The amounts being talked about are relatively small, certainly in the context of the aluminum market in China. The world’s biggest producer churned out over $100 billion of the lightweight metal last year, for everything from window frames to car parts. But what’s spooked traders is the similarity to a much bigger scandal eight years ago in the northern port city of Qingdao that caused a crisis of confidence in China’s metals markets.

What might cause the mismatch in stockpiles?

Commodities trading, whether that’s wheat, copper or oil, is typically a high-volume, low margin business. To optimize cash flow, traders often pledge their assets for loans. In the metals industry, that collateral takes the form of warehouse warrants, which record details like the quantity, quality, ownership and location of the goods. 

Fabricating multiple warrants for a single stockpile of metals would allow the owner to access loans from more than one lender, a practice sometimes referred to as “over-pledging.” A mismatch between receipts and the actual quantity of metal could happen under such procedure. 

Why would a trader take that risk? 

Traders running on already razor-thin margins have been operating under even tougher financing conditions in recent months. Banks have become more cautious on lending because of bigger price swings caused by the Russian invasion of Ukraine, as well as jitters over some high profile losses in the nickel market.

That’s encouraged some to seek alternative financing, including the practice where smaller, privately owned firms pledge their goods to larger, state-run traders to obtain cash. Commodities prices are also generally higher due to the war in Ukraine, which means that inventories may be worth more as a currency for making other investments.

The risk now is that larger traders aren’t going to lend to their smaller peers if they don’t have confidence that their loans are secured by valid warehouse warrants.

How was the potential foul uncovered?

That market volatility may have jangled creditors’ nerves. The sharp drop in aluminum prices after the latest virus outbreak locked down the entire city of Shanghai led some to try and take hold of the pledged metal, fearful that borrowers wouldn’t be able to repay their loans. That was when the mismatch between too many warrants and not enough aluminum became apparent, according to people familiar with the matter, who declined to be identified discussing a private matter.

What happened during the Qingdao scandal?

The Foshan incident is relatively small beer and so far involves just traders. At Qingdao, it was banks, including international institutions, that ended up with the biggest exposure to a merchant and its affiliates who pledged the same metals stockpile multiple times to obtain loans of more than 20 billion yuan.

But that in itself is probably instructive. Banks have learned the lessons of Qingdao and other commodities financing scandals, making them more cautious lenders and driving traders to seek other arrangements, including borrowing from larger peers. China’s regulator also urged banks to strengthen oversight, and the use of metals as collateral for financing has diminished since then.

Other similar frauds outside China include French and Australian banks getting hit by loan losses in 2017 that totaled over $300 million, after they discovered fake documents for nickel stored in Asian warehouses owned by Access World, a subsidiary of Glencore Plc. And in 2020, Singaporean oil trader Hin Leong (Pte) Ltd. forged documents to win trade financing for products it had already sold.

What are the potential outcomes?

The local police in Guangdong are investigating and will determine whether fraud occurred but because the warrants in question weren’t registered with the Shanghai Futures Exchange, China’s biggest commodities bourse won’t be on the hook for examining the regulatory angles to the case. Instead, the creditors will probably go after the warehouses first for the inventories, while waiting for investigations to decide if the borrowers are accountable for the losses. 

The incident has led to a domino effect whereby more warehouses in China have suspended operations to check on-site metal inventories, according to people with knowledge of the information.

Although the Chinese government and its state banks are preparing to expand lending to counter the ill-effects of the virus on the economy, their largess is unlikely to extend to commodities trading. As such, smaller outfits may find it harder to get financing in the wake of another scandal.

The incident is having a baleful effect on prices, as well. Aluminum has dropped in the days since news of the possible fraud started circulating, and traders will continue to be wary of buying metal while such uncertainty around ownership persists. There’s also the risk that confidence will be sapped in other important markets for materials that rely on warehouse warrants, like copper, nickel or zinc.

More stories like this are available on bloomberg.com