Commodity Finance Risk Mgt FYoussef.ppt

7/30/2019 Commodity Finance Risk Mgt FYoussef.ppt

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SPECIAL UNIT ONCOMMODITIES

Commodity finance and riskmanagement

Frida Youssef

UNCTAD

Palais de lONUGeneva, 18 Feb 10


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I. Commodity finance

Introduction

Traditional finance vs Structured finance

Examples


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Introduction: access to finance in

commodity trade and development

Importance of the commodity sector for developing economies andfinancial constraints:

- Over 2 billion people are estimated to derive their livelihood fromproduction and trade of commodities;- More than 50 developing countries and LDCs depend on three orless leading commodities for at least half of their export earnings.

Commodity trade and production is credit-intensive.

Risks in commodity finance.


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Traditional finance (balance sheet based)

vs Structured finance (transaction based)Economics, and political events that have global implications, especially in emerging markets,

have compelled financiers to develop and adopt innovative, structured financing techniques to

mitigate their risks and adapt to globalization and privatization of commodity trading activities.

- Until the onset of the Latin American financial crisis in the mid-80s, banks involvedinternational commodity finance relied on balance sheet lending and government guarantee.

Structured finance, on the other hand, is based on the transaction for which the finance is

provided.

- Such techniques aim to transfer risks in financing transaction from parties less able tosupport those risks to those more equipped to support them in a manner that ensures

automatic reimbursement of advances from the underlying assets such as inventory and

export receivables... This forms the pillar of structured trade finance.

Structured finance revolves around identify and mitigating risks associated with

transactions..and convert wealth, in the form of commodities, into ready cash.


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Through use of structuring techniques,

financiers can control their level of risk

Without structured

finance:

financier financier

Potential

borrower

With structured

finance:

Will the

borrower

reimburse?

financier

Potential

borrower

With secured

finance:

How to

control

collateral?

$

Goods

Will the

borrowerproduce?

Potential

borrower

$

Offtaker


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Practical use of structured trade finance:

There are no distinct standardized types of structure trade finance

transactions since one essential principle of these transaction is the

ability to tailor a structure that will satisfy the needs and

circumstances of all parties involved, provided that perceived or real

risks are mitigated. We are going to present some basic forms of

structured finance, their concept, and transactions flow.

1. Export receivables-backed financing

2. Supply Chain finance

3. Warehouse receipts finance


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ProducersProcessors

CommodityTraders

InputsAgricultural Agricultural

Production

Storage

Production /

Processing

Local producers & processors;

Commercial farmers;

International input suppliers.

Local producers & processors Commercial farmers International input suppliers

Input financing;

Crop risk management weather

insurance

Working capital/basic cash

Structured finance: WRS/inventory

based finance, etc..

Storage

Transport

Trade / Export Wholesale

AgriValue Chain

FinancingStages

AgriPlayers

Financing

Needs

CommoditySalesSales

Transport

Manufacture/Further

Processing/Packaging

Wholesale/Distribution

Small commodity tradersLarge commodity traders

Local distributors F & Bmultinationals Wholesalers.

Working capital; Trade finance;

Price risk management;

Structured finance: receivables-

back finance, pre-payment etc.

Foreign exchange.

Working capital/liquidity;

Structured trade finance and

collateral management, etc.;

Price risk management;

Foreign exchange.

Buyers

Success Factors Along The Value Chain

Pre-shipment finance Post-shipment finance


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Export receivables-backed financing

This model entails the provision of pre-export loans or advance payment

facilities to an exporter, with repayment being obtained from the exporters

receivables resulting from the sale of the pre-financed exported

commodities.

Under this model, banks take the following combined measures:

(a) Taking security over the physical commodities in the form of a local-law

pledge or similar security interest;(b) Assigning the receivables generated under the commodity export

contracts;

(c) Establishing an escrow account in a suitable (usually offshore) location

into which buyers of the commodity are directed to pay the assigned export

receivables.


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Exporter

EXAMPLE: Receivable-BasedFinancing

1. Underlying transaction:To trade naphthaand crude oil.

2. Lender : XYZ Bank.

3. Faci l i ty Amount:US$ 50 million for creditfacility.

4. Expor ter :Oil company

5.. Importers:oil refineries worldwide.

7. Tenor:30-90 days from B/L date.

8. Collateral:Outstanding account receivables.

9. Facil ity Per iod:1 year.

10. Each transaction amount: Over US$5million.

XYZ Bank

Payment after

30-90 days fromB/L date through

an escrowaccount

Letter of Undertaking(remedial procedures incase of non-performance)

Shipment Buyers (OilRefineries)

This f inancing is given to the expor ter once goods are shipped and repayment is done

automatically by importer thr ough an escrow account.

This creates an automatic reimbursement procedure.

