The financial world had been confronted heavily by trading scandals in 1995, with Japan's Daiwa Bank and the rouge trader, Nick Leeson. When it seemed the scandals couldn't get much worse, the Sumitomo Copper Scandal emerged. This was the biggest scandal in the history of commodities trading and ranked in the top five trading losses in financial history up until the late 1990's. Sumitomo Corporation is a Japanese trading house, which is currently one of the largest worldwide trading companies headquartered in Tokyo, Japan. In the 1990's Sumitomo owned large amounts of both physical copper, which was stored in warehouses and factories, as well as numerous futures contracts. Copper was a relatively small market compared to other metals, such as aluminum. According to Andrew Beattle's article, "The Copper King: An Empire Built on Manipulation", copper is an illiquid commodity that cannot be easily transferred around the world to meet shortages. For example, a rise in copper prices due to a shortage in the United States will not be immediately cancelled out by shipments from countries with excess copper. This occurs because moving copper between storage and delivery costs money, which can cancel out the price differences. It is important to note that Yasuo Hamanaka was the chief copper trader of this trading house, and attempted to corner the entire world's copper market leaving Sumitomo with a loss of more than $1.8 billion (Beattle).
For ten years, Yasuo Hamanaka had successfully managed to control the world's price of copper. He eventually came to control five percent of the entire supply of copper, which may not seem like much considering ninety-five percent was in other trader's hands (Beattle). However, due to the fact the abundant and cumbersome challenges that exist in the copper market (in movement, delivery, etc.) and the fact that even the largest traders in the market owned an even smaller percentage, Hamanaka's five percent was indeed very significant.
During the ten years of his manipulation he was able to use Sumitomo's size and large cash reserves to corner and squeeze the market through the London Metal Exchange. The London Metal Exchange is the world's biggest metal exchange. Furthermore, the London Metal Exchange's copper price essentially dictated the world's copper price at the time (Beattle). Although the London Metal Exchange was large in size, it was fairly poor in terms of regulation. In fact, this exchange had little to no regulation at the time of Hamanaka's rampant market manipulation. The Sumitomo Copper Scandal lasted for about a decade due to these negligent and almost nonexistent regulations on behalf of this particular exchange.
To put the entire crisis into laymen's terms, one must first understand that Hamanaka was taking a long futures position on copper and simultaneously buying up a substantial amount of physical copper as well. This caused any one trader who took a short futures position to have to buy long positions in order to cancel out their short positions. Due to the fact that Hamanaka had a large number of long positions, those people looking to buy them had to pay increasingly higher prices. These skyrocketing futures prices are what Hamanaka was able to control; the more the prices rose, the more money he made. This is because those with short positions were still paying this higher price in order to liquidate those positions. Another way that Hamanaka was making money was that while these prices continued to rise, some people holding short positions thought that instead of paying a high price for a long position they would buy the physical copper and deliver it to the holder of the long positions. So, because Hamanaka also owned 5% of the physical copper he could charge a very high price to those with short positions because they didn't want to keep paying money to liquidate their short positions. Essentially, he was making money by owning long futures as well as physical copper.
There are no assured reasons as to why Hamanaka engaged in such illegal trades. Perhaps he felt pressured to maintain the consistent levels of annual revenue for Sumitomo's traditional copper business-about ten billion dollars. He would therefore maintain his reputation as a phenomenal copper trader as well as his firm's dominance in the commodities market.
It is also important to note that individuals such as Hamanaka, do attempt to corner the market in order to create an unfair advantage by purchasing a significant amount of shares. This eventually increases the price of shares, making them appear to have a greater value. As the price of the shares continues to rise, more buyers become attracted, and then demand further increases the price of the shares. This causes short sellers to be driven out of the market through a short squeeze. In the article Short Squeeze, it explains that a short squeeze is a situation in which an increase in the price of the stock triggers a rush of buying activity among short sellers. Therefore, it is necessary for the short sellers to buy stock in order to close out their short positions to minimize their losses, causing a further increase in stock prices. Overtime, this causes one to sell their holdings at an artificially inflated price and then leave their investment or opt to sell their shares with the knowledge that the price will decrease once normal supply and demand forces return (Investing Answers).
