Structured commodity finance (2nd ed) techniques applications for successful financing arrangement

The first edition of this book had its roots in contributions made by Emmanuelle Moors to the discussions on structured finance for the commodity sector in various UNCTAD fora, and in pa

Structured Commodity Finance

Techniques and Applications for Successful

Financing Arrangements

Second edition

Structured Commodity Finance

Techniques and Applications for Successful

Financing Arrangements

Second edition

Emmanuelle Moors and Lamon Rutten

E U R O M O N E Y

B O O K S

Published by

Euromoney Institutional Investor PLC

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Foreword xvPreface xvii

Acknowledgements xxi

Introduction xxv

The 1990s: financing commodity producers and importers on a

Forfaiting 26

Factoring 28

Part 2 Structured commodity finance techniques

Amount 39Borrower 39Commodities 40Disbursement 41

Tenor 41Cost 42Repayment 42Security 42

Amount 59Borrower 59Commodities 59Disbursement 60

Tenor 61Cost 61Repayment 61Security 61

Amount 64Borrower 64Commodities 64Disbursement 64

Tenor 65Cost 65Repayment 65Security 66

Borrowers can benefit from lower payment risks of OECD and

Using structured commodity finance techniques for imports into

Buy-back 104Offset 105

Part 3 Third party credit enhancement: insurance and guarantees

Specialised departments of large insurance groups (political

IBRD 204IDA 206IFC 206

Other ways for the World Bank Group to support insurance and guarantees 208

Gold 230

Steel 234

Treatment of structured commodity finance under Basel I, II and III 266

Part 5 Final notes

To my parents, Bernard and Martine Moors,

for giving me the ambition to begin many projects.

And to my children, Irène, Nicolas and Giuliano,

who in their own way let me finish most of them.

Emmanuelle Moors and Lamon Rutten share with the readers of this second edition of Structured

Commodity Finance 50 years of combined experience in creative efforts to monetise and to

render financeable, complex international commercial flows Since the publication of Structured

Commodity Finance 10 years ago the world has seen major institutional efforts to assist providers

of working capital to reach down into the supply chain with self-liquidating loans that will

be repaid in full, on time, and with interest These efforts have been driven by a number of pressing factors: concern with bank liquidity, always a regulatory issue but exacerbated by the events of 2008; concerns of countries undergoing unprecedented economic growth but without local capital formation tools and know-how to adequately serve rapidly developing enterprises; concerns with inefficiencies in agricultural credit resulting in threats to food security and rural employment; and concerns about youth unemployment that could be addressed in part by the availability of working capital support to small and medium size companies In economic parlance, the defensive trade finance techniques during the 1980s and 1990s described in the Introduction were essentially demand-side responses driven by the need to demonstrate to lenders that the loans would be repaid in difficult circumstances Many of the interesting new tools considered in this book are in the nature of supply-side responses, designed to stimulate capital formation and drive financial flows in order to preserve social and political cohesion Looked

at in this light, these tools are likely here to stay and are not mere fads

Supply-side stimulation through structural changes Concessionary financing and guarantee

facilities coupled with modernisation of laws dealing with security over goods and receivables have been sponsored by the World Bank/IFC and the EBRD with remarkable success New forms of non-possessory security devices, pledge registries, warehouse receipt legislation, trad-able crop mortgages and commodity exchanges have been implemented throughout Eastern and Central Europe, Africa, Asia, the Middle East and India that did not exist when the first

edition of Structured Commodity Finance was published The IFC has launched its US$200

million (and growing) Warehouse Financing Program which is available to countries offering

a warehouse receipt system meeting minimum standards of eligibility following the launch of

a similar program by the EBRD around 2001 Having assisted China to design and ment a notice-based system to perfect security over goods and receivables, the World Bank

imple-is assimple-isting China to develop policies and standards for third-party collateral management services to banks lending to SMEs in all sectors All of these initiatives are intended to serve

as templates for Southern Asian countries, as are the warehouse receipt modernisation tives launched in Uganda, Tanzania, Kenya and Zambia for African countries

initia-Supply chain financing technologies and borrowing base lending With the accelerating

geographic diversity in the sourcing of raw materials and components, companies in Europe and North America have had to invest in tracking technology and communications and transport infrastructure in order to monitor and control the supply of raw materials and components required for the timely delivery of goods Supplier credit facilities by the buyer or the buyer’s bank can now be structured on the basis of daily reports of activities by suppliers and fabricators through ‘reverse factoring’ in which the lending institution will issue progress

payments to suppliers based upon online reports, enabling suppliers to avoid dependence on expensive local bank credit facilities and to ensure that production is not interrupted due to cash flow problems Such technologies require sophisticated source document protocols and software to detect anomalies, inconsistencies and gaps in reporting (sometimes referred to as

