Qingdao scandal casts a long shadow over metal markets

What will 2014 be remembered for in financial markets?
For oil and iron ore, it will be the year of price meltdown. In the broader financial universe it will likely be the year of Russian crisis, a drama unfolding with accelerating intensity. But for base metals the defining "black swan" event of the year was the Qingdao port scandal, news of which first broke at the end of May.
Seven months on and part of the Chinese port is still locked down by the authorities, who are investigating local trader Chen Jihong and his companies for alleged multiple pledging of metals for collateral.
The scandal has generated a deluge of lawsuits, the first of which has been publicly playing out in London's High Court as US bank Citigroup and trade house Mercuria lock horns over $270 million worth of affected deals.
But it has also caused tectonic shifts in China's trade flows as stocks of nickel and zinc are moved from the country's bonded warehouse zones to safe-haven storage elsewhere in Asia.
Imports of other metals, particularly copper, are still being impacted as banks, both Chinese and international, tighten their procedures for lending against metal as collateral.
Qingdao threw a harsh light on China's shadow finance sector and will cast a long shadow over metals markets well into next year if not beyond.
But what actually happened?
There are still many blanks, inevitably so since the Chinese authorities have stayed characteristically tight-lipped about their investigations.
Critically, with the key part of the port of Qingdao still under official lockdown there is a black hole at the core of this drama in the form of how much metal may, or may not, actually be there.
But thanks to the details revealed in the recent Citi-Mercuria proceedings, we can now sketch a skeleton storyline.
As is often the way with such things, the Qingdao scandal appears to have been discovered by chance, with the opening act playing out a thousand miles away in the city of Xining in Qinghai province.
In April, China's Central Commission for Discipline Inspection said it was investigating the city's Party secretary, Mao Xiaobing, for suspected "serious discipline violations", Chinese shorthand for corruption.
The accompanying probe of Mao's business dealings and associates seems to have put the spotlight on Chen. Both were executives at Qinghai province's flagship metals company, Western Mining Group, in the previous decade.
Chen himself was also a big player in the Qingdao metals trading world. He was chairman of Dezheng Resources Holding, an entity with subsidiaries in China and in Singapore and with deep-rooted ties to international traders.
Georgie Baker, who headed Citi's metals financing operations at the time the scandal broke, told the UK High Court she had been doing business with Chen for around eight years at Standard Bank before she joined Citi in October 2013.
Indeed, one of the more colourful episodes in the proceedings was Baker's admission Chen had given her a 10,000 pound ($15,700) watch for her birthday in 2012 at what "may have been colloquially called a party".
Chen seems to have been taken into official custody some time later in April, his disappearance generating mounting concern among Chinese lenders over the course of May.
But it was only on May 28 when the story first really broke as Chinese investigators sealed off parts of the ports of Qingdao and Penglai, seizing metals that had been pledged by one subsidiary, Decheng Mining, to companies such as Mercuria.
And many others, it quickly became clear, as banks and trade houses descended on Qingdao's port to try to work out what was really there and what was really theirs - a process complicated by a cascade of finance deals that sucked in banks such as Citi, Standard Bank and Standard Chartered.
There was, it is now clear, real concern that the investigation would spread to Shanghai, an even bigger depository of metals acting as collateral.
When Mercuria and Citi were still co-operating in the days just after the lockdown, Mercuria suggested Citi should move some of its collateral metal in Shanghai out of the country because it too had been supplied by Chen companies.
In the event, the investigation never seems to have tracked the metal chain as far as Shanghai. The port remained open and uncontaminated by the events unfolding in the northern ports.
Within days the scale of the potential losses had become evident, Citi having to inform the US Federal Reserve and Britain's Financial Conduct Authority it might be facing $400 million of pain, a figure that included an estimated $140 million of what turned out to be unaffected metal in Shanghai.
Now, using metal as collateral to access loan finance has been part and parcel of the metal markets for as long as anyone can remember, and probably a lot longer than that.
The details of Citi's dispute with Mercuria give a useful insight into how it works.
A typical "repo" deal saw Mercuria sell metal to Citi with a simultaneous resale of the same tonnage at a future date. The agreed difference in price was the de-facto lending rate, in this case a low annualised 1 percent.
Citi's Baker described the deals as "obligated repos" since "many of the risks were passed back to Mercuria as obligations". So, for example, Mercuria was responsible for storage and insurance during the tenor of the deals, although in the event Mercuria in turn passed the storage costs back up the chain to a Dezheng Group subsidiary.
Such inventory financing is used in many commodities and across many countries. Previous "repo" deals between Citi and Mercuria, for example, had been done for aluminium being stored at the Dutch port of Vlissingen.
The problem at Qingdao and Penglai was the complexity of storage responsibility.
Although well-known warehouse operators such as CWT, Impala and GKE were the named storage facilitators in the Citi-Mercuria deals, they themselves were using local bonded warehouse companies.
The local companies produced Chinese warehouse receipts, or "rudukans", issued by the port authority to the warehouse firms, which then issued "back-to-back" warehouse receipts to Mercuria and Citi.
The suspected fraud seems to have originated in the first stage of that verification chain, leaving the named warehousers "as much in the dark as to what has really happened as Mercuria and Citi", according to the skeleton trial argument from Mercuria's legal team.
The complexity of storage responsibility, together with a wholesale re-examination of counterparty risk, has generated a surge of metal out of Qingdao and other Chinese ports to safer-haven destinations.
Most affected have been the nickel and zinc markets.
China has been a net importer of both metals for many years but that's changed since Qingdao.
China's refined nickel exports, for example, totalled a record 73,000 tonnes in the June-October period, the country turning to consistent net exporter for the first time.
Two of the most significant flows of outbound nickel have been to Malaysia and South Korea, both of which host London Metal Exchange (LME) warehouses.
The resulting rise in LME nickel stocks has in effect killed off the strong rally that began at the start of the year when Indonesia banned nickel ore exports.
Similarly with zinc. Refined zinc exports totalled 86,000 tonnes in the June-October period. The total tally in the prior five-month period was just 1,012 tonnes.
China was a net exporter of zinc in October for the first time since December 2008.
Many copper traders had feared a similar shift in trade patterns but the relocation of stocks seems to have largely taken place within China in favour of established storage companies not using sub-contracted warehousing facilities.
That said, however, reduced appetite for copper for collateral financing has been a feature of the market since Qingdao and is expected to remain a dampening influence on import flows next year as well.
Qingdao is also going to cast a long legal shadow. The recent Citi-Mercuria proceedings have really been about the legal niceties of Citi's attempt to bring forward settlement of all outstanding deals and Mercuria's refusal to do so.
More court action is likely once the port is unsealed and the true extent of suspected fraud is uncovered.
The reopening of Penglai doesn't bode well. Citi and Mercuria have found that around 5,000 of the 20,000 tonnes of metal they were "repo-financing" simply aren't there. Those two entities alone have deals covering around 91,000 tonnes of aluminium and copper in Qingdao. It is clear that there are many other claims and counter-claims, including for alumina.
As legal counsel for Mercuria told the High Court this month, "this trial is (...) taking place expressly on the basis that neither the parties nor the Court will have the full facts with regard to what has occurred in China and whether the metal (...) is in the warehouses".