How to Blind a Pilot: Aluminium Price Manipulation
July 10, 2017 - David Buckham CEO of Monocle
In 1994, airport officials in Rotterdam found it necessary to lodge a formal complaint against a company that they felt had begun to endanger the lives of their passengers and pilots. This company had amassed such a significant volume of aluminium in storage around the Rotterdam airport and sea port that the reflected light off the metal was blinding their pilots on take-off and landing. In investigations that followed, it was found that the actual owner of the aluminium, held through a series of offshore companies, was in fact a well-known, yet surprising entity: Goldman Sachs.
What – one may ask – would be the purpose of an investment bank, renowned for brokering corporate take-overs and mergers, and for underwriting equities and bonds, for owning such a tremendous volume of aluminium? The answer lay of course in the fact that Goldman Sachs had significantly ramped up their presence in the commodity trading markets.
Whereas within equity and debt trading operations – in which there is no actual physical delivery of the underlying asset – in the case of commodities, should the contract expire, the commodity itself needs to be physically delivered, to be stored at the very least, somewhere in the world. In this case Rotterdam was the port which held the storage facilities that were required by Goldman.
This kind of activity – that of taking large volumes of commodities onto their own balance sheets – already a stretch of the concept of banking, had been growing steadily since banks began offering commodity hedging as part of their raft of services to their corporate clients.
Should Coca Cola, for example, wish to hedge the future cost of aluminium anticipating price volatility in the metal – a key component of their cost of production – they may wish to enter into a commodity futures or forward contract with Goldman Sachs for a fee. There would seem nothing untoward about this – it being one of the core purposes of financial services, at the service of industry and economic growth in general. In this regard, Goldman Sachs would be engaged simply in the process for which banking is meant: that of financial intermediation.
However, over time, the benefits to firms like Goldman Sachs and Morgan Stanley of trading commodities for their own balance sheets – what is known as proprietary trading – far outweighed the margins they were making by providing commodity price hedging services to their clients. In fact, the business of proprietary trading commodities became so attractive to Goldman Sachs that they bought a firm called Metro International Trade Services in 2010, although they had made extensive use of this firm for some time prior.
The sole purpose of Metro, now a wholly owned subsidiary of Goldman Sachs, is to store and distribute aluminium. In taking control of Metro, Goldman was then able to slow down the delivery of aluminium from initial storage to delivery from an average of 40 days to an average delivery time by 2014 of 674 days. In order to skirt around the rules that the London Metal Exchange (LME) had put into place to prevent precisely this nature of hoarding – which would have obvious price implications for the metal – Metro, instead of selling the aluminium to desperate end-users such as Coca Cola and Coors, would simply move the metal from one storage warehouse to another. They would do so on behalf of a trade that had been executed with a counterparty who did not wish to take delivery, and who may of course have been a trading counterparty of Goldman Sachs, if not Goldman Sachs themselves.
By dominating both the market for the spot and futures trading of aluminium, and by also dominating the market for the storage and distribution of aluminium to end-users, Goldman Sachs was no longer acting as a financial intermediary. In fact, they were acting as a competitor against their own clients, with the advantage of both having inside information in respect of the timing of demand as well as being the master of price determination. It should be noted that this nature of market manipulation, in which investment banks were able to inveigle themselves also into their clients’ businesses and from there to be allowed to radically manipulate prices, was only made possible through regulations that were introduced under the Clinton administration.
In 1999, several market observers and regulators had felt strongly enough that the over-the counter (OTC) derivatives market was sufficiently opaque that they should lobby for increased regulation of all OTC trading. Increased regulation would hopefully ensure that counterparties in trades would have to properly identify themselves, and that the purposes of the trades would have to be clearly understood. The derivatives market, after all, had already radically eclipsed the underlying market – betting on market prices had become a far larger business than the making of markets themselves.
The response from the Clinton administration to the lobbying for increased regulation, was met with a fierce and somewhat malicious backlash. Larry Summers – one of Clinton’s key advisors at the time – led the charge to introduce a new act, called the Gramm-Leach-Bliley Act, which was quickly shepherded through Congress and ratified into law. Among other aspects of this Act, the law now insisted that there should not be more regulation of the OTC market, but less.
This Act also effectively repealed the 1933 Glass-Steagall Act, which had been written out of the ashes of the Great Depression, and which had separated investment banking activities from commercial banking activities. It was precisely the cosy and unregulated relationship between the selling of equities, and the underwriting of equities that US regulators had clamped down on post-Depression – this conflict of interest being identified as one of the principal causes of the stock market Crash of 1929. In fact, it was the Glass-Steagall Act that forced JP Morgan to split into JP Morgan Co. and Morgan Stanley the investment bank.
In repealing Glass-Steagall, Clinton and Summers augured in the years of the banking hey-day – in which it was not uncommon for investment banks to make returns on equity of over 30 percent using leverage of over 30 times equity. This was ultimately, in the final analysis, perhaps the key underlying cause of the 2008 financial crisis. Investment banks could now take on deposits, sell directly to retail end users, and most significantly in terms of the crisis, package mortgage-backed securities, as well as sell them to naïve buyers.
