structured commodity finance - issues in india

04/08/23 by Amit Bhushan1

Structured Commodity Finance – Issues in India

By Amit Bhushan Contact: [email protected] works with Global Transaction Services team of an MNC Bank in India. Views are personal


Structured Commodity Finance –Explanation

What is Structured Finance Structured Commodity Finance (SCF) Why Structured Commodity Finance


What is Structured Finance

Definition: “A technique whereby certain assets with more or less predictable cash flows can be isolated from the originator and used to mitigate risks (eg. transfer of foreign exchange, contract performance and sovereign risk), and thus secure a credit”.

(1) Arrangements which ensure that if a transaction proceeds normally, the financier is automatically reimbursed. The loan is therefore self-liquidated.

(2) Arrangements further ensure that, if anything goes wrong, the financier has recourse to some assets as collateral.


Structured Commodity Finance

Suggests that structured finance is financing based on Assets / Commodity which are IDENTIFIED / ISOLATED and are of more or less ASSURED VALUE (since they do not have much differentiation from products which are being readily sold in the market). Also, the commodity is being USED to mitigate risk.

Commodity linked financing is also a form of Structured Finance as it makes the use of commodity (pledge) or asset to improve the credit quality of financing.

Structured Commodity Finance commonly refers to the sum of banking / financing operations pertaining to an import or export of commodities which are not plain vanilla. It provides working capital in difficult environments by mitigating the risk through mortgaging an export/trade flow.


Why Structured Commodity Finance

– “Bankability” increases because transaction economics improve.

– Can be used in credit structures by bank or non-bank entities

– From the financier’s perspective, better pricing can be offered since credit is either enhanced or the risk shifted to a strong off-taker and all other risks identified and mitigated.

– From the borrower’s perspective, better costing achieved, longer maturity periods and more favourable balance sheet treatment.


Structured Commodity Finance –Advantages

What SCF Does What more can SCF offer How SCF attains Commodity Price linked Flexibility Benefits of Price linked Financing


What it essentially Does ?

From Financers’ perspective Structured commodity finance seeks to achieve the following:

– Externalize the credit risk (generally to a credit worth buyer/importer).– Commoditize the transaction (thus market risk of the isolated asset / commodity and

ability of borrower to perform play key role over credit rating)– No exposure to the balance sheet (Credit risk is of the buyer/importer mitigated with

insurance/guarantee of Export Credit Agencies)– Relevant to new entities without track records (who have strength in procurement)

From Borrowers’ perspective such financing delivers the below:

– Exposure is off balance sheet (i.e. Financing may be given off balance sheet treatment)

– Based on Performance of borrower rather than his credit rating (Leverage the strength of commodity by using it as primary collateral)

– Difficult to enforce banks’ rights due limited recourse nature of such facility.– Get financing in tranches aligned with stock build-up schedule– Repayment schedule aligned with actual usage


What else can it deliver ?

Additionally, Structured Commodity Finance can offer Commodity price linked financing

Financing corporate at rates linked to commodity prices. Eg. Financing of Aluminium done at price linked to Aluminium for an Aluminium trader

The structure helps corporate to directly match revenues and interest costs

Corporate pays lesser interest rates when commodity prices fall and higher interest rates when commodity prices rise


How does it attain Commodity Price linked Flexibility

Thru Fixed-to-floating Swaps

Transforming existing fixed rate liabilities into floating rate liabilities linked to commodity prices

Corporates can take advantage of directional movements in commodity prices and reduce interest costs

Corporate can enter into zero cost collar structures where it – Buys put option at 90% of Spot (price protection level) and – Sells call option at 125% of Spot (profit sharing level)

Corporate can take advantage of fall in commodity prices but has to give up the upside of rise in commodity prices

Bundled with Warehouse Receipt Financing– Can allow greater funding by Banks since value of collateral is

protectedThere are several structures possible based on Commodity, Foreign Currency & Interest Rate market offerings. Fixed to Floating Swap is among more common structures


Benefits of Commodity Price linked Financing

Benefits to – Borrower

Debt service payments proportional to revenue stream Reduces cash-flow volatilities

– Financer Reduce risk of corporate default (separate market risk from

credit risk) Assured fixed return on the loans (though corporate pays

floating rate linked to the aluminium prices) Improving asset quality


Structured Commodity Finance –Explanation

SCF - Common Methods INVENTORY FINANCING PREPAYMENT


Structured Commodity Finance-Common Methods

1) Inventory financing

2) Prepayments

Other complex forms of Structured Commodity Finance like Tolling, Barter, Counter-trade, Processing Finance, SCF with Reverse Factoring for Exporter etc. are not covered in this presentation.


