Shaken by a fraud investigation into metal financing in the world's seventh-busiest port, banks and trading houses have been made painfully aware of the risks they face storing commodities in China's sprawling warehouse sector.

The probe at Qingdao port centres around a private metals trading firm suspected of duplicating warehouse certificates in order to use a metal cargo multiple times to raise financing.

Some banks have asked clients to shift metal, used as collateral for loans, to more regulated London Metal Exchange (LME) warehouses outside China or those owned and operated by a single warehouse firm to limit their exposure.

"The banks still haven't looked under the hood," says an executive at a bank involved in commodity financing in China, referring to China's warehousing sector.

At the heart of the issue is China's roaring commodity financing business, which has helped drive up stockpiles of commodities at ports to record levels, stored in warehouses not always regulated to the same extent as elsewhere.

Though many global firms are involved in the warehouse industry in China, there has been outsourcing to local firms to cut overheads and avoid dealing with complex local regulations.

Using commodities as collateral in financing in China is common practice and not illegal, but issuing receipts to repeatedly mortgage an asset is fraud and could leave more than one creditor holding claims to the same collateral.

Illustrating how difficult it may be to unravel competing claims, China's CITIC Resources Holding Ltd says that a court had been unable to secure more than 100,000 tonnes of alumina stored at the Qingdao port.

Traders say there was a risk the metal could have been already claimed before part of Qingdao Port was sealed off, adding that at least two trading houses had moved metal out as soon as news of the scandal broke.

CITIC Resources says it will conduct its own investigation and is considering further legal action.

Trading blame

In Qingdao, sources with knowledge of the probe say authorities are looking at whether the firm under focus, Decheng Mining, had secured multiple warehouse receipts because an affiliate managed logistics at the port's Dagang bonded zone.

"Warehouse receipts are not title documents; they are documents of entitlement. But they are being used as title documents for sales and purchase and transfer of ownership," says a person at a warehouse company with operations in Qingdao.

"Everywhere else outside of China, a warehouse receipt is cut for one party."

A source at a Western bank with direct knowledge of Qingdao says warehouse firms should bear responsibility, while a senior official at a warehouse firm at the port says responsibility "remains very much up in the air."

A lawyer, who has previously been involved in litigation over fraudulent warehouse receipts, says banks’ primary recourse would be against whoever had forged receipts.

"But if the fraudster is gone, the bank may decide that it wants to go against the warehouse," says a lawyer on condition of anonymity.

A warehouse operator and a banker say agreements with clients meant there could be limited liability for a cargo, capping a payment at around $100,000 depending on specific terms and conditions. For example, a shipment of 10,000 tonnes of copper would be worth about $68 million at current prices.

Even if banks or their customers have insurance for the metal, some warehouse sources say they might struggle to get paid if fraud is uncovered or their agents are implicated.

Global firms

Singapore-based GKE Corp, a part-owned unit of Louis Dreyfus Corp, CWT Ltd and the metals warehousing arm of Glencore, Pacorini Metals, is among global firms involved in the warehousing business in Qingdao.

GKE said on June 16 “to the best of its knowledge, management or employees were not implicated in the port investigation.”

A firm that appears to have steered clear of the current problems at Qingdao is C. Steinweg Handelsveem B.V., the world's largest independent metals warehousing and logistics firm.

The Dutch firm, which does not operate in the Dagang area of the port where the fraud probe is centred, does not contract out logistics operations to third parties and usually owns its warehouses, according to traders, bankers and warehouse sources.

Benefit LME?

In addition to potentially benefiting firms which own and operate warehouses, the Qingdao probe has prompted some movement of metal to LME-approved warehouses in locations such as South Korea.

The LME, which is owned by Hong Kong Exchanges and Clearing Ltd, has approved more than 700 warehouses and storage facilities in about 40 locations globally.

The exchange is keen to break into the Chinese market, where it is not currently permitted to license warehouses.

The LME sets down specific requirements for warehouse firms it licenses, such as evidence of adequate capital and insurance, as well as regulating metal movement and conducting audits.

"The extension of the LME's warehouse network into mainland China is an important issue for the LME and its users, and we alongside HKEx, put a high priority on this initiative,” says a LME spokeswoman.

A person at a warehousing company in Singapore says that countries where the LME operates show that the "the confidence level is much higher" with a regulatory system in place.

But the reverberations from the Qingdao probe may not be clear cut, since global warehousing firms potentially exposed to the scandal are licensed by the LME to operate in other ports.

