Analysis Banks push into physical iron ore trading

Post on: 2011-09-05 By: admin

LONDON (Reuters) - An increasing number of investment banks are poised to muscle into the trading of physical iron ore, a business long dominated by trading houses, lured by the market's huge size and its shift to a more transparent pricing system.
"The global market volume is a major incentive, the iron ore market dwarfs any other metals ... and now they have a functioning financial market," said Macquarie analyst Colin Hamilton.
"The majority of the commodities banks, including Macquarie, are looking at physical iron ore."
About 1 billion tonnes of sea-borne iron ore are traded every year, with about 20-30 percent sold on the spot market and the rest sold in long-term contracts.
The banks may never match trading houses in this market, because their risk limits will curb both speculative trading and deals in some risky parts of the world.
Even so, banks will build their physical iron ore businesses for several reasons. Involvement in this market will help them to limit risk in their burgeoning iron ore derivatives businesses as well as to forge deals to finance companies in the booming mining business.
"Having access to the physical material will give banks more leverage and will limit their risk on the derivatives side," said Abe Ulusal, a trader at Mitsui Bussan Commodities.
After pioneering iron ore derivatives trading, Deutsche Bankstarted trading physical iron ore in 2010. Other banks such as Citiand Goldman Sachsare now following.
Iron ore swaps trading started in 2008 but began to gain more traction in 2010, when iron ore miners dumped a decades-old annual price benchmark system and moved to pricing in the shorter term.
Iron ore swaps allow producers, consumers and financial market participants to hedge or bet on prices in the future.
The volume of swaps cleared on the Shanghai Futures Exchange reached a record annualised level of almost 50 million tonnes last month, and although it is still small compared with the physical market, it is growing quickly.
"Being able to dispose of the physical material will give banks another exit strategy, better protection," said Jean-Luc Fiorenzoni, director of risk management at steel trading company Stemcor.
OFF-TAKE DEALS
Entering the physical trading market will mesh well with banks' efforts to secure more off-take agreements and finance deals with industry players.
Off-take deals, generally negotiated before the construction of a mine, allow the buyer to lock in the purchase of part of the producer's future production in exchange for providing finance for the project.
Standard Bank , Africa's biggest bank by assets, has been financing commodities businesses for many years, but its physical iron ore trading business has gained momentum only in the past few months.
"We have already concluded some long-term (iron ore) off-takes in Sweden, Latin America and Australia, and we are actively trading material in China as well," said Jim Coupland, Standard Bank global head of base metals and bulk commodities.
RISK LIMITS
Banks' ambitions in physical iron ore are likely to be curbed, because they operate under more strict criteria than do trading houses when it comes to counterparties and credit risk.
"Banks cannot deal with small, silly trading companies. You have to deal with big guys with credit lines," Ulusal said.
Finding the right suppliers or the right customers may prove tricky for the large financial institutions, considering also that much of the material comes from risky areas.
"I don't see banks trading iron ore in Iran or Venezuela," said a London-based iron ore trader.
"Banks are not in the business to replace physical traders. They will focus on a few off-takes and on financing, but in terms of the spot market they won't do much, maybe an average of 3-5 million tonnes per year (each)."
The potential for banks' building up proprietary or speculative businesses will also be limited.
Standard Chartered , which is boosting its iron ore derivatives business, is looking to get involved in the physical side of the business through financing but has shunned speculative trading.
"I think that going into that market is a considerable investment, so you need to make sure you can make money out of it, but I think it will be challenging," said Standard Chartered global head of metals trading, Jeremy East.
(Editing by Jane Baird)
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