INVENTORY FINANCING

DEFINITION: A loan is made with limited recourse to the exporter whereby the security is provided by an assignment of the commodity stored in a warehouse and the repayment comes from export proceeds paid by future buyers directly to the lender. Involves below steps:

Exporter puts goods in warehouse Bank takes security interest over goods in warehouse Goods inspected and security interest perfected Bank makes loan to exporter Exporter sells goods (preferably Ex-Works/Warehouse or as per comfort of financer) [If necessary Bank obtains top-up goods and gives order to warehouse for sold goods to be delivered to

buyer] Buyer pays sale proceeds into escrow account (common if banker is based outside the country of

financing) Bank is repaid from escrow account and excess after agreed deductions release to exporter


PREPAYMENT

DEFINITION: A loan is made without recourse or with limited recourse to the buyer/ importer for prepayment of the commodity sold by the exporter whereby the security is provided by an assignment of the prepaid export sales contract and by an assignment of the commodity stored (or to be stored) in a warehouse and whereby the repayment comes directly from the buyer.

Used when relationship between the buyer and the exporter is strong eg. when the exporter is a subsidiary or JV of the buyer.

Sale contract between exporter and importer providing for prepayment by the importer assigned to Bank Bank inspects goods for purposes of loan to importer (at Warehouse in country of exporter) to enable

importer to prepay for goods to exporter. Bank takes security over goods stored in warehouse upon prepayment.. Can make advance without

security over goods. Importer sells goods to sub-buyers with sub-sale proceeds from sub-buyers assigned to Bank Goods released from warehouse against payment paid to Bank with excess split between exporter and

importer


Structured Commodity Finance –Concerns

SCF – Suppliers’ Concerns SCF – Buyers’ Concerns SCF – Financers’ Concerns


Structured Commodity Finance – Suppliers’ Concerns

Favourable terms for availment (pricing as well as disbursement conditions) of such finance so that performance of production / procurement & timely supply towards fulfillment of contract is intact

Availability of hedging tools to cover Price Risk of commodity at the time of procurement / production

Suitable certifications at the time of production / procurement to avoid future quality inspection shocks

Availability of guarantees / insurance from Warehouse / Collateral Managers to cover all risk including deterioration of quality

Market Risk of holding commodity & Counterparty credit risk to be borne by financer.

Suitable trade terms to minimize requirement of any other type of collateral Lastly, stakeholders such as Collateral / Warehouse Managers, Logistic /

Shipping Companies & Governments should create favourable policy & regulatory environment for facilitation of such trade and minimize financers’ risk.

Generally SCF is seen as highly favourable form of financing for supplier / exporter from the perspective of risk mitigation as financer absorbs counterparty risk


Structured Commodity Finance – Buyers’ Concerns

Operational

Commercial

Technical

• Evaluate performance quality in field (in supplier's Country).• Arranging for suitable Packaging & logistics to get on-time delivery while keeping in line with financers’ interest• Complying with Safety, Environmental, Sanitary & Phytosanitory implications & changes taking place

• Procure sufficient volumes at competitive prices• Develop sophisticated contract model to mitigate/manage supply risk while not compromising on ability to purchase elsewhere • Regulatory Risk & taxes associated with the contract at favorable jurisdictions

• Integrity, reliability and performance of Supplies / Suppliers• Non-usage of Banned substances in supplies or parts• Assurance of quality for pre-processing, processing & Post-processing phases

A Favourable type of financing from Buyers’ perspective as Risk component of Transaction have been outsourced/shared with financer who has limited recourse on Buyer. Such financing offers better control on supplies, price advantage in procurement, professional supervision of suppliers’ performance, management of Market Risk and favourable structure of pricing.


