Copper Collapses Most Since Dec 2011 On China Credit Fears
Copper, as China pundits may know, is the key shadow interest rate arbitrage tool, through the use of financing deals that use commodities with high value-to-density ratios such as gold, copper, nickel, which in turn are used as collateral against which USD-denominated China-domestic Letters of Credit are pleged, in what can often result in a seemingly infinite rehypothecation loop (see explanation below) between related onshore and offshore entities, allowing loop participants to pick up virtually risk-free arbitrage (i.e., profits), which however boosts China's FX lending and leads to upward pressure on the CNY.
Click through to see a detailed description of how this works. A similar system was used last April with gold when fake exports caused a yuan rally, but that was a short-term phenomena. The copper financing goes back years and is a complex arrangement. It is unknown how much debt is backed by copper, and it is also unknown how many times the same copper has been used to take out loans (rehypothecation). There's enough anecdotal evidence to suggest the debt far exceeds the collateral. Were copper to break $3 and heavy selling to commence, banks may call their loans and find there is no collateral, thus pushing more banks to call their loans. Eventually, what copper there is will come out of financial storage and get dumped on the world market, or at least satisfy Chinese demand internally for some time. Either way, copper could be in for a plunge.
I went short base metals via two ETN products, PowerShares DB Base Metals Double Short (BOM) and the single short product, BOS. The latter fund is very lightly traded and never proved popular with traders. I could only get a very small position, but it traded at a more than 40% discount to NAV, a nice margin of safety. BOM had a smaller, but still significant premium, currently about 17%. BOS is the 20th best performing ETF in 2014 thanks to the discount being cut in half; it's now about a 23% discount. Given the small volume, it doesn't make sense to go with BOS anymore. Even getting shares of BOM at a good price will prove difficult.
That said, there is plenty of evidence that these types of unloved ETNs and ETFs coming to life. Traders ignore them when they're not moving, but if there's a big trend unfolding, I expect volume will pick up enough to close the discount at least partially.