‘small clues’), such that lenders and buyers have the opportunity to verify the accuracy of reports provided by suppliers and other borrowers Agricultural loans in Brazil and certain African countries are typically accompanied by on-farm inspections prior to planting, prior

to harvest and during storage The evolution in emerging economies towards non-possessory security over movables, mobile banking and cloud-based software should soon render the transaction cost of borrowing base facilities sufficiently low and the reliability of tracking software (already developed by banks such as Citibank for their multinational corporate customers) sufficiently high to enable collateral management companies and insurance compa-nies to underwrite the risks of misreporting

Enterprise finance and agricultural credit The multilateral institutions, particularly the

World Bank during and since the tenure of Jim Wolfensohn, have been supporting structural initiatives designed to foster financing for farmers and business enterprises The social objec-tives are obvious: for agricultural credit, the issues are rural unemployment, food security, and education (the more disposable income for the family farm, the greater the opportunity for children to attend school instead of working in the field) For SMEs the social objective

is job creation through the proliferation of small (as opposed to micro) businesses that have the ability to provide needed goods and services to the community and to employ post-school-age youth These structural initiatives largely require the creation of structured commodity finance tools through law reform and training initiatives (once again, non-possessory security enabling convenient means of pledging inventory and receivables), warehouse receipt systems, and crop and livestock insurance

Brave new world One suspects that the future is that the financial community will develop

the combination of funding mechanisms, structural innovations in forms of legal security and collateral management, and software and insurance products that will enable any enterprise that requires acquisition and value-added financing for raw materials or components, for transformation of goods pending sale, for transportation, storage and insurance pending delivery to customers, for price and credit risk management services, and for the collection period of invoices, required to afford appropriate financing At that point, the easy but bad old days of ‘bricks and mortar’ loans will be behind us and the transformative power of financing for good ideas and diligence will finally be unleashed As and when this happens, the tools described in this fine book by Moors and Rutten, developed initially to meet the exigencies of large scale international trade, will have played an out-sized role

Nicholas Budd, retired partner, White & Case LLP, Consultant to the World Bank Group,

UNCTAD, UNDP, USAid, Common Fund for Commodities, past member of the UNCITRAL Working Group VI (Security Interests)

March 2014

The first edition of this book had its roots in contributions made by Emmanuelle Moors

to the discussions on structured finance for the commodity sector in various UNCTAD fora, and in particular for a paper entitled ‘The role of collateralised finance in funding the commodity sector’ presented in 1998 to an UNCTAD Expert Meeting on applications of structured commodity financing techniques for commodity-dependent countries

Back in the 1990s, anyone marketing structured commodity finance still needed a religious zeal Just consider that sections dedicated to ‘loans secured by inventory’ and

quasi-‘loans secured by sales receivables’ together filled a mere two pages in the 924-page

corpo-rate finance book (Principles of Corpocorpo-rate Finance by Brealey and Myers) that was used

to train staff in a bank like Bankers Trust in 1991 Both of us were fortunate enough to get close to the field and get a better understanding of how structured finance techniques worked and for what they could be used At Bankers Trust, Emmanuelle worked on the first structured finance deal for the Ghana Cocoa Board, which gave her an interest for structured commodity finance that has not abated since At the time, banks’ credit commit-tees were rather sceptical of the ability of these techniques to mitigate the risks of doing business in emerging markets, while borrowers in those markets simply suspected that banks’ hidden agenda was to control their commercial operations Although tremendous progress had already been made in applying sophisticated risk management techniques to the field

of finance, these techniques were largely restricted to corporate finance transactions With

a few notable exceptions, innovations had bypassed the field of commodity finance What knowledge there was, was the privilege of a few

At UNCTAD, Lamon Rutten had discovered in 1990 that those rare bankers who worked

on bringing over-the-counter commodity price risk management transactions to emerging markets (through swaps and similar instruments) were all too happy to discuss this new and exciting field with a neutral counterparty Many of these same people (and their teams) later began to incorporate such instruments into structured commodity loans, and continued

to enjoy the forum that UNCTAD provided to discuss their work and educate senior-level policy-makers on its importance – the many UNCTAD meetings on this topic in the 1990s attracted a very senior audience, including a number of heads of state and government UNCTAD was able to develop papers and presentations on issues that hitherto had not been the subject of much (if any) writing

