Chinese Commodity Contagion Leads To First Letter Of Credit Settlement Failure

At the heart of the China Commodity Financing Deals (CCFD) is the ability to leverage a letter of credit on the basis that there was some collateral somewhere that backed the risk of this rehypothecatable 'money'. Until now, the biggest concern has been "where's my copper, nickel, gold, etc..?" as the Qingdao ponzi scheme is unveiled; but, as Metal Bulletin reports, the contagion from the exposure of CCFDs ponzi has now hit Western banks. At least one western bank has stopped discount financing of copper into China after Industrial & Commercial Bank of China (ICBC) applied for the right not to settle a letter of credit it issued earlier this year, as a result of the Qingdao investigations. In other words the collateral chains were just snapped…

As Metal Bulletin reports,

This is a new development in the fallout from the Qingdao warehousing scandal, in which Chinese firm Decheng Mining allegedly used false warehouse receipts to gain multiple loans from banks.

ICBC's request for the right not to make this payment is a move that is lawful in the country in cases where there are concerns about fraud.

It is the latest legal move by parties that may have exposure to the Qingdao fraud to try to protect their interests, sources said.

But if the move was granted, it would be likely to leave its counterparties out of pocket, and would risk a renewed ratcheting-up of concerns about copper financing.

The western bank, which was not an ICBC counterparty in the deal to which the injunction applies, has responded by ceasing to do some forms of copper financing…

This is a major problem as when the collateral chains break, the whole house of cards falls rapidly…

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And Citi is already actively denying any exposure…

*CITI SAYS NO COMMODITY-LOAN EXPOSURE TO CHINESE FIRMS IN PROBE
*CITI: COMMODITY LENDING CONTRACTS GUARANTEED BY PARENT FIRMS
*CITI: FINANCING IS WITH MULTINATIONAL FIRMS' NON-CHINESE UNITS

Good luck with that legal case…

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But as we explained previously, LCs are crucial in the leveraging of the actual commodity deal…what does all this mean for explicit rehypothecation chain leverage (initially just at the CCFD level although a comparable analysis must be done for systemic as well) and CCFD risk exposure:

Leverage in CCFDs

Below is a demonstration of the LC issuance process in a typical CCFD. Assuming an LC with a duration of 6 months, and 10 circuit completions (of Step 1-3) during that time (i.e. one CCFD takes 18 days to complete), Party D is able to issue 10 times the copper value equivalent in the form of LCs during the first 6 month LC (as shown from period t1 to t10 in Exhibit 10). In the proceeding 6 months (and beyond), the total notional value of the LCs remains the same, everything else equal, since each new LC issued is offset by the expiration of an old one (as shown from period t11 to t20).

In this example, total notional amount of LC during the life of the LC = LC duration / days of one CCFD completion* copper value = 10. In this example, the total notional amount of LC issued by Party D, total FX inflow through Party D from party A, and total CNY assets accumulated by party B (and C) are all 10 times the copper value (per tonne).

To raise the total notional value of LCs, participants could:

Extend the LC duration (for example, if LC duration in our model is 12 months, the notional LC could be 20 times copper value)

Raise the no. of circuits by reducing the amount of time it takes to clear the paperwork

Lock in more copper

Risk exposures of parties to CCFDs

Theoretically, Party B risk exposure > Party D risk exposure > Party A risk exposure

Party B’s risks are duration mismatch (LC against CNY assets) and credit default of their CNY assets;

Party D’s risks are the possibility that party B has severe financial difficulties. (they manage this risk by controlling the total CNY and FX credit quota to individual party B based on party B’s historical revenue, hard assets, margin and government guarantee) (Party D has the right to claim against party B (onshore entity), because party B owes party D short term FX debt (LC)). If party B were to have financial difficulties, party D can liquidate Party B’s assets.

Party A’s risk is mainly that party D (China’s banks) have severe financial difficulties (Party A has the right to claim against party D (onshore banks), because Party A (or Party A’s offshore banks) holds an LC issued by party D). In the case of financial difficulties for Party B, and even in case Party D has difficulties, Party A can still get theoretically get paid by party D (assuming Party D can borrow money from China’s PBoC).

In brief (pun intended): a complete, unpredictable clusterfuck accompanied by wholesale liquidations of "liquid assets", deleveraging and potentially a waterfall effect that finally bursts China's bubble, all due to a simple black swan. Although, in reality, nobody knows. Just like nobody knew what would happen when the government decided to let Lehman fail.

So… is this China's Lehman?

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Just as Lehman hit the US when trust failed, this first failure of settlement in China's CFD shadow market is yet another straw on the camel's back…

Don't think it can happen? Think again – China money market rates are surging as liquidity demands soar…