In Depth: A bitter $1.4bn lesson on commodity price speculation

Linda J. Dodson

The epic crash last week of crude oil taught 60,000 Chinese investors a bitter, 10 billion-yuan ($1.4 billion) lesson on the risks of speculating in commodity prices.

The clients of Bank of China (BOC), one of the country’s largest state-owned lenders, were trying to buy on a dip in crude prices using a paper investment product known as Yuan You Bao. Little did they expect that values would keep on plunging past zero and well into negative territory.

One investor told Caixin that his entire 50,000 yuan ($7,063) investment in the bank’s Yuan You Bao product linked to West Texas Intermediate (WTI) futures evaporated April 22 after prices dropped below zero. That left him owing 80,000 yuan to the bank. Another investor took a 9.2 million yuan loss on a 3.9 million yuan investment and ended up owing 5.3 million yuan, a screenshot of a transaction record circulating online shows.

Futures contracts are investments linked to the value of certain commodities on a specified date in the future; they trade on markets around the world. Chinese investors are barred from foreign oil futures markets, and commercial banks are not allowed to participate in domestic futures trading. But they can offer broker services for derivative investments linked to foreign futures markets. That’s where the Yuan You Bao products come in.

It isn’t clear how much Chinese investors lost on the product. But sources with knowledge told Caixin that BOC had more than 60,000 investors in Yuan You Bao who put 4.2 billion yuan into margin deposit accounts. Based on the settling price after the April 21 oil collapse, the investors owed 5.8 billion yuan to the bank on top of the loss of their initial investments, wiping out a total of 10 billion yuan.

The investors were caught up in a catastrophic crash of oil prices resulting from a collapse in global energy demand amid the Covid-19 pandemic and widespread shutdowns of commerce on all levels. The value of the benchmark WTI crude May futures contract, traded on an exchange operated by the American giant CME Group Inc., plunged to a historic low on April 21 of minus $37.63 a barrel, meaning producers would have to pay buyers to take delivery of oil.

The episode spotlights how China’s mom-and-pop investors betting on swings of oil through cheap access provided by Chinese lenders can be exposed to massive losses. While they are generally prohibited from directly investing in foreign crude futures markets, such investors can buy banks’ paper crude products offered without opening an offshore account. The investments are pegged to the flat price of the front-month contract and are settled in Chinese yuan.

The case also raises questions about whether there were significant design flaws in the BOC product that put people with low risk tolerance into high-risk investments, industry experts said. The contracts themselves may be in a regulatory gray zone as they are structured to sidestep legal restrictions on risky investments in futures markets, regulatory experts said. Moreover, the peculiarities of the BOC product may have exposed investors to a last-minute attack by predatory short sellers.

In addition to BOC, several other major banks, including the Industrial and Commercial Bank of China (ICBC), Agricultural Bank of China (ABC), China Construction Bank (CCB), Bank of Communications (BoComm), Minsheng Bank and Ping An Bank, have launched similar products over the past few years.

Since March, such products have become popular among retail investors betting on crude prices to rebound as they fell to $20 a barrel, a bank trader told Caixin. A surge of buyers forced ICBC to halt sales of the investments on March 13 after the bank used up its government-set foreign exchange quota for the products, an ICBC source said.

More than 100,000 Chinese retail investors flooded into the market though paper crude products and never expected prices to slide below zero, market sources said. The three biggest sellers of the investment vehicles — ICBC, CCB and BOC — held a combined $3 billion of positions in futures contracts linked to prices for WTI and ICE Brent, another oil benchmark, according to an estimate by a futures company manager.

Most of the banks halted sales of the products after BOC’s catastrophic losses. BOC suspended its Yuan You Bao clients from opening new positions starting April 22, allowing them only to close positions.

Paper crude investors with ICBC and CCB may have been luckier than BOC clients because they limited losses by settling May contracts earlier. Banks agreed with investors on a certain day before contract expiration to close positions or roll over investments — opening positions for the next month’s contracts while closing the current ones. But the day for BOC clients to settle contracts happened to be the very day of the unprecedented crash.

Under the product agreement, BOC froze investors’ accounts at 10 p.m. on April 20, the day before contract expiration, to settle outstanding positions. WTI contracts were trading at $11 a barrel in the U.S. But in the following hours, the price took a nosedive to as low as minus $40 and settled at a negative $37.63 a barrel as of 2:30 a.m. April 21 in Beijing. During that period, investors could do nothing but watch their investments vanish and debts pile up.

On April 22, BOC said investors had to settle their positions at the Monday WTI settlement price of minus $37.63 a barrel, leaving them with huge losses and money owed to the bank. Angry investors flooded onto the internet to protest, accusing the bank of flaws in the product design and demanding that BOC shoulder some losses. But the bank maintained that it settled the contracts in accordance with guidelines agreed with clients.

According to BOC materials, the Yuan You Bao product requires 100% margin deposits and does not allow any leverage. Several banking sources told Caixin that the paper crude products are normally registered with the banking industry regulator as R3 level wealth management products, meaning they are balanced investment options with medium risk.

“How come the investors were exposed to losses that are multiples of their initial investments?” demanded one BOC investor.

Several lawyers questioned whether the products failed to comply with investor suitability requirements.

“It is seriously unmatched to its risk assessment,” one lawyer said.

The extreme situation

It was a situation where the “trading mechanism encountered an extreme situation in the extreme,” a bank trader said.

Some investors said the bank should have acted to settle the contracts shortly after 10 p.m. when the price was still around $10 a barrel. But BOC said rolling over investors’ positions doesn’t start right after the accounts are closed and must follow the settlement arrangement with brokers. During this period, BOC doesn’t follow the market or take any action on clients’ accounts, according to the bank.

