Here's What You Need To Know About The Crisis In The Chinese Metals Market

At issue are numerous loans that have been made with copper and aluminum pledged as collateral. The growing concern is that the same copper and aluminum has been pledged multiple times improperly.

A subsidiary of a Chinese aluminum producer, Dezheng Resources, is being investigated for allegedly pledging the same stock of aluminum and copper against multiple banks, to access cheap funding, reports Lucy Hornby at Financial Times.

Qingdao Port said last week that there were ongoing investigations into commodities held at Dagang Port, which is under Qingdao's management.

Chen Jihong, founder of Dezheng was detained as part of a different investigation, and this prompted banks to check their exposure to Dezheng.

CITIC Resources has asked courts in Qingdao to secure alumina and copper stored at the port Port. Citigroup Standard Chartered and other international banks also have exposure to such commodity backed deals.

Goldman SachsGoldman Sachs explains how the repo business in China's Commodity industry works.

Remember, commodity financing is very common in China, as companies failed to secure traditional bank loans.

Companies offer metals like copper and aluminum as collateral.

Basically, a commodity owner imports commodity using letters of credit and stores it at a warehouse. It then borrows against the commodity offshore, in U.S. dollars. This is a way for commodity owners to gain access to short-term liquidity, it also lets them lend the money inside China for a higher rate and profit from the difference in interest rates.

In Qingdao, the main concern is that there have been more warrants than the amount of underlying commodities, and that company in turn defrauded various banks.

What does this mean for markets?

Banks are now struggling to ensure whether these warehouses do in fact have the stock of collateral they claim to. And the Qingdao issue is expected to act as a catalyst that prompts banks to unwind their Chinese commodity financing deals (CCFDs).

"In our view the developments in Qingdao are likely to continue the significant scaling back of FX inflows from foreign banks into China via commodity financing business,"Goldman analysts Roger Yuan and Max Layton wrote in a note out earlier this week.

"...As foreign banks reduce their exposure to Chinese commodity financing deals (CCFDs), the profitability of these could be reduced meaningfully (via an increase of US rates and/or a lower FX loan quota to CCFD participants), more physical metal previously tied up in financing deals would be freed up for the physical market, helping ease the current temporary regional tightness."

That basically means, as more supply is unleashed in the market, commodity prices are expected to decline.

What's more? As more international banks are moving their offshore businesses from Hong Kong to Singapore, the risks from these commodity financing deals is spreading.