The interest of Euromoney in publishing the first edition of this book was, therefore, very welcome It helped educate a whole new generation of bankers about structured commodity financing techniques To produce a second edition a decade later was a challenging proposal, but one that makes eminent sense: there is still very little written on structured commodity finance, and still a lot to learn for many fund providers eager to finance the commodity sector Especially so in the current environment, where risk capacity is becoming increasingly scarce and the art of risk management, as applied to commodity finance, comes at a premium

Emmanuelle Moors and Lamon Rutten

March 2014

List of abbreviations

Electronic Presentations

Development Finance Company)

List of abbreviations

UNCITRAL United Nations Commission on International Trade Law

UNCTAD United Nations Conference on Trade and Development

Corporate names that are commonly used in their abbreviated form, such as ABN-Amro, ANZ, HSBC, ING or Sonangol, have not been included in this list

comes to structured commodity finance, the Devil is in the details Thus, I would also like

to acknowledge my debt to the various external legal counsels who have advised Bankers Trust and other banks throughout these early years They have helped make these syndicated structured commodity finance loans watertight and palatable to the credit committees of participating banks, which was essential for these deals to close

Emmanuelle Moors

I wish to thank my former colleagues and team at UNCTAD, who made it possible to develop

a whole new work program and to convince UN member states to give us a mandate to

‘maximise the use of modern financial instruments in commodity trade and production’ And

I need to thank the many practitioners in commodity risk management and finance who were willing to share their passion and insights, because, like me, they believed that techniques like structured commodity finance can and should be powerful forces for the good

Lamon Rutten

About the authors

Emmanuelle Moors is a regional Head of Project Finance at Technip, which is a world leader

in project management, engineering and construction for the energy industry, employing 38,000 people She is responsible for the management of financial risks in Technip’s projects, and for supporting clients’ financing arrangements, in the Offshore and Onshore business segments of Technip for projects based in southern and eastern Europe, Russia and other CIS countries, Latin America and Canada, Libya and Egypt, and selected projects elsewhere

Lamon Rutten is Manager of the program on Policies, Markets & ICT (information and

communication technologies) at the Technical Centre for Agricultural and Rural Cooperation (CTA), an international organisation operating under the EU-ACP Cotonou Agreement Both have been working on structured commodity finance for about a quarter century, which

on a good day makes them feel very experienced Emmanuelle started her career in banking

in 1987, gaining experience in both the front and back offices of the New York office of Crédit Commercial de France (bought in 2000 by HSBC) In 1990, she moved to the City

of London where she joined the Africa desk of Bankers Trust Company, a US bank (bought

in 1998 by Deutsche Bank), widely recognised as a pioneer in structured commodity finance and risk management In mid-1994, she moved to the Structured Commodity Finance Group

of Standard Bank London

Lamon had his first experience with structured finance in 1987 when, to enable private traders in Mali to take on the grain trading roles of the former government monopoly, he set up a collateral management arrangement of a (with hindsight) amateurish nature – but

it worked That created a lasting interest in market solutions, which came in good stead when he joined the United Nations Conference on Trade and Development (UNCTAD) in

1990 His original challenge was to build market solutions that would permit developing countries to insulate themselves from global commodity price volatility It quickly became clear that this required better access to finance Bankers Trust was quite keen on enhancing understanding of modern instruments for commodity finance and risk management (they needed to prepare education material for their clients anyway), and their small but highly experienced team appointed Emmanuelle as the front person to collaborate with Lamon on these issues Their first paper helped drive a steadily expanding UNCTAD work programme

on structured commodity finance, which came to include Africa’s largest oil trade and finance conferences at which Emmanuelle was a frequent speaker, and many publications When in 2002 Euromoney showed an interest in publishing the earlier version of this book, UNCTAD was most pleased that Emmanuelle was willing to make the sacrifice The book did well enough to warrant this second edition, and Emmanuelle, having learned her lesson, got Lamon to take some responsibility

Over the years, both Emmanuelle and Lamon have continued working on issues related

to price risk management, and commodity trade and project finance Emmanuelle was a financial adviser for a commodity B2B project sponsored by a Russian commodities trading