The paper crude investments can be divided into two separate parts. One part is the deal between banks and Chinese retail investors on derivative contracts linked to global crude futures benchmarks, which don’t involve oil delivery in the end. The other part is an agreement between the banks and brokers in real futures trading. BOC hired JPMorgan Chase & Co. and BOC International Holdings as its brokers for offshore crude futures trading, Caixin learned.

Most of the paper crude products sold by Chinese banks allow investors to leave their positions to be automatically rolled over to the following month’s contract. In 2019 when oil prices rose steadily, investors earned yields of more than 10% annually without doing anything while banks profited by simply helping clients maintain their positions.

It wasn’t until January this year that investors realized the seemingly easy investments could carry high risks, a futures manager said. After the April 14 settlement, some ICBC clients found that the value of their positions shrank by nearly one-fourth.

Many industry insiders said they were puzzled that BOC set its settlement date only one day before the monthly contract expiration, giving itself little flexibility to deal with potential price fluctuations. Anyone holding WTI futures after they expire could be forced to take delivery of crude in the U.S. oil hub of Cushing, Oklahoma.

A futures industry source said the arrangement might reflect BOC’s attempt to compete with other banks’ similar products. A later settlement date means the prices are closer to the final market prices and could reduce the costs of rolling over positions under the normal market liquidity condition, a brokerage manager said.

But market liquidity was not normal this time for BOC. An industry insider said the bank’s positions were targeted by international short sellers who in a few minutes drove down the crude prices that are crucial for settling the May contract price.

The price of WTI May contracts was under pressure since April 8 when the United States Oil Fund (USO), the biggest exchange-traded fund tracking crude prices, cut its positions over four straight days. The price gap between the May and June contracts further widened after ICBC and CCB rolled over their positions on April 14. Both banks agreed on settling their paper crude products five working days before the contract expiration.

When BOC started to roll over its positions April 20, “the money had been targeted” by short sellers, a futures company manager said.

With a fixed transaction time and little flexibility, “it is like showing the cards to rivals when playing Texas hold ’em,” a form of poker, an investor said.

BOC hasn’t disclosed how much in positions it held for Yuan You Bao clients, but several local regulators said the bank ordered local branches to report their client information. Available data shows about 95% of the investors held long positions. A Caixin calculation shows that the losses based on the settlement price could amount to 9 billion yuan.

Bloom in gray zone

Unlike global futures investors who trade oil contracts in thousands of barrels, Chinese investors buying banks’ paper crude products can start with 0.1 of a barrel. The threshold for investors to tap the high-risk market is as low as 14 yuan. Banks split 1,000-barrel crude contracts into smaller tranches to sell to retail investors, a financial expert said.

“It transformed high-requirement and high-risk products and offered access to clients with low risk tolerance,” the expert said. “It is unclear how regulators assess the risks and nature of such products.”

“The banned individual investment (in foreign futures) is happening and even uses the yuan,” said a futures industry regulator.

Chinese regulators since 2017 barred individual investors from directly trading overseas futures contracts on concerns of financial risks following a surge of speculative and illegal investments.

Chinese retail investors can tap into the foreign futures market through funds offered by wealth management operations under the qualified domestic institutional investor (QDII) program. In 2013, ICBC launched the first paper crude product, offering an alternative path for investors to bet on foreign futures. Other banks quickly followed. Meanwhile, such products also help banks to bypass rules that prohibit them from participating in domestic futures trading.

The products are similar, allowing investors to take both long and short positions, linking to foreign futures, and requiring 100% deposits but low entry requirements. In addition to crude oil, banks offer a wide variety of products linked to foreign commodities contracts, from copper to silver to soybeans.

A person close to the top securities regulator said the paper crude products offered by banks involve some gray-zone practices that were previously a target of a regulatory crackdown on illegal futures trading and provided ineligible investors access to foreign futures markets.

Although banks distinguished their paper crude products from illegal futures trading by allowing zero leverage and collecting 100% deposits, it is still a de facto investment in futures markets that violated banking industry rules, the person said.

Who to blame?

Yuan You Bao investors are exposed to risks of losing all of their deposits or even owing money to the bank, as CME Group started on April 15 to allow the WTI oil futures to be traded and settled at negative prices.

“The product design (of Yuan You Bao) had never taken negative value into account,” one banker said.

If BOC could closely monitor market changes and suggest that clients cut their positions in a timely way, things would be different, a bank executive said. “It reflects the operational risks, and banks must always consider the most extreme situations,” he said.

The incident thrusts BOC into the center of a controversy. Some industry sources said the bank should not ask clients to pay for the losses in excess of their deposits as the product required 100% deposits.

A lawyer said BOC should shoulder the risks of its overseas futures trading without translating the losses to Yuan You Bao investors because its trading systems with domestic investors and overseas brokers are separate.

Chinese regulations require futures trading companies to pay close attention to their clients to prevent losses exceeding deposits. If large-scale losses occur, the securities regulator will step in to investigate.

Chinese lenders have aggressively marketed paper crude products this year, recommending that investors buy on the dip. Public information showed that since early March, a BOC branch’s Yuan You Bao clients surged from 3,000 to 13,700. Weekly transaction value rose from 320 million yuan to 1.2 billion yuan.

Industry insiders criticized banks for inadequate risk disclosure to paper crude investors. One BOC staffer said Yuan You Bao was listed as a normal wealth management product.

“How can salespeople know about the risks?” said the staffer.

Read also the original story. is the English-language online news portal of Chinese financial and business news media group Caixin. Nikkei recently agreed with the company to exchange articles in English.

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