Sumitomo Copper Affair

Brief Overview

Prior to 1996, Sumitomo Corporation (“Sumitomo”) was one of the top copper market makers in

the world in terms of its trading size. Yasuo Hamanaka (“Hamanaka”), head of copper trading,

was a key player in the market. He, however, engaged in illegal copper trading, which

culminated in extensive losses and massive cover-ups. Hamanaka participated in conduct that

attempted to avoid losses due to the pressure of generating $10 million annual revenue from

Sumitomo’s traditional copper business, and therefore made off the book deals to recoup his

unrealized losses. However, since Sumitomo’s trading volume was so huge compared to its

market size, the London Metal Exchange, LME, created new regulations to prevent the market

from dominating, which resulted in a huge loss to Sumitomo’s portfolio.

Malfunctions in the control process and the segregation of duties allowed Hamanaka to keep two

sets of trading books, one reportedly showing big profits for Sumitomo and a second, secret

account, that recorded unauthorized trades for over 10 years. Until an accountant found

unauthorized deals in a bank statement in 1996, no employees except Hamanaka were aware of

the accumulated loss of $1,800 million. The following sections provide a detailed analysis of

Sumitomo, how this happened, and what takeaways the company learned.

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Sumitomo Corporation

Sumitomo Corporation is one of the largest worldwide trading company (Sogo shosha 1), and is a

diversified corporation. Sumitomo is headquartered in the Harumi Island Triton Square Office

Tower Y in Chuo, Tokyo, Japan. It was incorporated in 1919. It is a member company of the

Sumitomo Group. Today, the company, Sumitomo Corporation, is one of the top three Sogo

shosha companies in the world. It is originally founded as Osaka Hokko Kaisha Ltd. (capital

stock 35 million yen), a company engaged in real estate management, conducting land

reclamation, land grading, harbor repair construction, etc. in the Osaka northern harbor region. .

It has 120 oversea branches in 65 countries with highly diversified business such as Metals,

Mineral Resources, Energy, Chemical & Electronics and Infrastructure. The Copper trading

department includes the Mineral Resources, Energy, and Chemical & Electronics business units,

which contribute approximately 10% of the gross margin of Sumitomo.

Yasuo Hamanaka

Yasuo Hamanaka was the chief copper trader at Sumitomo Corporation. He committed his

wrongful acts between 1985 and 1996. He was referred to by many as "Mr. Five Percent"

because he traded approximately 0.5 million metric tons per year, which was 5% of total world

demand. He was also known as "Mr. Copper". Due to his extensive experience in copper trading

(over 23 years), Hamanaka was given a great deal of responsibility from Sumitomo Corporation.

1
Sogo shosha means general trading companies, a business entity unique to Japan trading a wide range of products and materials. In addition to
trading, they have historically acted as investment banks and private equities. Sōgō shōsha may be better described as a business philosophy than
with a visual model.

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Details of Sumitomo Copper Scandals:

What happened……

From 1985, Hamanaka lost a total of $1,800 million.. He executed as many as $20 billion worth

of unauthorized trades a year. His main strategy was the “short squeeze2”. The future market

was particularly vulnerable to manipulation since the market volume was relatively small. By

buying up futures and choosing physical delivery, future sellers ended up buying copper in a spot

market, which resulted in backwardation3: the spot price is higher than the forward price. LME

only counts its inventory in their authorized warehouses. Thus, if someone moves copper

inventories outside of an authorized warehouse, LME inventory appears to decrease and

therefore, copper prices rise due to a perceived tight supply in the market. It should be note that it

is not certain as to whether Hamanaka implemented such a strategy because all of his illegal

trades were not booked, but it is clear that this was a possible way to induce backwardation.

Hamanaka’s aggressive position-taking distorted the market; as evidenced by the figure of

backwardation from 1987 to 1991 exceeding $100. Hamanaka tried to dominate the copper

market by increasing volume and thus gained his reputation as “Mr. Five Percent”.

2
A situation in which a lack of supply and an excess demand for a traded stock forces the price upward. Short squeezes occur more often in
smaller cap stocks with small floats. Short sellers get squeezed when the price of the stock they have shorted begins to rise. This can happen
because investors are feeling good about the stock and more and more are starting to add it to their portfolios, because some investors who sold
the stock short are exiting their trades and covering their positions or a combination of both. 

3
A theory developed in respect to the price of a futures contract and the contract's time to expire. Backwardation says that as the contract
approaches expiration, the futures contract will trade at a higher price compared to when the contract was further away from expiration. It occurs
F  S e rT
when a cash and carry arbitrage is created, that is when 0,T 0
. This is said to occur due to the convenience yield being higher than
the prevailing risk free rate. When backwardation does occur in a futures market it has been suggested that an individual in the short position
would benefit the most by delivering as late as possible.