About the authors

company, and for many years was contributing editor to African Business, Africa’s leading

English-speaking business magazine More recently, she has been lecturing for Università

La Sapienza in Rome with a Master’s seminar on project financing Since October 2013, Emmanuelle has also been a member of Technip’s core corporate Sustainable Development Department Lamon was on the advisory board of IIG Capital, a leading alternative investment fund specialising in trade finance, and helped set up the Global Network of Export-Import Banks and Development Finance Institutions (G-NEXID) He lectured at the Institute for Banking and Financial Management of HEC Lausanne, and was and still is on a couple of company Boards, including, as at 2013, as the Chairman of the Global Markets Exchange Group, (GMEX), based in the UK Lamon also managed for almost a year the leading collateral management company in Africa (as part of a botched corporate acquisition) He was MD and CEO of the Multi Commodity Exchange of India (MCX), the world’s eighth largest exchange in 2006 when he joined and number two when he left in 2012, after having concluded a highly successful initial public offering He also found time to contribute several papers on commodity risk management and finance to international organisations such as the African Development Bank (AfDB), the European Bank for Reconstruction and Development (EBRD), the World Bank and the UN’s Food for Agricultural Organisation (FAO)

In 1990, Emmanuelle obtained an MBA (honours) in Finance, International Business and Development Economics from the Leonard N Stern School of Business at New York University, where she also worked as a Fellow for the L Glucksman Institute for Research

in Securities Market and as a Graduate Assistant in the Accounting Department Lamon got his MA (honours) in International Economic Management in 1986 at the University of Tilburg in The Netherlands

Not that long ago, trade finance was largely considered as one of the mechanical aspects

of world trade Important, of course, but not something that a policy-maker or, for that matter, the average CEO, should really be concerned about, at least no more than he or she should be concerned about the mechanics of international shipping That changed with the financial crisis of 2008, when companies worldwide suddenly found their access to credit severely restricted, which was one of the factors that set into motion a downward spiral of economic crisis in a number of Organisation of Economic Cooperation and Development (OECD) countries At the April 2009 Summit of the G20 (the world’s 19 richest countries plus the European Union) a commitment was made to ensure the availability of at least an additional US$250 billion over the next two years to support trade finance The situation was serious enough for governments to follow up on their commitments: in the first year

It also became clear that problems in the trade finance system, while they had hit western countries hard, would well hurt the poorest countries even more, putting a damper on the hopes of ‘eradicating extreme poverty and hunger, and halving world poverty by 2015’, the first of the eight Millennium Development Goals adopted by the member countries of the

UN in 2000 As noted by a banker, tighter liquidity and tougher banking regulations were prompting some big commercial banks to consider shutting down their African trade finance operations ‘If you’re trying to cut down your balance sheet, what do you cut first? You

conducted a survey in 2012 to identify and quantify trade finance gaps It showed that ‘the total value of trade finance requests received in 2011 by the banks responding to the survey amounted to about US$4.6 trillion Of this total amount, more than US$1.6 trillion was rejected This suggests a global unmet demand (or gap) of US$1.6 trillion Of the US$1.6 tril-lion, US$425 billion in unmet demand was in developing Asia.’ It also found that ‘companies said that a 10% increase in trade finance support would result in 5% more production and 5% more jobs.’3 The official responsible for the survey concluded that ‘dramatic shortfalls

in meeting financing needs of importing and exporting companies are exacting a huge toll

One consequence of this realisation is that trade finance now seems to have become

a part of the international policy debate The Leading Group on Innovative Financing for

G8 endorsed the G20’s work on trade finance Now under scrutiny from the G20, the Basel Committee on Banking Supervision, whose rule-making was at risk of squeezing trade finance for emerging markets even further, has started taking the concerns of emerging markets more seriously (the above-mentioned ADB survey had found that if the Basel Committee continued

on its chosen path unchallenged, banks would have cut their trade financing activities by 13% with the full implementation of the upcoming set of capital adequacy rules, Basel III) The World Trade Organisation (WTO), which in the early 2000s had just two meetings on

a number of new facilities for supporting international trade finance, but the issue left no lasting memory in the policy debate.

