authorities have allowed this to happen as a way of boosting credit-driven economic growth. But they have become more worried in recent months that some metals merchants have been pledging the same commodities to multiple banks, causing systemic risk in the financial system.
That's great. The problem is that as we showed recently, in a country in which $1 trillion in debt is added per quarter to a total debt load which is 150% of US (not China) GDP...
... China needs every possible source of credit funding. And as the funding deal pathway - which is a major part of China's shadow credit creation pipeline - unravels and is magnified, the economic shock will be severe.
Finally, since commodity funding deals, the transactions at the basis of the broken Chinese repo/rehypothecation pathway will become a prominent feature of the mainstream media circuit as soon as journos figure out what they are, here is a reminder of the key basics involved , as we posted over a year ago.
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.
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.
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How an unwind may impact each CCFD participant
As we discussed on pages 4 and 5, SAFE’s new regulations target both banks’ LC issuance (first measure) and ‘trade firms’ trade activities (second measure). Here we discuss how the different entities (A, B, C, D) would likely adjust their portfolios to meet the new regulations (i.e. what happens in a complete unwind scenario).
Party A: Party A, without the prospect of $10-20/t profit per Step 1-3 iteration, is likely to find it hard to justify having bonded copper sitting on its balance sheet (the current LME contango is not sufficient to offset the rent and interest costs). As a result, Party A’s physical bonded copper would likely become ‘available’, and Party A would likely unwind its LME short futures hedge.
Party B, C: To avoid being categorized as a B-list firm by SAFE, Party B and C may reduce their USD LC liabilities by: 1) selling liquid assets to fund the USD LC liabilities, and/or 2) borrowing USD offshore and rolling LC liabilities to offshore USD liabilities. The broad impact of this is to reduce outstanding LCs, and CCFDs will likely be affected by this. It is not yet clear what happens to the B-list firms in detail once they are categorized as such. However, if B-list firms were prohibited from rolling their LC liabilities this would increase the pace of the CCFDs unwind. In this scenario, these trade firms would have to sell their liquid assets (copper included) to fund their LC liabilities accumulated through previous CCFDs.
Party D: To meet SAFE’s regulations, Party D will likely adjust their portfolios by reducing LC issuance and/or increasing FX (mainly USD) net long positions, which would directly reduce the total scale of CCFDs and/or raise the LC financing cost, respectively.
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Finally, how much leverage, and risk in general, is involved with the unwinding of CFDs?
Leverage in CCFDs
Below is a demonstration of the LC issuance process in a typical CCFD. Assuming an LC with a duration of 6 months, and 10 circuit completions (of Step 1-3) during that time (i.e. one CCFD takes 18 days to complete), Party D is able to issue 10 times the copper value equivalent in the form of LCs during the first 6 month LC (as shown from period t1 to t10 in Exhibit 10). In the proceeding 6 months (and beyond), the total notional value of the LCs remains the same, everything else equal, since each new LC issued is offset by the expiration of an old one (as shown from period t11 to t20).
In this example, total notional amount of LC during the life of the LC = LC duration / days of one CCFD completion* copper value = 10. In this example, the total notional amount of LC issued by Party D, total FX inflow through Party D from party A, and total CNY assets accumulated by party B (and C) are all 10 times the copper value (per tonne).
To raise the total notional value of LCs, participants could:
- Extend the LC duration (for example, if LC duration in our model is 12 months, the notional LC could be 20 times copper value)
- Raise the no. of circuits by reducing the amount of time it takes to clear the paperwork
- Lock in more copper
Risk exposures of parties to CCFDs
Theoretically, Party B risk exposure > Party D risk exposure > Party A risk exposure
- Party B’s risks are duration mismatch (LC against CNY assets) and credit default of their CNY assets;
- Party D’s risks are the possibility that party B has severe financial difficulties. (they manage this risk by controlling the total CNY and FX credit quota to individual party B based on party B’s historical revenue, hard assets, margin and government guarantee) (Party D has the right to claim against party B (onshore entity), because party B owes party D short term FX debt (LC)). If party B were to have financial difficulties, party D can liquidate Party B’s assets.
- Party A’s risk is mainly that party D (China’s banks) have severe financial difficulties (Party A has the right to claim against party D (onshore banks), because Party A (or Party A’s offshore banks) holds an LC issued by party D). In the case of financial difficulties for Party B, and even in case Party D has difficulties, Party A can still get theoretically get paid by party D (assuming Party D can borrow money from China’s PBoC).