One thing looks certain, however. Banks involved in commodity financing in China are set to charge higher fees.

"The cost is certainly going to go up, whether it's going to be from local banks or international,” says analyst Colin Hamilton of Macquarie in London.

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Shift metals in China to secure warehouses, banks tell clients

By Polly Yam of Reuters

At least two global banks involved in commodity financing in China have asked some clients to shift copper and aluminium, used as collateral for loans, to better regulated warehouses, three sources with direct knowledge of the matter say.

Banks and trading houses have been making urgent checks on the security of metal holdings in China, sparked by a suspected fraud at Qingdao Port, the world's seventh biggest. Police are investigating the duplication of warehouse receipts by a third-party firm on metal cargos used to obtain financing.
Standard Chartered and South Africa's Standard Bank have already contacted clients, two sources say.

The banks had requested that some metal stocks be moved to warehouses owned directly by operators, rather than rented by third parties, say the two people, whose firms have metal in bonded warehouses in Shanghai and the province of Guangdong.

Another person at a warehouse firm involved in the issue also confirmed the request from the banks.

"We were asked to move stocks to warehouses that are not rented but owned by the warehouse operators," says one of the sources, whose firm trades aluminium and copper, as well as producing aluminium in China.

Asked whether it had asked some clients to move metal, Standard Chartered said in an emailed statement: "We recognise that there are currently issues in China around commodity financing which we are monitoring."

Arun Murthy, global head of commodities at Standard Chartered, says that commodity financing remained a key focus for the bank.

The bank has said it had started investigations into potential irregularities at the Qingdao port and was working with local authorities.

Fees had been waived by the warehouse operator to allow for bonded copper stocks in Shanghai to be moved to storage spaces directly owned by the operator, one of the sources says.

The source says his firm was told that the relocation of metal had to be completed before existing financing deals expired, otherwise metal would be moved to London Metal Exchange (LME) warehouses in Singapore. The more highly regulated LME warehouses are located in several countries in Asia, but China does not currently permit them in the country.

Limited storage space

The Qingdao port investigation has hit metal prices, reflecting market fears about business practices in China and worries that the probe could spread to other ports and prompt a crackdown on using metal as collateral for financing.

Domestic and foreign banks were tightening requirements on new commodity financing deals in China, with some adding new stipulations on how to secure stocks, trading sources say.

Pledging commodities to a bank, often using a warehouse receipt as proof of ownership, has become a popular way of raising finance in China, helping create huge stockpiles of metals at some ports in China.

A lack of sufficient storage directly owned by warehouse operators in China could become an obstacle to moving stocks.

Market estimates put copper in bonded warehouses in Shanghai alone between 500,000 and 600,000 tonnes, more than double combined exchange stocks held in LME and Comex warehouses.

The head of trade finance for a Southeast Asian bank, which offers credit to companies importing copper in China, says it is now checking on whether warehouse companies used by its clients had outsourced any part of their business.

The Asia manager of a global warehousing company says it was common practice in many countries to outsource the management of warehousing to local companies, particularly in order to avoid dealing with often complex domestic regulations.

"It comes down to the rigour and discipline you have in operating with a third party - do you audit the material in the warehouse? Do you audit their procedures? Do you audit their processes?"

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China's small commodity traders at risk if banks tighten financing

By Fayen Wong, Polly Yam and Melanie Burton of Reuters

A warehouse fraud at China's third-largest port has forced banks and trading houses to consider new controls in the country's massive commodity financing business, which traders say could lead to drying up of credit for all but large firms and state-owned companies.

China's commodities trading is dominated by the large and state-owned companies, but there are thousands of small firms in the market. Faced with tougher bank requirements for financing, they could sell down stockpiles, squeezing demand for metals and other raw materials such as rubber in the world's biggest consumer of commodities.

Any new requirements would also ratchet up the risk that customers who do not regain credit lines may default on payments for services such as hedging, or for imports.

"The fear is not so much about the big boys, but some of the other smaller, newer players, who may have only been in this commodity financing game for the last two to three years," says Jeremy Goldwyn, a director with commodities broker Sucden in charge of Asia business.

"If all of a sudden the tap is turned off to them, they might have more of a crisis. Is it having an effect on the market? Yes, people are very nervous. We obviously have a lot of business in China so we are watching it very closely," he says.

According to sources, Standard Chartered Bank has suspended some commodity financing deals in Qingdao port after authorities there launched a probe into a private trading firm, Decheng Mining, that is suspected of duplicating warehouse certificates to use a metal cargo multiple times to raise financing.