WHO WAS RESPONSIBLE:
Yasuo Hamanaka, also referred to as "Mr. Copper," was the former copper trading chief for Sumitomo Corporation. Following research of the Sumitomo Copper Scandal, one can confidently say that Hamanaka is the key player who is held responsible for the 2.6 billion dollar loss over a ten-year period. In fact, the article, Sumitomo Corporation states that, "it believed that Mr. Hamanaka was solely responsible for the unauthorized trading" (215). His attempted action to corner the world's entire copper market by falsifying financial records and forging signatures alluded to such a significant loss for the company.
It is also important to note that prior to the discovery of Hamanaka's accumulation of illegal trades, he was given a great amount of responsibility within the company. This was because he was perceived by top executives to have superior knowledge and experience within copper trading. Therefore, one can also conclude that the top executives within the corporation can also be held responsible for the Sumitomo Copper Scandal. This is because the Sumitomo Corporation and senior management did not have secure safeguards in place to ensure that they knew exactly what their employees were doing. Furthermore, Hamanaka's reputation as being a superstar copper trader only worked to solidify the lack of regulation and discipline (Sumitomo Corporation).
When Sumitomo Corporation's reputation began to tarnish from individuals outside the company, they responded to the allegations by stating that Merrill Lynch and JPMorgan Chase were the two banks responsible. In the article The Copper King: An Empire Built On Manipulation, author Andrew Beattle explains that Sumitomo Corporation claimed that Merrill Lynch and JPMorgan Chase granted the loans to Hamanaka via future derivatives; hence the two banks kept the scheme going. Consequently, both banks were found guilty to some extent (Beattle).
RIPPLE EFFECTS ON THE MARKET:
Historically, there has been a close correlation in the behavior of metal prices. When one metal falls, the others tend to follow. However, the Sumitomo announcement did not harm other metals despite the recent dramatic drop in copper prices. Copper is a relatively small market compared to other metals, such as aluminum and gold. The price of the metal was above $1.25 a pound in New York in early May of 1996, but it fell to $1.04 on June 13, just before Sumitomo announced its loss. Following the announcement, copper was trading at about 89 cents (Wall). The decline in prices of copper before the Sumitomo scandal was believed to have risen from people being concerned about the number of new copper mines that were planned and the potential supply problems that it could bring about (Wall). Copper prices fell ten percent in the weeks following Hamanaka's removal (Fletcher), however, prices had been falling for a while, and the scandal only exacerbated the trend (Uchitelle).
The main effect of Sumitomo's losses was the decline in public confidence in financial institutions. Americans wondered how well their local financial institutions were handling oversight of management. They also were concerned about a temporary decline in stock prices as well as higher interest rates for money to seek to borrow from banks (Uchitelle).
The dollar is driven by people's perception of commodity price movements, and although the dollar had weakened before news of the Sumitomo scandal, the fall in copper prices has contributed to the dollar's softness (Wall). The Sumitomo affair concerned the United States about the openness of Japan's financial system and the implications for interest rates. These worries as well as the copper crisis had contributed to the decline of the yen. The collapse in copper prices also hurt the Australian dollar.
RISK MANAGEMENT ERRORS:
In the Sumitomo copper scandal, the financial debacle originates from the failures of proper risk management. By entering into fictitious trades for over ten years and manipulating several accounts, Hamanaka successfully misled his management into believing that he was making huge profits. Hamanaka had been trading on the London Metal Exchange forward market for copper. Sumitomo was the largest participant in the physical market for copper-he handled twice the volume as his competitors. Hamanaka was known in the copper markets as "Mr. Five Percent" because Sumitomo's copper trading team traded approximately 500,000 metric tons of copper a year, which was five percent of the total world demand for copper (Weston).
In regards to risk management, whenever any hedge fund or speculator who was aware of manipulation tried to take short positions, Hamanaka invested more money into his positions, thus sustaining a higher price because he dominated the market. However, despite these illegal practices no action was taken against Hamanaka because of the profits he generated for the company (Weston).
