Commodity Traders’ Buildup on Easy Money Seen as Risk in Report; 10 largest trading houses with $1 trillion in revenue could potentially become “too physical to fail.”

Commodity Traders’ Buildup on Easy Money Seen as Risk in Report

Trading houses active in multiple commodity markets have built up physical holdings through easy access to financing, creating a possible systemic risk, according to a report by the Centre for European Policy Studies. Disclosure of physical holdings and a minimum amount of information that must be provided to regulators could reduce the risks for governments that might have to bail out trading houses, Brussels-based CEPS wrote in a statement with the European Capital Markets Institute. The 10 largest trading houses had about $1 trillion in revenue in 2011, according to CEPS and ECMI, and trading houses could potentially become “too physical to fail.”“The use of financial leverage to increase physical holdings, through the easy access to international finance helped by accommodating monetary policies, may have systemic implications,” according to the two organizations. Reporting requirements “may reduce risk of moral hazard for national governments that have to cope with the sheer size of these entities in case of trouble.”

The full report will be available online today at noon in Brussels, according to CEPS and ECMI.

The researchers found linking of the global physical commodity markets with the financial system and accommodating monetary policy have raised the effect of the economic cycle and commodities’ vulnerability to short-term shocks coming from the financial system.

11 Commodities

Demand and supply fundamentals remain “solid” long-term drivers of commodity futures’ price formation in all studied markets, according to the report. CEPS and ECMI looked at oil, natural gas, iron ore, aluminum, copper, wheat, corn, soybean oil, sugar, cocoa and coffee.

The role of non-commercial operators in commodity markets has been “generally benign,” and the growth of index investments has not yet caused distortions in price formation, the report stated.

“An indiscriminate ban on legitimate trading practices may result in liquidity losses at the expense of the efficiency of price formation,” CEPS and ECMI wrote.

Corn Comparison

Claims that the size of futures markets compared to physical markets may distort price formation could be neither proved nor ruled out, according to the report. Annual volumes of trading in the main corn future is as much as nine times larger than physical production, it said.

Public spending on infrastructure or technology to improve production may be beneficial alternatives to price subsidies, which have a possible distorting effect, the organizations wrote. China overtook the U.S. as the biggest subsidizer of agricultural commodities in 2012 at about $180 billion, according to the report.

To contact the reporter on this story: Rudy Ruitenberg in Paris at rruitenberg@bloomberg.net