However, what is perhaps less well known is that the Gramm-Leach-Bliley Act also allowed in certain clauses that were lobbied by the investment banks in the hope of aiding their desire for even greater domination of the commodities trading business. After all, Goldman Sachs and Morgan Stanley were now facing increasing competition from non-banking entities that were on a huge growth spurt, such as Cargill and Glencore. An amendment to the 1956 Bank Holdings Act was easily passed in 1999 that in essence allowed Goldman to do openly what it had for some time wanted to do, and possibly had been doing through broken Chinese walls – to take delivery. Essentially, Goldman could now, through entities such as Metro, control not only the trading of aluminium, but also its storage and release.
A further piece of legislative engineering was required however, and this was the ratification of the Commodities Futures Modernization Act (CFMA) in 2000. It is particularly telling that at the dawn of the 21st century, a democratic US president – the leader of the western world, at the helm of a country which sells its brand of liberal capitalism as the only form of political governance worth fighting for – completely deregulated the OTC derivatives market whilst simultaneously legislating that, under the CFMA, the OTC contracts themselves were legally enforceable in a court of law. This is really a case of helping firms such as Goldman Sachs to have their cake and eat it.
To clearly explain: investment banking players in the commodities OTC market wished to ensure that they be allowed to make markets, price contracts for clients, delay delivery of the underlying, in a completely unregulated manner; but at the same time wanted the law of contract on their side in collecting on debt. Recall, these investment banks had already successfully argued – in lobbying the Gramm-Leach-Bliley Act – that they should be allowed to do so on the basis that they were in engaged in hedging activities on behalf of clients, and that market regulation of complex derivatives would lead to an absence of liquidity and deleterious effects on price. Essentially, they had argued for the market in OTC derivatives to be entirely free of oversight, even SEC oversight.
Naturally, in a world without regulation, authorities would have no way to test whether trades in which investment banks or commodities houses were engaged in were of a ‘hedging’ nature or of a pure ‘trading’ nature. The problem, of course, with having enormous values of pure trading – or betting – on underlying prices in economically-critical commodities such as aluminium is that the price of the actual underlying commodity then becomes more driven by speculation – and specifically by highly leveraged speculation – than by supply and demand factors. By trusting that the free market would not overly speculate, the Clinton administration had not only augured in the financial crisis, but had also opened the door to the commodities price boom of the early 2000s.
Just as it is not the job of the police to enforce the payment of bets made at underground blackjack tables, the investment banks could hardly insist on having contracts enforced should they go bad – especially if the purpose of the contracts was not to hedge, but rather to bet, just as one might take a bet on the outcome of a turn of a card on a table in an illegal casino.
However, in lobbying for particular clauses to be scripted into the CFMA, the investment banks achieved precisely this: not only could they bet to their hearts’ desire, they could also call on the authorities to enforce the contracts should their counterparties balk at paying up. The investment banks wanted – despite wishing to conduct themselves free of any oversight or rules – to be able to go to court and make use of the institutions of law where it best suited them. One would have to search hard for a more one-sided form of prudential oversight.
It is no coincidence that the price of food reached its highest level in 2008, since 1845 – that is, for over 150 years. For it was not only the price of aluminium that had been manipulated, or ‘financialised’ to use Rana Foroohar’s term in her remarkable book Makers and Takers, it was pretty much everything. The extent to which dominant market participants have entered into traditional businesses, obstructed them, and then altered them forever, beggars belief.
The sheer cynicism of the banking fraternity, when interrogated by Congress in respect of the specific amendments being made in 1999 and 2000 to the Bank Holdings Act of 1956 – which had been originally scripted to specifically prevent banks from competing against their own clients – was to cite the notion that financial firms engaging in ‘complementary’ businesses could benefit their clients. Credit card services, they argued, could be enhanced by offering travel advice, as an example.
To cite travel advice as a reasonable example of complementary business, and to use it as justification for being allowed to take delivery of underlying commodities such as aluminium, is to deliberately miss the wood for the trees. Remarkably, and inexplicably, the congressional subcommittees investigating at the time did not take umbrage at the banality of the argument. It really is – in retrospect – impossible to accept the naiveite of the lawmakers at the time. It is also impossible to accept the lack of accountability that has been taken by those same lawmakers and regulators to this present day.
More specifically, there has been virtually no accountability taken by western leaders or their advisors for helping usher in the dramatic run-up of events that led to the 2008 financial crisis. Alan Greenspan, in spite of the criticism that has been levelled against him, at least has the distinction of being perhaps the only economist in the history of western civilization who admitted – albeit in the face of overwhelming evidence – that he might have been wrong. No such speech has yet been forthcoming from Larry Summers, who went on after his years as one of Bill Clinton’s most trusted advisors, to become President of Harvard University.
The aggression of firms such as Goldman Sachs is symptomatic of their nature, one could argue. They are what they are – highly competitive players making use of each and every inch of advantage they can find on the field of play.
This is simply not an argument one can make in the case of Clinton and Summers. There is no rational argument for not insisting on regulating OTC derivatives, especially at a time when the face value of the derivatives market was doubling every three years.
To use a football metaphor: the fact that Maradona made use of the “Hand of God” to help his country win the World Cup, or the fact that Luis Suarez savagely bit Giorgio Chiellini’s shoulder during Uruguay’s game against Italy in 2014, are insignificant infringements in comparison to those of Sepp Blatter.
If FIFA is to football what the US and Europe’s governments are to free market capitalism, then surely it is the leaders who should be hauled over the coals, not the delinquent players. Sadly, it took many years of intense pressure before FIFA was finally exposed. One suspects it will take even longer in the case of the financial markets.