Early Warning on the Qingdao port scandal

When discussing the Qingdao Port Scandal, my view is that proper risk surveillance would have highlighted the glaring "rehypothecation" risk that had been building up over the years.

In fact, way back in 2013, a full year before the Qingdao port scandal erupted, Goldman Sachs had highlighted how commodity repo financing was used to arbitrage the interest rate differentials on onshore CNY and USD (see here) . An update was issued in March 2014, a full three months before all things broke out (see here), which foretold quite precisely what was going to happen in an unwind. This was reported in noteworthy finance blogs such as Zero Hedge way back in 2013 as well (see here)





Basically, the larger deal structure involved was a bit more complicated than a straight cash - forward sale agreement.

Generic Chinese Copper Financing Deal Structure (Source: Goldman Sachs Commodities Research)

The picture looks slightly complicated so let me explain it step by step and where the risks actually build up.

But before we begin, lets take a step backward and actually try to understand what is the motivation behind the entire deal structure.

Well the reason is to have entity B, which is a firm in China borrow USD at USD LIBOR + 100/150, or 2.5%, and invest in domestic Chinese interbank rates of lets say 5%.  Actually in a subsequent article, I will present a financial model of this transaction, based off the workings provided by the researchers from GS.

So now the question arises - how is it done and where are the risks?

As per the GS report.

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.

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.

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.

Step 4 is where the risks build up. Assuming the onshore bank, lets call it Bank of Qingdao for simplicity, had entered into a repo style transaction with the onshore trader A, they would end up financing the same tonne of copper up to 30 times.

Thus, in theory, even though the risks were largely with the onshore banks, it was quite surprising that the most high profile case involved an offshore entity, Citigroup and Mercuria.

The point is not to try to place Mercuria or Citi within the structure of this CCFD. It could very well be that Mercuria wanted to get inventory of copper so that it play the role of onshore entity A, or maybe its intention was for other trading purposes.  That does not really matter.

As noted in the judgement delivered by the High Court was that Citi accepted that it had risk in and title to the metal at the time the alleged fraud was uncovered and so no finding was made on whether the transaction was a "true sale" or not. Under the terms of their agreement, Citi’s service of valid bring forward event notices meant that Citi had a claim for the price of the metal, in the sum of US$270 million. However, because Citi could not give good delivery, it was not entitled to judgment for the price as claimed.

The key operational risk is the fact that was highlighted in the 2 reports I shared earlier, which was known a year earlier. The same tonne of Copper and Aluminium was being refinanced 10x over. The risks of rehypothecation was well known after the Lehman Crisis and should have raised red flags all throughout.  Additional controls could have been instituted, for example financing against warranted copper / aluminum in the Shanghai Metals exchange over humble warehouse receipts.