This enables exporters to use future trade flows to raise self-liquidating export-based financing at better

cost and tenor. It also enables financiers to externalize country and credit risks by the assignment of exportcontracts and receivables, and by receiving payment in an offshore escrow account.

Letter ofAcknowledgment

Payment at

shipment

Assignment of

contract/A/R etc..


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Fisher

men

Processor/

freezingplant

Foreign

buyers

Local

market

Diesel oil

Foreign

bankLocalbank

MonitoringLoan used

for buying oil

Reimbursement

Fish

Diesel

Fish

Fish

Example - revolving pre-export finance for fishermen and a fish

processing plant


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A simple warehouse receipt finance scheme - open to various depositors. Thiscan act as a model to reach farmers - who are often willing to pay high interest rates.

Farmer

Trader

Banks

Warehouse

1. Deposits

products

2.Issues

receipts

3.Lodges receipts with bank

4. Provide credit

5.Signs sales

contract

6. Reimburses credit; in return, bank transfers receipts

9. Deliversreceipt;

warehouse

makes delivery

Guarantee

agencies

Government

regulator

Approves

Warehouse

Guarantee, insurance,

etc.


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Rice

exporterWarehouse

Rice

ImporterWarehouse

An example of using a collateral manager to finance

South-South trade

Collateral

manager

Bank

Collateral management

agreement

Payment when goods enter

into warehouse controlled by

the collateral manager

Acceptable payment will

allow rice to be released

from import warehouse

Collateral manager takes full control from moment on thatgoods enter export warehouse, until release (as authorized bythe bank) from the import warehouse. The bank will haverecourse to him for most losses during this period.


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Commo-

dities

Paper

Money

Commodities will increasingly

become a financial asset any

commodity will be like a

currency.

Financial markets will develop

around these new currencies.

Independent entities will be

doing the leg work to convert

commodities, as they move

through the value change, into

financial assets.

Technology will link it all

together through a Global

Commodity Receipt system.


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WRS in Tanzania

- The CFC funded Coffee and Cotton marketing development project whichwas launched in 1999.

- Tanzania has passed a Warehouse Receipts Act (2005) and Warehouse Regulations

(2006),

- and has designated a Licensing Board in the Ministry of Industry, Trade andMarketing

-This has registered some 20 warehouses (12 for cashew, 5 for coffee, 2 for cotton and

2 for paddy rice), and plans to establish a fully-fledged licensing regime.


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WRS in Tanzania

Commodities Finance includes:

- Traditional crops (coffee, cotton) has expanded their loans portfolio at

ground level.

The WRS has taken off with coffee since the latter 90s and 25% - 30% of the countrys exports are

reported to pass through the system, much of it supplied by POs (farmer business groups, primary

cooperative societies etc.) that bulk on behalf of their members.

- Non traditional crops such as Paddy (MF-linked approach, with upward of

10,000 tonnes being stored by farmers per year), Maize and sunflowers are

recognized and getting finance from the bank.

- Cashew nut WRS initiative emerged in 2007. More than 168 primarycooperative societies in cashew nuts sub sectors are financed in in the

business of raw cashew nuts. Total loan portfolio in cashew nuts WRS finance

exceed U$50 million.


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II. Price risk management

Describing briefly organised and over-the-

counter markets

Hedging tools


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The need to pay margin deposits/guarantees

Margin calls, which could be required, and which

can be high

The fact that in some countries, intermediaries do not

really exist, or even use of these markets is banned

Although the basic ways to use these tools can easily be learned, hedging strategies can

become quite complex.

Even with a good mastery of

these instruments, some

difficulties exist, due to:

Market used for risk management is divided in two part

Commodity

exchange

Over-the-counter

market

{

Hedging

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Tools for Commodity Risk Management

Specification of price or minimum price incontracts for sale of commodities by farmers or

processors at future date Forward and futures contracts

Forward contracts negotiated on individual basis

Futures contracts specified on commodity exchanges

Options is right and not obligation to purchase or sella commodity at a a strike price on or before aspecified date pay a premium at time contractsigned

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Concept of price risk management

Financial markets provide possibilities to hedge against price risks. These

hedging instruments are:

Futures

Options (put, call)

Swaps

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Futures

Futures are kind of standardised contracts for future delivery of an asset (that could be

commodity). There are:

These kinds of contracts are regulated by exchanges authorities, and there execution are guarantee by

clearing houses.

