This picture taken on July 8, 2014 shows workers standing on a pier by a cargo ship in Qingdao, east China's Shandong province. China's monthly trade surplus jumped 16.4 percent in June to $31.6 billion, official data showed, as exports and imports both rose in the latest sign of strength in the world's second-largest economy. CHINA OUT AFP PHOTO

Qingdao — pronounced chin-dow — is a port city in China famous for its Tsingtao brewery, but the name continues to cast a long shadow over the global metals market. Here’s why.

What has happened?

After reports emerged last May alleging a fraud in the city’s warehouses, some of the world’s largest banks have been scrambling to assess the damage. That spurred a flurry of lawsuits, with a judgment due in the first case between Mercuria, a commodities trader based in Switzerland, and Citigroup, this month. Citi argues it is owed more than $270m.

What is at issue?

The world’s commodities traders regularly rely on banks for short-term loans and unsecured credit lines to purchase commodities. One such structure to obtain funds from banks is known as a repurchasing agreement, known as a repo, where metal is sold to a bank (providing funds to the trading house) and then agreed to be repurchased at a future date.

In May 2013 Citi and Mercuria entered into a series of such transactions, involving metal stored in warehouses in Chinese ports.

As reports of a fraud centred on the Qingdao port surfaced, Chinese authorities responded by sealing warehouses as it became apparent that some of the metal had been pledged multiple times as collateral by a Chinese trader, Decheng. Some of that was metal Mercuria had sold to Citi. Since they could no longer get access to the metal, could they buy it back from Citi?

Why does it matter?

The case provides a glimpse into the workings of the use of metal and other commodities as collateral to raise financing, which has acted as a shadow banking system in China.

The ruling, due from a UK High Court judge this month, could also affect how the world’s largest commodities traders — from Glencore, to Trafigura, to Gunvor, get short-term financing from banks to carry out their day-to-day activities that see everything from cotton to oil shipped around the world.

What impact will it have?

If the judge decides Mercuria could not have repaid Citi as it could not access the metal, banks are likely to be more cautious about engaging in repo financing, especially in China.

Furthermore, if China opens up the warehouses and proceeds with its investigation, and finds the metal pledged by Mercuria is indeed missing or was used by others as collateral, Citi could potentially sue Mercuria, alleging it did not safeguard the metal. In other words: things could get even uglier.

The case has reminded everyone of the possible risks that a repo contract carries. They might look good on paper, but they are certainly not worth their weight in metal when it comes to any fraud.

In the future, banks are likely to pay more attention to how they can physically get at the metal they are lending against, rather than resting assured that metal is a safe asset that can sit in a warehouse and keep its value.

Whoever loses is likely to need to drown their sorrows with a lot of Tsingtao beer.

This article is part of a series online on commodities made easy.

For further reading:

Qingdao fraud case taints commodity financing

Luxury watch cited in China fraud case

Also in the series:

Commodities explained: Contango

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