The Base Metals and Precious Metals Desks: Should they sit together?

I was skimming LinkedIn today and saw some gold and copper articles. They are both quite volatile markets and have performed robustly for some time in the case of gold (and silver!) There are macro and micro reasons for the current dynamics, none of which I will discuss here, but I was recently asked whether the gold traders were better off with the FX desk, and if so, what about the base metals traders? Should they follow suit, stand-alone or reside with the other commodity traders (oil, gas, electricity, gas, shipping, etc.)

Here is a small essay on my thoughts. Oh, and one bit of advice in another article (by Perfectly Hedged LLC) suggested that if you are not currently trading copper spreads, it may be better to stay on the sidelines for now. I agree, as occasionally, the best trade you do is the one you don't! (Also, this applies to fighting, which I can attest to as well)

Enjoy!

For over 6000 years, gold has been involved in trade and economic systems. Today, gold is mainly used for jewellery production and a few industrial applications and remains a store of wealth. Silver and other precious metals have a similar story but also have many industrial uses.

Gold has an interest rate and can be considered a low-yielding currency, mostly quoted against the dollar. It is traded on multiple exchanges and in the Over the Counter (OTC) markets. Gold reserves, like currencies, are held at certain banks (mainly in London, New York, and Switzerland), and the settlements for OTC trades are like that of most currencies. The Office of the Comptroller of the Currency permitted banks to hold gold, silver and platinum (and, from 1997, copper) because of their role as a store of wealth and for coin production. However, since 2016, there have been revisions and proposals from the Federal Reserve Board about reducing the ability of banks to hold these metals on account: that is, as strategic assets rather than assets that require cash reserves to be held against them.

After the Global Financial Crisis and numerous banks' withdrawal from commodity markets, many gold trading desks in banks found new homes alongside the FX traders instead of being housed in an independent commodities unit. The relative synergies between booking (currency pairs), settlements, trading technology, and the client base meant that FX and gold traders understood each other.

Base metals are inexpensive compared to precious metals and are primarily used in industry. Production, transportation, refinement, and fabrication require participation from many supply chain companies and lots of capital from banks well-versed in project, trade, and commodity finance. Many investment banking clients are mining companies or large fabricators, and they use derivative hedging to reduce the cost of financing operations by guaranteeing their future cash flows. After debt and equity, risk capital is the third important pillar of finance for a commodity enterprise.

Most banks focus on clients because proprietary activities are severely limited under current banking regulations. Their clients include investors (Hedge funds, Mutual funds, Private Equity and Endowments) looking to trade, hedge and invest across the commodity markets; corporations hedging exposures to commodities that will affect their earnings performance (such as an airline hedging its jet fuel consumption exposure, or buying EUAs to satisfy regulatory obligations). However, the most lucrative hedging business often originates with IBD clients or the Debt Capital Markets teams (working with IBD), who provide financing structures to allow, amongst other things, new electricity production facilities and greenfield minerals and mining exploration projects to begin.

Reserve-based lending (RBL) is financing for independent exploration and production companies. RBL is a “borrowing-base” type of loan sized based on the projected Net Present Value (NPV) of cash flows generated by the underlying oil & gas assets. Similar royalty-based structures are used for metals and mining, and many banks have been servicing mining clients for decades. A key feature of such structures is the need for cash flow certainty through price guarantees and often physical offtake. This occurs through hedging the future production. The bank will take on the physical power when financing a power-generating asset. Morgan Stanley led the way with its seminal power deal (PPA) with the state of Georgia in 1997.

The oil and gas desks provide hedges for all ‘Royalty type’ structures (including VPPs, ORRIs, etc.); the power trading desks provide hedges, enter tolling agreements, capacity payments, and revenue puts to allow greenfield electricity-generating assets to be financed and built. Structured mine (base and precious) finance to develop mining activity, inventory finance (mainly base and silver in production) to free up working capital, and lend-lease and pre-pay deals generate exposure to underlying commodity markets and need hedges to allow the loan structures to work. Nearly every loan type in the oil, gas, and power generation space has an analogue in base metals and mining. In short, a bank's commodity unit can be a bustling, diverse and highly profitable commercial centre.

Given the synergies and relationships used (IBD/DCM et al.), having a centralised commodity desk is beneficial so that commodity risk management knowledge, ideas sharing, multiple client touch points (shipping, diesel, offtakes), and margin/finance efficiencies can all be exploited to maximise client impact and revenue generation for the desk, especially when metals and energy contracts trade on the same exchange (CME).

Base metals trading and settlement mechanisms are not the same as gold and FX and are more akin to settling oil, gas, and other commodities. Metals have locations to consider, including warrants for the deliverable material and different grades and quality. They are also considerably more volatile (due to supply and demand characteristics in a global economy) and historically open to squeezes.

Base metals trading almost certainly belongs to a traditional commodity trading desk (at a bank or any commodity business). However, gold trading can prosper in an established commodity unit or with the FX trading department. And many bullion dealers stand alone.

Kevin O’Reilly

February 2025, Berlin