Structured Commodity Finance – Financers’ Concerns

The Financer is the principal stakeholder in the SCF transaction and the Pledge of Commodity / Warehouse Receipt is one of the principal collateral instruments. Financer has interest in adequacy of its control over the collateral at all stages of the transaction

Integrity and commitment of Stakeholders at all stages i.e Pre-Procurement Procurement, Storage, Transportation, Processing, Post-Processing & Final Delivery to Buyer with clarity of processes & controls.

Management of Market Risk of Commodity & linked structure with Fx & Interest rate markets and thus availability of a transparent & Liquid market for the same. Such hedges should preferably be assignable to financers

Easy enforceability of Security Interest at jurisdiction favoulable to financer and ensuring that such judgments are adequately honored by Collateral Manager, Logistics Providers and other such agencies to ensure risk mitigation for financer.

Operational Flexibility to get out of transaction within reasonable time and cost Structuring Term Sheet, Trade Terms, Collateral Management Agreement, Logistics Agreement to

protect Financers interests in all jurisdictions to which the transaction is spread. Ensure Risk Mitigation through clearly defined policy & procedures.

Conduct of all stakeholders such as Buyer, Seller, Financer, Logistics provider & Collateral / Warehouse Manager and other agencies involved is covered with adequate guarantees

Counterparty Risk of Buyer is either absorbed by financer with adequate Lines being blocked or with cover from an Export Credit agency while Performance risk of Supplier is mitigated by adequate examination of past track record.


Structured Commodity Finance –Issues in India

Generic Concern Areas Collateral Management Document-Custodian Service Price-Valuation Service Monitoring Services Market LiquidityTrade Policy & Tariffs


Structured Commodity Finance - Generic Concern Areas

Collateral Management Document-Custodian Service Price-Valuation Service Monitoring ServicesMarket LiquidityTrade Policy & Tariffs


Collateral Management

The objective of collateral management services is to assure the availability and physical control of the commodities and to enable the bank or purchaser to acquire clear legal title to the commodities as owner or pledgee by virtue of the possession of the commodities.

The challenges to the bankers with reference to India are: Warehouse agent presents a credit risk for the Bank - so Banks are concerned

about offer performance guarantees or insurance bonds (Systems, yet to develop) We have less than appropriate licensing and monitoring systems therefore Private /

Field Warehouses are of specific concern while in SCF Negotiability/transferability issues - Negotiable Warehouse Receipts Act being

formulated De-mat warehouse receipts -Not recognized by Warehousing Act or Depository Act

– Encouraging signals as NCDEX-CSDL had successful implementation


Collateral Management

Some other concerns are:

Professional Collateral Management Services now offer to insure the commodities under its custody through a first-class underwriter against cargo or political risks in addition to other covers but are available at limited locations & at higher costs

Legal environment and the enforceability of pledge locally is an issue owing to slow judicial process (Legal validity of Pledge may not be an issue though). Negotiability if & when it becomes law might improve the environment. Legal options presently are best to be avoided or should be the last options


Document-Custodian Service

Commodities under collateral are often fast-moving operations, involving multiple storage, processing, and transport points, in each case accompanied by the issuance and release of storage and transport documents.

For continual validity of the bank or trader’s legal claims to the commodities, these documents should be issued to the principal or be in negotiable form.

Negotiability issue is still to become law as discussed previously Issuance of Documents in name of Principal/Bank has Restrictions exist on

commodity exposure by banks directly. Banks are also not allowed to deal in commodity derivatives for hedging – Banking Regulations Act needs to be amended to facilitate above

Also, Options on commodities not allowed - FCRA to be amended. Since documents & commodity ownership can be transferred frequently in SCF

transactions, so electronic form of issuance is required. The infrastructure is yet to develop fully. Beginning has been made by NCDEX-CSDL.


Regardless of the type of risk-management services employed, the bank or purchaser will require frequent reports of the quantity, quality, type, location and value of the commodities in storage, processing or transport.

These reports need to be as per principal order & are used to create structures for hedging (Currency, Forex, Commodity Price & Interest Rates). Markets yet to be fully developed/liberalized. Also, hedge instruments are not to be taken by bank directly hence additional monitoring/documentation/structuring issues.

Timely and comprehensive inspection reports are required to monitor the borrowing base/performance and the ability of financer to call for additional collateral as needed in the event of changes in market value, an inherent flaw in the commodities or losses in general.