It appears that this time, it will be different The political interest in trade finance has already brought several innovations useful for commercial bankers – in particular, new products that permit risk mitigation – and this is opening up new opportunities for trade finance, in particular for structured commodity finance which is made for providing solutions

in difficult, unfamiliar circumstances In addition, while western countries have not been doing well since 2008 – it was over half a decade before the first signs of recovery became visible – emerging markets have continued hurtling ahead, even though they have had to struggle with their own economic challenges Yet the rise of these countries since the early 2000s, and in particular of China, has profoundly changed international trade patterns and

is now starting to change the way trade is being financed It is also affecting the currency

in which commodities are traded: in December 2013 the renminbi overtook the euro as the second most used currency in global trade finance after the dollar (changing the traditional concept of ‘hard currency’).6 Not to mention technological changes which are making serious inroads into the traditional document flow of international trade and finance – the electronic age finally seems to have arrived for commodity and trade finance Exciting times indeed

Of course, for those working in the field of trade finance it has always been exciting; and probably the more so for those who had the fortune to engage in the art of structured commodity finance Finding attractive financing solutions to fund the commodity sector has always been critical Without the proper financing, a commodity producer may not be able

to expand its facilities; a trading company may think twice before buying from a high-risk country; and an importer may simply go out of business

Producers, exporters, local merchants, international trading companies, importers, processing companies and other intermediaries – in effect all ‘players’ in the commodity business – need financing at one point or another, whether in local and/or foreign currency Importers need hard currency to pay for most commodity imports, and producers for a portion of their production costs, for example to import fertilisers or machinery Partners

in crude oil production joint ventures often need to pay for cash calls in hard currency Any party hedging commodity price risk would generally have to pay hard currency for the related cash outlays (premiums, margin requirements, settlement amounts) And so on

Evolution of commodity financing

The 1980s: financing trading companies on a corporate basis

After the 1982 world debt crisis, it became increasingly difficult for both private and eign borrowers in emerging markets to raise financing from commercial banks This was

further exacerbated for the commodity sector by worsening terms of trade and increased commodity price volatility The debt crisis also reduced the availability of trade finance to countries where governments still controlled domestic and international trade and had previ-ously relied on balance of payment support to fund their commodity sector

By the mid-1980s commodity financing was provided primarily through simple rate loans to commodity trading companies, which would in turn finance the trading of commodities on their own balance sheet, often on the back of red-clause letters of credit Typically, trading companies would be prepaying commodity exporters and extending favour-able payment terms to commodity importers Banks would not scrutinise the terms and conditions of the transaction between the trading company and the commodity producer or importer based in emerging markets At the most, they would require that the purpose of the financing be disclosed and that the trading company receive its payment at an account with the bank These corporate loans were typically big volume, low-margin transactions.Toward the end of the decade, however, as more private capital was starting to flow to the ‘best’ emerging markets, commercial banks began to resume their direct involvement in the commodity sector of emerging markets, albeit on a different basis

corpo-The 1990s: financing commodity producers and importers on a structured basis

With the sudden demise of several trading companies in the 1980s, the resumption of bank loans to emerging markets and the upsurge in net private capital flows to emerging markets, the situation tilted back in favour of directly financing producers and importers This forced banks to properly assess the risk of underlying commercial transactions, as they were less knowledgeable about the financial situation of the borrower In higher-risk coun-tries, commodity-sector borrowers were generally unable to raise funds solely on the back

of their balance sheet, while government guarantees not only had proved unreliable in the past, but also were fast disappearing

Banks now required collateral when making new loans to the commodity sector of emerging markets However, sovereign risk was not effectively mitigated until banks insisted that borrowers establish foreign exchange escrow accounts based outside the country In the late 1980s and early 1990s, a few innovative banks, notably Bankers Trust Company,

an American bank, ABN Amro, a Dutch bank, and UBS, a Swiss bank, turned to prime offshore commodity buyers to effect payments to such escrow accounts This enabled these banks to resume business with the high-risk countries of Africa and marked the birth of structured commodity finance In these early days, borrowers were exclusively central banks, commodity boards or state-owned companies

Meanwhile, banks that continued to provide financing to those international trading companies that had not gone bankrupt did so in a more secured and structured way, with greater scrutiny of, and recourse to, the underlying commercial transaction, with full or limited recourse to trading companies As summarised then by a commercial banker, ‘the old style

of “Finance and Forget” is being replaced by “Finance and Follow” Eyes on the market,

inherent part of the risk assessment process From then on, risks had to be properly fied, quantified, mitigated and remunerated

