Op-Ed: What level of commodity credit risk lurks beneath the next financial crisis?

It is hard to believe that we are now eight months on from the US regional banking meltdown (Silicon Valley Bank) that sent shockwaves through the global financial system.

Photo by v2osk on Unsplash

While ultimately, the focus of this unforeseen event was centered around a Moody’s A-rated bank failing to manage its fixed income risk exposure against the backdrop of rising interest rates, the knock-on instability across the wider industry has raised concerns about the potential contagion effects across other asset classes. None more so than commodities.

The collapse of SVB saw an immediate hit to the oil market, with the Brent crude price tumbling on fears of a potential recession and a slowdown in demand. In contrast, precious metals, such as gold and silver, surged as investors scrambled for exposure to these traditional ‘safe haven’ assets following the banking scare.

While the relationship may not be direct, a banking crisis of any kind can have ripple effects on credit risk in commodities markets for various reasons. Take the interconnectedness of financial institutions as a prime case in point. The banking sector, including regional banks, is highly interconnected with other markets. Any highly contagious event can cause liquidity and funding problems for commodities market participants. Reduced liquidity and increased counterparty risk can lead to a significant amount of credit risk, particularly as market participants scramble to secure finance and hedge their commodity-sensitive positions.

This begs the question, eight months on from the SVB saga, are commodity markets in a better position to monitor for credit risk factors in order to assess and manage future challenges stemming from unforeseen events? The answer really does depend on the market participant in question, but one thing is for certain, the industry would be much better placed to manage credit risk if settlement for both metals and cash was not taking place separately.

Right now, with most metals and cash settlements occurring on two separate platforms, there are still a lot of unknown credit risks and complexity taking place throughout the market. These credit risks are primarily associated with the lack of coordination between the two platforms. Consequently, market participants on the cash settlement platform are left heavily exposed to counterparty risk associated with the entity or entities responsible for facilitating cash settlements. If the counterparty owning the cash for settlement defaults or encounters financial difficulties linked to the next banking crisis, firms may not receive their expected cash settlements.

On top of this, cash settlements and metal deliveries may occur on different timelines, leading to major timing mismatches. An example of this is that London metals have a settlement cut of 4pm UK however the US dollar will have a cut of 9pm. When looking at the physical market, the timing issue is amplified with cash settlements occurring immediately while metal deliveries have a longer settlement period, this can create huge credit risks as one party will be required to deliver cash before receiving the metals or vice versa. The lack of coordination between platforms can also lead to settlement failures where one party fulfills its obligations on one platform but encounters difficulties in receiving the corresponding settlement on the other platform. This can disrupt the settlement process and result in credit risk for one or both parties.

Unfortunately, when it comes to commodities settlement, there are still too many market participants operating in this siloed fashion. In order to conduct thorough due diligence on the creditworthiness and reliability of the various counterparties operating in this market, there needs to be an industry-wide shift to connect the metals and cash settlement networks together for simultaneous settlement. This is the only way to continuously monitor transactions and communication between platforms to detect and address discrepancies or issues interlinked with global events in a prompt manner.

Anoushka Rayner, Head of Growth – Commodities at Paxos
Anoushka Rayner, Head of Growth – Commodities at Paxos

Ultimately, what SVB taught us is that there is no telling where the pockets of risk within the global financial system lie, only that there is risk out there. That a good credit rating quickly becomes a historical data point useless in the event of a default. The answer, at least for commodity market participants, must be to move towards protecting your assets used for settlement through a more integrated and coordinated approach to the process. Adopting a settlement platform that combines metals and cash on a single platform is the only way to achieve true simultaneous settlement. This is the logical step to reduce the potential for misalignment and failures to help mitigate future credit risks.

The subject matter and the content of this article are solely the views of the author. FinanceFeeds does not bear any legal responsibility for the content of this article and they do not reflect the viewpoint of FinanceFeeds or its editorial staff.

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