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In December 1991, the LME announced new regulation about backwardation, which limited the

price between the spot and forward to 25 pounds, thus expanding Sumitomo’s loss. Hamanaka

tried to recoup the loss by increasing the trade volume and made a contract with Winchester for

1mn metric tons over two years at the price of $2,800, however, due to price declines, the loss

kept expanding.

Hamanaka’s next step was to create an option portfolio named “Radr” transactions. He made six

different transactions in Radr. The counterparty of these transactions was Credit Lyonnais Rouse

(“CLR”, currently Calyon Group). Since the position held by CLR was large and caused

backwardation, LME tightened the backwardation limit to $5 in September 8, 1993. In addition,

LME informed Credit Lyonnais that they were to cancel part of their transactions with Sumitomo

on September 17th,, Thus resulting in a $1.16 billion loss for Sumitomo. After the new regulation

was released, the price went down slightly to $1,600, as Hamanaka expected. If there had not

been a regulation change, Hamanaka would have recovered his loss.

The steps taken by Hamanaka to recover the loss……

 1st: In June 25, 1993, Hamanaka buys call option with an average price of $2,400 and

which expires after 2 years. The transaction is totally irregular because the total volume

was 1 million metric tons as compared to all LME inventory of 0.5 million. The portfolio

could make a profit if the price went up to $2,480. To pay a premium of $69 million,

Hamanaka made a 2nd trade.

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 2nd: Hamanaka made a short strangle4, combination by selling a 0.5 million $2,100 call

and $1,900 put option. The portfolio could make a profit if the price remained between

$1,900 and $2,140. From this transaction, he got $94 million of premium and paid for the

1st option. With 1st and 2nd strategy, total breakeven was $2,700.

 3rd: Selling future at a price of $2,000 which increased payoff to around $1,900.

 4th: Buying 1.35 million metric tons of $1,750 put, breakeven was $1,580. He predicted

that the copper price would go down below $1,600 level.

 5th: Buying 1.35 million metric tons of $1,800 put again, breakeven was changed to

$1,680. This portfolio could make a profit slightly if the price went down below $1,700

level.

 6th: Selling 1.2 million metric tons of $1,950 call to get $29 millions of premium. With

this transaction, breakeven was changed to $1,680. However, if the copper price

exceeded $1,950, Sumitomo suffered a huge loss.

Effect and necessary steps…….

In December of 1991, the LME decided to set new regulations that would limit the range of

backwardation within 25 pounds to prevent market manipulation. Backwardation shrunk to

almost $0 or even negative, thus causing a huge loss in Sumitomo’s portfolio. To recoup the loss,

he conducted a Radr transaction in June 1993. A Radr transaction is an extremely large

4
An options strategy where the investor holds a position in both a call and put with different strike prices but with the same maturity and
underlying asset. This option strategy is profitable only if there are large movements in the price of the underlying asset. 

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transaction compared to the market size and aims to achieve a profit, even with a declining price.

LME, however, intervened again to avoid market domination by setting new rules that limited

backwardation within $5, and, to increase market control, LME forced Credit Lyonnais Rouse, a

major counterparty of Sumitomo Corporation, to reduce its positions. Based on these regulations

and changes, Sumitomo ended up closing their Radr position and incurred a $1.1 billion loss.

Reasons behind the scandal……

 However Hamanaka’s “5%” of copper trading was mainly off the books, no one at

Sumitomo noticed the cumulative losses as Sumitomo’s segregation of duty was totally

inept at that time.

 He even forged signatures of executives for documents such as payment confirmations or

trade contracts.

 LME is a top non-ferrous metals market which provides both spot and future markets and

has clearing system to reduce counter-party risks. The delivery takes place in authorized

warehouses and storage facilities. The specification of copper trading includes quality

(Electrolytic Copper cathodes Grade A, 99.99% purity), trading unit (25 metric ton),

price quotation (US dollar), trading months, minimum fluctuation ($0.50 per metric ton),

and Tick Value. Although LME is a listed market, its copper contract is similar to that of

an on-the counter forward; the counterparty information is open and the delivery

condition is by the parties, not the LME. Not surprisingly, margin is not required if

agreed upon between the market participants. In contrast, COMEX, a division of the New

York Mercantile Exchange (NYMEX), is the top market in United States and the second

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biggest market in the world, and plays intermediary role to help achieve anonymous

trading and requires a significant portion of the margin. It was LME’s flexible regulation

that helped Hamanaka engage in unauthorized deals.

 In Sumitomo’s case, the financial debacle originates from the failures of proper risk

management. 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. From a

management perspective, the middle office didn’t work well as it should have.

 The firm looked past the early warning signals based on senior managers’ experience and

the fact that Hamanaka was perceived as a superstar trader.

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References:

 http://www.investopedia.com
 http://en.wikipedia.org
 http://www.investorwords.com
 The key to Risk Management Adrian E Tschoegl, Wharton Financial Institution
 http://www.sumitomocorp.co.jp
 Derivatives : The Tools That Changed Finance by Phelim P. Boyle
 Fundamentals of Derivatives Markets by Robert L. McDonald