Banks, metal warehouses and the 'dark inventory' game

Over the last decade there have been many complaints, including lawsuits detailing allegations of market manipulation, about big US bank holding companies' involvement in the commodities business.

Several US statutes, dating as far back as the National Bank Act of 1863 up to and including the Dodd-Frank Act of 2010, generally bar banks from conducting commercial, non-financial activities.

But since the US Federal Reserve determined in 2003 that certain commodity activities are "complementary" to financial activities and therefore permissible Wall Street bankers – Morgan Stanley, Goldman Sachs, and JPMorgan are the biggest players – have been moving aggressively into everything to do with physical commodities including mining, processing, transportation, warehousing and trading.

The supply of aluminum has been particularly distorted according to manufacturers with about $3 billion in additional costs to buyers as premiums have doubled since 2003 despite a glut of aluminum being produced.

The ever cogent John Gapper writes in the Financial Times banks "have evaded the regulatory barriers by using their merchant banking (private equity) arms to take ownership of warehouse, mines and ships "under another guise:"

Given that the aluminium price has fallen further than the premium for getting it promptly has risen, the beer guys’ lament deserves to be played on a very small violin. They could have bought at the bottom of the market themselves, rather than letting speculators do so and then complaining loudly.

Nonetheless, there are murky aspects to aluminium trading. Banks and commodity trading groups can store some of their metal in private facilities – “dark inventory” – in order to make it appear scarce. Furthermore, the fact that banks’ investment arms decided to acquire assets that dovetailed so neatly with their trading operations feels too convenient for comfort.

This abrupt integration of metals trading and storage echoes how banks piled into subprime mortgages before the 2008 crisis, buying origination and servicing companies to securitise the loans. When Wall Street takes a detour from trading into surprising new activities, sound the alarm bell.

According to the FT "commodity collateral can be reclassified from private "dark inventory" to publicly visible inventory, according to the interests of the trading institutions:"

When it suits an institution to benefit from a move towards backwardation, public inventory will be taken dark, and positions established to benefit from an apparent destocking effect — even though the collateral is not heading to market at all. When it suits an institution to benefit from a move towards contango, dark inventory will be taken public, presenting the appearance of a sudden surplus and glut in supply (even though the glut was always there).

This is the other reason why owning warehouses became so appealing. It’s much harder to keep inventory out of sight of public eyes if you’re dependent on the LME warrant system or third-party providers.

Continue reading at (paywall) and click here for an FT explanation of how banks profit from dark inventory.