There are several reasons from a management perspective as to why the scandal carried on as long as it did. The middle office may have bypassed early warning signals perhaps because Hamanaka was perceived as an experienced senior trader. Hamanaka was chief of the trading office and intentionally had an incentive to maximize profit opportunities through illegal ways. Employees within the firm may have allowed the fraud to occur by turning the other way. This is a case of decentralization (Tschoegl).
The Sumitomo scandal has provided valuable insight and enables one to appreciate and understand the importance of internal and external controls. If there had been any controls, it is believed that the scandal would have been detected much earlier and before a loss of $1.8 billion.
WAS IT PREVENTABLE? IF SO, HOW?
The Sumitomo Copper Crisis was, at its core, a very preventable crisis-almost embarrassingly so. The huge financial swings that the copper market saw in the late 1980s and early 1990s as a result of Hamanaka's indiscretions were exactly that: the result of one man's greed and indiscretions. Hamanaka initiated and participated in the illegal trade of copper-like making off the book deals in order to recover unrealized losses-and incited a wave of regulatory laws by the London Metal Exchange and the Commodity Futures Trading Commission (CFTC).
Hamanaka exploited various agents and partnerships in his ten-year long market-manipulating extravaganza. He was able to do this due to serious misgivings and loopholes in the commodity futures markets, as well as taking advantage of gaps in the chain of command and knowledge. Hamanaka maintained two different sets of trading books: one that recorded fabricated profits for the Sumitomo Corporation and another real record of all the off-the-book and under-the-table deals that were made to maintain control of the market. This long-term interference and domination of the copper market was nonetheless very hard to maintain due to one key fact: in order to corner a commodities market, the company must actually hold the assets, which presents an additional strain on resources and funds. This very requirement may be the answer to preventing scandals like this in the future (Wall).
As aforementioned, the Sumitomo Copper Crisis was largely unavoidable simply because one man's poor decisions affected the rest of the affiliated market. "The essence of the problem was unauthorized trading that the culprit undertook to enhance his firm's profitability and then his own career and pay," Adrian Tschoegl mentioned in The Key to Risk Management. However, the true debacle is a result of a lack of internal and external controls. The Sumitomo Corporation, which was divided into essentially three separate "offices" (front, back and middle), simply did not harbor or even encourage communication between departments and sectors (Tschoegl). The middle office (which is responsible for one of the most key business functions: risk management) can easily be said to have failed most spectacularly in this scandal. The lack of risk awareness and management led to a loss of $1,800 million dollars and a stain on the Sumitomo name, all because of a decentralized, non-communicative corporate structure (Tschoegl).
The most effective approach to avoiding something like this in the future is basically three-pronged: more and better management-level controls, independent transaction monitoring, and more stringent regulation (of the London Metal Exchange, by the government, and of corporations e.g. "corporate social responsibility") (Tschoegl). The management-level controls should consist of a conscious effort at centralizing every part of the company, as well as maintaining strict inter-company discipline and training. Independent transaction making should be monitored so no "two-book" accounting systems are permissible; that is to say, that there is a system of checks and balances within the corporation to ensure above-board transactions. In terms of regulation on behalf of various agencies and governments, it's only necessary to say that more of it is probably needed to avoid price manipulation. Perhaps a system of rigorous reporting and accounting policies could be implemented, which would strengthen the market's effectiveness anyways.
It's fair to say that the Sumitomo Copper Crisis leaves the skilled and careful trader with a few pivotal takeaways. First, both internal and external management controls are absolutely crucial to the success of any company, but if said management is left to run unchecked through the system, mishaps and misdeeds are bound to occur. Strict and standardized corporate training and discipline is the remedy to this pitfall. Second, given the right amount of determination and finesse, the market on almost any given commodity can be cornered, for better or for worse. Events like this, despite their far-reaching negative implications for the perpetrator, always help make the market a more efficient and fluid network. The lessons that are learned from scandals such as the Sumitomo Copper Affair in the long run only work to better and enhance the market.