Inspection Service /Performance Certification on Field should be available to value commodities by checking quantity and quality on agreed intervals and compare them in accordance with local indices as per agreement and acceptable to the financer.

Price - Valuation Service

Most services are available in India however Transparency & Liquidity of Local markets/mandis is some concern. Absence of standard grade quality is another hindrance.


Monitoring Services

Monitoring and controlling the movement of the commodities is necessary to assure performance by the exporter and to assure that commodities are continually capable of identification.

Services include continuous monitoring services or periodic spot inspection services to control the movement, care and condition of the commodities.

The services ensure integrity of claim of Financer over stock, damages & misappropriations are addressed, performance is monitored & in the event of fire, flood, theft or similar causes claim to insurance is secured.

Monitoring services are available, however for service to be effective the stakeholders including Sellers, Collateral Managers, Insurers, Logistics Providers etc. to the transaction should agree for jurisdiction/arbitration at locations favourable to financer.


Market Liquidity

Even at the cost of being repetitive, it may be stated that the spot and derivatives markets are central to conduct direct transactions and for use of prices for information processing and financing decisions.

The spot and derivative markets for commodities have yet to develop a sophisticated institutional capacity to offer transparency & comfort to Financer as no central dissemination of information of prices. Considering the fact that cost of transportation of commodity is significant, a reliable price source & liquidity of the physical stock at local wholesale markets provides comfort to the Financer.

Certification and standardization of commodities is required to shift to an electronic exchange, pooling order flow and liquidity from a much larger area & provide price reliability & transparency. The electronic exchanges are progressing to do their bit towards opening up of such market.


Trade Policy/Tariffs & Exchange Management

The Trade Policy (Exim Policy, Tariff & Non-Tariff Barriers) and Exchange Management Regulations of RBI are other concern areas.


Trade Policy/Tariffs & Exchange Management

Exim Policy: Frequent Changes in Exim policy with respect to Bulk traded Commodities (both Imports (where Pre-Payment Finance is used) as well as Exports (where Inventory Finance play a role) has been a hindrance in market penetration of Structured Commodity Finance (specially for SMEs who have limited options). Prominent restrictions are Quantitative Restrictions on Exports, Imports & Storage, Minimum Export Price, Export/Import Duty, Canalising Agencies for Import, Exports etc.

Though Inventory Finance (Exporters) product can be serviced if Financer is ready to undertake risk relating to collateral management basis some additional margins from exporter like comfort from buyer etc. However, issues relating to changes in Trade Policy & tariff structures with regards to the commodity being financed needs to be looked carefully has frequent changes have been witnessed in policies/export tariffs to export commodities like Iron Ore, Rice, Cotton etc.

Convoluted/restrictive Forex regulations in addition to Collateral Management issues and those pertaining to transparency & liquidity of the domestic markets have kept market for Prepayment Finance for Importers from developing. Also, other barriers are frequent changes in Trade Policy & tariffs for Edible Oil, Lentils, Sugar etc. Issues (pertaining to forex policy) exist with regards to Pre-Payment (financing imports) like non- availability of Buyer’s Credit for Advance payments need to be addressed.


Final Note

Lack of Structured Commodity Finance affects SMEs who lack direct access to foreign banks (Corporates do find routes to avail these products through offices/subsidiaries abroad).

While commodity exchanges are being developed and freedom of movement of commodities (softs’) and taxation are being resolved; it may be advisable to look into the issue of making greater financial resources available to commodities sector in particular, for the healthy development of this employment generating market in its entirety. It is also easier to raise international financial resources to fund self liquidating transactions for funding commodities than Foreign Direct Investment to projects which the country has been trying get for a long time. This may also spur Warehousing capacities & thus avoid a huge wastage (of soft commodity).


Final Note

It may be further stated that addressing the issues by bringing clarity & liberalization of policies of Government agencies may go a long way and bring SMEs much needed liquidity as well as developing a dependable supply source in a tightening Credit Environment (present scenario) & worsening business environment. This shall create a level playing field for Domestic commodity traders who are no way behind their foreign counterparts in enterprise & innovation, but also help domestic buyers gain access to resources which are a must for a fast growing major economy.


Thank You