Spurred by the fall of the former Soviet Union, the liberalisation and deregulation of the commodity sector in most emerging markets again changed the rules of the game, and created an even greater need for structured finance This new environment encouraged the development of new companies which had neither the size, nor the government support (and guarantees), nor the track record and even less the comfort of a monopoly situation that were necessary to support unsecured or unstructured loans There was also a massive demand for commodity finance from borrowers from CIS countries Finally, the greater competition for private sector funds put banks, therefore, in a better position to ask for tighter security requirements, often trespassing on the commercial territory of their clients by selecting satis-factory commodity buyers to support the proposed structured commodity financing

In the second half of the 1990s, the sudden financial crises of South-East Asia (1997) and Russia (1998) momentarily reduced the availability of unsecured commercial loans to even the best emerging countries However, by the late 1990s, Russia had already returned

to the banking markets thanks to new loans arranged on a structured commodity finance basis In fact, throughout the decade, the techniques of structured commodity finance evolved

by taking lessons from successive emerging market crises and idiosyncratic weaknesses of a few structured deals

The 2000s: shock and awe

Some of the leaders of the financial innovation in the commodity sector in the 1990s had been the ‘smartest guys in the room’ – at Enron, the mammoth energy trading (and producing) company However, in 2001 it was discovered that much of this innovation consisted of smoke and mirrors to disguise Enron’s dreadful financial status The reputation of finan-cial innovation would take a hard hit, and concepts like securitisation and special purpose vehicles (SPV) were suddenly seen with suspicion When a few years later other innovative financial structures – mortgage-backed securities (MBS) – turned out to be toxic not just for the companies who bought them but for the whole of the world’s financial system, that was a further setback for financial innovation

It did not help that the international financial sector regulators seemed to agree that banks had gone too far in financial creativity, did not understand the risks and needed to

be protected from themselves A spate of regulations followed, including at the international level Reforms to the Basel capital adequacy standards for banks, which removed much of the independence of a bank in deciding themselves how to define their risk so as to determine how much capital they needed to cover it The latest version, Basel III, treats trade finance

as if it is as risky as an off-balance sheet exposure

Bankers reacted in several ways First, as they grew more skilled they fully developed the range of structured finance techniques that they had at their disposal – for example, the old financing technique of factoring was remodelled to fit with the needs of modern supply chains and the liquidity management desires of large companies Thanks to innovative techniques and performance track records, structured commodity finance deals have pushed tenors well into the medium term, and techniques were being combined in innovative ways Islamic finance has become more mature More banks, including in emerging markets, started developing skills

in structured commodity finance Second, they learned how to use the new risk mitigation

tools for international trade finance offered by multilateral development banks Third, they started to co-operate and to lobby, for example to prove that trade finance is a safe asset class Fourth, some bankers decided that as banking regulation became more of a problem,

it would be better to develop investment funds to finance trade – several such funds became active in the 2000s, some of whom received support from multilateral development banks There were also other developments that affected the development of commodity trade finance in the 2000s Commodity prices were highly volatile during the 2000s, and they reached unprecedented levels after 2005; meaning that the corporate lines established using simple balance sheet criteria were no longer sufficient to carry the much-higher costs of commodity stocks and cargoes, so banks had to look for ways to lend extra money Developing country banks, led by China, emerged – as a partner in syndications organised by western banks, but also increasingly as a competitor Supply chains were being formalised and often, equipped with electronic backbones, which made the traditional paperbound banks look unappetis-ingly slow Commodities became an asset class, with hundreds of billions of dollars invested

in commodity assets (US$400 billion in 2012, compared with US$10 billion in 2000) The nature of trading companies changed In the early 1990s, ‘there were typically 15 to 20 traders in each commodity, whereas today there are around 15 large houses globally trading across a range of commodities They have thus become much more powerful, but they have also diversified: a company might trade crude oil, petroleum, gas, corn, coffee, zinc, coal

processing plants, storage facilities and transport companies, and even mines, plantations and petrol stations Traders thus need much more money, and they need more longer-term loans; they have, therefore, been looking at new ways of funding At the same time, post-2008, the traditional western trade finance banks have less funds to spend; but government-supported export credit agencies as well as multilateral development agencies expanded their offer of finance and risk management tools, both in terms of available amounts and in terms of variety of products

What are the 2010s bringing?