For Western banks such as Standard Chartered, HSBC and BNP Paribas, which are restricted in the domestic loan market in China, the metals financing business is a lucrative alternative but the Qingdao scandal has renewed focus on counterparty risk.

Goldman Sachs estimates that commodity-backed deals account for as much as $160 billion, or about 30 percent of China's short-term foreign exchange borrowing.

Besides metals, the banks are now taking a fresh look at loans backed by other commodities such as iron ore, soybeans and rubber, fuelling concerns that any drying up of credit could spark a series of defaults on trade loans, or force other cash-strapped firms to cancel term shipments in the second half of this year.

"In the next two months, some smaller companies may default on term copper shipments if they cannot receive letters of credit or if they can't find a bank to do inventory financing," says a trader at a large international trading house.

As they review their commodity lending business, some foreign banks are considering measures such as getting finance guarantees from Chinese banks for letters of credit issued to local firms and taking on insurance with more comprehensive coverage, bank sources say.

"If we are signing contracts with their Singapore or Hong Kong-registered company, we may also start demanding guarantees from the Chinese parent," says an executive at a Western bank affected by the port scandal.

In the case of Decheng, there are worries among exposed banks that they would have difficulties recovering the losses because most of the financing agreements were signed with its Singapore-registered unit, which has limited assets to pay back creditors, says the executive.

Weeding out smaller firms

For smaller end users and trading firms, both local and Western banks are also thinking of imposing loan restrictions that will require shippers to prove that they already have domestic buyers lined up for the metal, sources say - a move that could weed them out of the commodity financing business as they struggle to meet these tougher requirements.

These measures are set to make commodity financing in China - already under scrutiny by authorities - even harder and costlier, in turn helping large players, such as state-owned Chinese firms and large end-users, get even bigger.

Chinese state-owned firms, such as Minmetals, Jiangxi Copper International and Founder Commodities, are favoured by local and foreign lenders alike as trading partners because of their financial muscle. There is also a perception that Beijing would bail out these companies if things go awry.

Authorities have not yet disclosed the amount of metal involved in the Decheng financing probe, but sources familiar with the matter say it was about 20,000 tonnes of copper, nearly 100,000 tonnes of aluminium ingots and about 200,000 tonnes of alumina, the raw material for aluminium production.

That quantity of metal would be worth about $390 million at current prices.

According to Chinese business daily Caixin, Decheng's parent company, Dezheng Resources, and its subsidiaries had borrowed a total of 14.8 billion yuan ($2.38 billion) from Chinese banks for trade and other loans, part of it for metal imports.

Chen Jihong, a veteran trader and chairman of Dezheng Resources, has been detained by authorities since April and is being investigated as part of a corruption probe unrelated to Qingdao port, trading sources and bankers who have dealt with Decheng say.

With the incident putting China's sprawling warehouse sector under scrutiny, foreign banks are also likely to demand more stringent requirements of warehousing companies from whom they accept inventory receipts.

Import squeeze and default risks

Pledging commodities to a bank using a warehouse receipt as proof of ownership, while agreeing to buy the cargo back at a set point in future, is a popular way to raise finance in global commodity markets.

It took off in China as traders sought to profit from the difference in global interest rates in the wake of the 2008 credit crisis: borrowing in dollars to invest in China's sizzling shadow banking markets - often through non-traditional wealth management products linked to property - where the gap between returns and funding costs could be as much as 10 percentage points.

While the Qingdao scandal has rattled global metals markets, investigations so far suggest this is an isolated case, with several bank sources saying that stock checks at other Chinese ports have not found any wrongdoing.

Still, the episode has already made banks more reluctant to grant letters of credit, even when legitimate, raising the spectre of loan defaults and cancellation of copper imports in the later part of this year.

Worries of a worsening credit crunch have led some companies to sell their refined copper stocks in bonded warehouses in Shanghai, trade sources say, putting pressure on futures and on premiums which fell by nearly half after news of the scam broke.

Since then, banks have taken longer to approve finance for copper imports, boosting demand for Shanghai copper stocks and buoying futures prices. Shanghai copper hit a four-month high of 49,690 yuan ($8,000) on Tuesday.

To be sure, no foreign banks - even those that have hit by the Qingdao saga - are thinking of exiting the lucrative financing business permanently.

"Foreign banks are largely shut out of the domestic loans market, with restrictions on funding and products we can offer. But offshore trade financing, however, is one that plays to our strength," says an executive at another Western bank.