Chinese "Ghost Collateral" Scam Leads To Market "Shockwaves", Huge Loss For Giant Commodity Trader

Back in 2014, a scandal erupted when media reports confirmed what many had previously speculated about China's banking system: namely that much of China's staggering loan issuance had been built (literally) upon air and that trillions in loan collateral had been "rehypothecated" between two, three or many more debtors - or never even existed - forcing banks to accept that they would never recover much if any of the pledged collateral - in most cases various commodities - if the economy were to suffer a hard-landing resulting in mass defaults. The most famous example involved collateral fraud at China's 3rd largest port, Qingdao, where numerous borrowers were found to have "pledged" the same collateral of steel and copper to obtain funding from various banks.

For those unfamiliar there is an extensive selection of stories covering the topic, which peaked three years ago, and then quietly faded away as China did everything in its power to deflect attention from what some have said is the biggest threat facing its economy: a giant hole . Below we link to some of our more comprehensive articles on the topic:

To be sure, the story briefly resurfaced in May when we reported that "Some Chinese Banks Suspend "Interbank Business" As Regulator Demands That Collateral "Actually Exists", although it then quickly fizzled again, for two reasons: i) China watchers assumed that Beijing no longer had a "collateral problem" which had been somehow fixed after all the noise rehypothecation stories from in 2014, and ii) China now seemingly has even bigger problems on its hands, such as finding the right balance between maintaining the latest housing bubble, keeping capital outflows in check and its currency stable at a time when China's debt (well over 300% of GDP) was downgraded by Moody's (and later S&P) for the first time in 28 years, while its gargantuan shadow debt powder keg is one big red headline away from a $9 trillion shadow bank run.

And while the latter is certainly accurate, the former couldn't possibly be further from the truth.

That was revealed by a terrific June expose when Reuters reporters went to China to determine the current status of China's long-standing collateral problem. What they found was that "ghost collateral" continues to haunt countless loans across China's debt-laden banking system, which is a problem because as we explained in 2014, and as Reuters noted "lax lending practices and overvalued collateral spurred the U.S. financial crisis in 2008. Now, banks in China face risks of their own as fraudulent borrowers and corrupt bankers burden the financial system with loans lacking genuine collateral."

Fast forward to today, when China's "ghost collateral" problem has re-emerged with a bang, and this time there is a quantifiable price tag. As Bloomberg reports, the giant agricultural commodities merchant ED&F Man Holdings Ltd., best known for trading sugar and coffee, has taken a major hit of about $80 million "after falling victim to a scam in the metals market."

The scam, for those who have been following our reports on China's ghost collateral, will be familiar: ED&F Man's loss is linked to fraudulent metal-financing that was uncovered at a warehousing firm owned by Glencore Plc earlier this year, said Bloomberg's sources.  Back in 2013, we published an extensive discussion on the nature of China's commodity-financing deals, many of which were designed as quasi-legal ponzi scheme, meant to boost liquidity and funding by rehypothecating the underlying collateral on numerous occasions; at the time copper was the preferred underlying asset, however with time this spread to virtually all commodities.

This tale of "missing" collateral comes at a bad time for ED&F Man, which was already nursing a smaller losses at its sugar unit.

The metals issue comes as ED&F Man had a tough year at its sugar business, with the 230-year-old commodities trader last month saying it would cut costs and headcount at the unit amid surplus supplies and low prices. The London-based firm this week said Chief Executive Officer Phil Howell is leaving after three years in the role and more than two decades at the company.

While the impact on the company’s final earnings won’t be clear until ED&F Man releases its annual financial statements, it will be sizable: last year the company reported pretax profit, adjusted for acquisitions, of $100.9 million, which means that China's fake collateral has cost nearly one full year of net income for one of the world's best respected independent traders.

Here's what happened: Glencore’s Access World - one of the world's biggest provider of LME warehousing and logistics services -  warned customers in January that it found forged warehouse receipts circulating in the market. The announcement, Bloomberg writes "sent shock waves through the commodities-trading industry, reawakening concerns about fraud after a metal-financing scam was uncovered at the Chinese port of Qingdao in 2014."

Meanwhile, ED&F Man Capital Markets acted as a broker between Australia & New Zealand Banking Group and two Hong Kong-based trading companies in a sale-and-repurchase financing deal. The trade was backed by storage receipts for about $300 million of nickel stored in Access World warehouses in Asia, according to court documents filed by the bank in the U.S in June. However, when ANZ looked to sell the nickel, it discovered that all but one of the 84 storage receipts were likely to have been forged, leaving it with “substantial losses,” the bank said in court filings, which were part of a request for information it could use in lawsuits in other jurisdictions.

There is still some hope that ED&F Man can recover some losses...

Some of ED&F Man’s nickel-related losses could still be recovered when court proceedings are concluded, the people said. The company last month said its brokerage business in general continues to perform well.
Suedzucker AG, Europe’s largest sugar producer, has a 35 percent stake in ED&F Man.

... however, the odds are slim to none. In fact, what is surprising is that it has taken over three years for the first serious hit from China's "ghost collateral" to emerge. Or perhaps not: in a time of generally rising prices, few if any traders actually bother to check if their pledged collateral ever exists. The problem emerges when prices decline, which courtesy of China's bubble machine, has so far not been an issue. However, there are those random occasions when spot checks reveal shocking surprises, as Reuters reminded of over the summer:

The banker at the other end of the phone line was furious, recalled Shanghai lawyer Wang Chaoyu. A pile of steel pledged as collateral for a loan of almost $3 million from his bank, China CITIC, had vanished from a warehouse on the outskirts of the city. Just several months earlier, in mid-2013, Wang and the banker had visited the warehouse and verified that the steel was there. “The first time I went, I saw the steel,” recalled Wang, an attorney at Beijing DHH Law Firm, which represents the Shanghai branch of CITIC.


“Afterwards, the banker got in contact with me and said, ‘The pledged assets are no longer there.’”

Now, it was ED&F Man's turn to make the same shocking discovery. However, with trillions in dollars "guaranteed" by Chinese "ghost collateral" based on various third party estimates, at least the giant commodity trader can find solace in the fact that it will not be the last to learn that "it's gone... it's all gone."