Helpful to

hedge price riskexposure

Useful for some

marketingstrategies

An ideal

benchmarkprice

Initial position can easily be reversed

Delivery is not necessarily implied

No need to negotiate contract

specifications

Lock-in a future price

Protect the value of inventories

or finance storage

Give a good benchmark

price to barter

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Differences between Forward and Futures Contracts

Forward Contracts Futures Contracts

Most are traded OTC Are traded on organized exchanges

through clearing houses

Can be tailor-made to match specific

hedging needs

Have standardized contract terms

Require cash transfer only at maturity of

contract

Require initial transfer for margin

payments and may require daily

settlements to adjust margins to adverse

price movements

Involve a high degree of counterparty risk

because no clearing house facility exists

Imply very little counterparty risk

because the clearing house guarantees thefulfillment of contractual obligations

Contain the expectation of physical

delivery

Only a small fraction of futures contracts

result in actual delivery of the underlying

commodity

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Options

Options contracts give the right (but not the obligation), to purchase or sell a specific asset at a

predetermined price on or before a specified date. There are two kinds of options contracts:

US call: the right to buy at any timeduring the period.

European call: the right to buy, but

only at the end of the period.

Call option Put option

US put: the right to sell at any timeduring the period.

European put: the right to sell, but only

at the end of the period.

Obtaining

short-term

finance

Protection against

unfavourable

price movements

Part of

marketing

strategy

Limits the size of the maximum loss but

do not eliminate the opportunity to takeadvantage of favourable price movements

An over-the-counter

financing

In regard of longer-term

trade relationships

Main use are for:

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Swaps

A swap is a purely financial instrument under which specified cash-flows are exchanged

at specified intervals.

Guarantee

income streams

Obtain easier

and cheaperaccess to capital

Lock in long-

term prices

No or less-strict margin calls

Low administrative costs once

structured

From financial operations or

new investments

Tailor-made

Long term instrument

Combination of price

hedging and investment

securization

It should be noticed that swaps are purely financial tools, which means that no delivery of physical

are requested.

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Coffee Cooperative in Tanzania

Multiple payments to farmers throughout theyear

Minimum price when deliver coffee Supplementary payments based on price at whichcoffee sold on world market

Risk to cooperative of setting initial price

Too low, farmers sell elsewhere Too high, lose money

Mitigated through hedging in futures market

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Role of UNCTAD UNCTAD has been a pioneer in helping commodity-developing

countries address the commodity problematique including byadvocating the importance of increased access to, and diversifiedsources of finance.

One recent example, UNCTAD as part of its technical capacityactivities (funded by the EC All ACP project), been looking at financing

tools such as Factoring (discount of receivables) that would enablethe integration of small scale farmers into the supply chains, such asof the tourist industry (the mainstay of many Caribbean territorieseconomies) and supermarkets.

Yet, nowadays, the problematiqueextends beyond the commoditysector and its traditional issues to cover other cross-cutting concerns,

such as food insecurity, water shortage, climate change impact,energy security, and more broadly, sustainable commodity sectordevelopment. In other words, the challenge for UNCTAD and for allrelevant stakeholders is of a greater magnitude today than it has everbeen. To address the challenge, concerted and considered efforts arerequired at all levels, national, regional and international and fromboth the public as well as the private sector (including financiers,

insurers, research, academia, enterprise, civil-society, etc).

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Role of UNCTADUNCTAD activities targeted to both public and private sectors include:

Building perspectives on broad trends in financing and pinpointing theimplications for development of commodity sectors and the institutionsthat serve them.

Advising on the structuring of financing mechanisms

Engaging in institution- and capacity-building and policy advice toimplement new commodity financing and risk management schemes.

Organizing large awareness-raising and networking workshops and high-level conferences on financial techniques.

Arranging tailored training programmes

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Thank you

[email protected]

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The practicalities of

risk management: the

markets

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Commodity exchanges

Commodity exchanges are financial organised

market where commodities are traded on standard

contract. There exist a several commodity exchanges

around the world, each place trading a certain part of

commodities.

Main Commodity Exchange around the world:

Chicago Board of Trade (CBOT)

New York Mercantile Exchange (NYMEX)

Coffee Sugar and Cocoa Exchange (CSCE)

New York Commodity Exchange (NYCE)London Metal Exchange (LME)

International Petroleum Exchange (IPE)

London Commodity Exchange (LCE) MATIF

(Paris)

As shown, main commodity exchanges are located in USAand UK. There are the most efficient and can therefore

provide good international benchmark prices for the

commodity they trade.

Commodity exchanges provide

Standardised contracts

Strict controlled financial streams

Efficient market (due to thenormally great volume of trade,

clear information, control...)

Good international benchmark

prices for the traded commodities

Secured trade

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Over the counter market

The need for more sophisticated and specific hedging instrument has lead the over-the-

counter market to be more and more used. This is mainly due to the fact that this kind of

market provide:direct interaction between client and intermediary (bank,

trade house, brokerage firm)

contract uncontrolled by a clearing house

tailor made contract

long term hedging instruments

Nevertheless, it should be paid attention to the following fact:

this market is not transparent

once entered into a transaction, it is very difficult to reverse

margin are not about to decrease, since contracts are not

standardised (i e intermediaries try to keep contract highly

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