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Structured Commodity Finance –

Issues in India

By Amit Bhushan
Contact:
amitbhushan@rediffmail.com
Author works with Global Transaction
Services team of an MNC Bank in India.
Views are personal

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Structured Commodity Finance –
Explanation

 What is Structured Finance


 Structured Commodity Finance (SCF)
 Why Structured Commodity Finance

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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.

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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.

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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.

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Structured Commodity Finance –
Advantages

 What SCF Does


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

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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

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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

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

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Structured Commodity Finance –
Explanation

 SCF - Common Methods


 INVENTORY FINANCING
 PREPAYMENT

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Structured Commodity Finance-Common
Methods

1) Inventory financing

3) 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.

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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

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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

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Structured Commodity Finance –
Concerns

 SCF – Suppliers’ Concerns


 SCF – Buyers’ Concerns
 SCF – Financers’ Concerns

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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
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Structured Commodity Finance –
Buyers’ Concerns
• Evaluate performance quality in field (in supplier's Country).
• Arranging for suitable Packaging & logistics to get on-time delivery
Operational 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
Commercial • 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 &
Technical 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
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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.
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Structured Commodity Finance –
Issues in India

 Generic Concern Areas


 Collateral Management
 Document-Custodian Service
 Price-Valuation Service
 Monitoring Services
 Market Liquidity
Trade Policy & Tariffs

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Structured Commodity Finance -
Generic Concern Areas

 CollateralManagement
 Document-Custodian Service
 Price-Valuation Service
 Monitoring Services

 Market Liquidity
 Trade Policy & Tariffs

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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

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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

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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.

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Price - Valuation Service

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.
Most services are available in India however Transparency & Liquidity of Local
markets/mandis is some concern. Absence of standard grade quality is another
24 hindrance.
03/15/09 by Amit Bhushan
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.

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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.

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Trade Policy/Tariffs & Exchange
Management

The Trade Policy (Exim Policy, Tariff & Non-


Tariff Barriers) and Exchange Management
Regulations of RBI are other concern areas.

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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.
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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).

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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.

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Thank You

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