The 2010s are continuing the trends of the 2000s, but the changes have now become very visible Structured commodity financing techniques continue seeing innovation – for example, securitisation, in new forms, is back in fashion In 2013, the world’s largest bank by assets was from China, as were two other banks in the top 10 Supply chains are becoming fully electronically integrated, and trade finance is becoming part of this electronic system Trading companies are raising funds outside the traditional western markets, and are raising them

in – for traders – innovative ways (Glencore’s initial public offering (IPO) in 2011 is just one example) Non-western banks everywhere are playing a larger role in trade finance – in their countries and regions, and increasingly, internationally – and are also becoming increas-ingly innovative in adapting structured commodity financing techniques to their advantage Investment funds are becoming more important in structured commodity finance, and banks are getting better at working with them The co-operation among banks to influence deci-sion making by the Basel Committee has borne fruit, and banks may learn from this to co-operate also in other regulatory areas, for example on know your client (KYC) rules

How exactly the different changes will work out is impossible to predict, but what is certain

is that bankers who want to be successful in commodity finance will need to be innovative and open to new partnerships

What is structured commodity finance?

By ‘structured commodity finance’ we simply mean structured finance for the commodity sector Banks include various products under the umbrella of ‘structured commodity finance’

A French commercial banker once defined it as ‘the sum of banking operations pertaining to

an import or export of commodities which are not “plain vanilla”’ Others define structured commodity finance more narrowly, like this Austrian banker who includes only transac-tions that ‘provide working capital in difficult environments by mitigating the risk through mortgaging an export flow’ Although this definition rightly stresses the ability of structured commodity finance techniques to mitigate risk in difficult environments, it covers only a portion of what this book defines as structured commodity finance, excluding for instance structured inventory financing Similarly, it is commonly acknowledged that ‘structured trade finance’ is the same thing as ‘structured commodity finance’ when the goods traded can be classified as commodities However, this perspective now seems outdated since the techniques

of structured commodity finance have evolved to provide medium-term financing for general purpose financing or to fund new projects Some projects are even financed on the back of hybrid structures, taking elements of both techniques.9 But as explained in Box I.1 there are fundamental differences between the two financing solutions Outside the field of commodities,

in the area of corporate finance and investment banking, structured finance typically relates

to complex products, such as leverage and management buy-outs, asset-based financing and structured leases, which are outside of the scope of this book

To open the discussion, this simple definition of structured commodity finance is proposed:

‘Financing transactions whereby an inventory and/or flow of commodities can be isolated from its owner and used as collateral for security and repayment.’

Box I.1

Project finance versus structured commodity finance

Project finance is the term used when the project is separated from its sponsors and funding

is based on the assumption that the project will generate a sufficient surplus cash flow after operating costs to enable debt servicing and to provide return to sponsor(s) and other investors In practice, pure project-supported finance is now rare, and complex structures are put together to provide limited recourse to sponsors and other parties That said, there are fundamental differences between project finance and structured commodity finance arrange- ments, even if the latter can be used to support the former In a simplified manner, these differences are summarised in the table below.

Continued

Need to find equity investors No need to find equity investors

Involvement of engineering, procurement and

construction (EPC) contractors; completion risk

Assets already constructed; no completion risk Due diligence on new project Due diligence on existing facilities

Analysis of estimated future cash flows Analysis of identified existing cash flows

Market risk more difficult to mitigate Market risk easily mitigated by contracts with

buyers Supports long-term financing Provides short-term and medium-term financing Initially, security is obtained on both fixed assets

transferred by the EPC contractor to the SPV and

floating assets (offtake contracts and receivables)

Security can be obtained on existing fixed and floating assets (inventory, offtake contracts and receivables)

Risks are bigger and more complex to evaluate Risks are smaller and easier to evaluate

Off-balance sheet financing for sponsors Possibly off-balance sheet financing

Without recourse financing Possibly without recourse financing

Scope

Structured finance has been developing in all directions, overcoming conventional commodity financing habits linked to particular commodities, geographical areas or financing needs This book discusses the techniques and applications of structured commodity finance within the range of financing alternatives available to the commodity sector In particular, it endeavours

to put discipline into a subject that has been extensively discussed by banking, insurance, capital markets and legal professionals, yet often with their own professional bias

Before discussing the various forms in which structured commodity finance can present itself, the building blocks of trade finance are reviewed Understanding the role of more complex forms of letters of credit, forfaiting and factoring in financing trade is also essential These issues are covered in Part 1 of this book

The basic techniques of structured commodity finance are presented in Part 2 They include inventory financing and pre-export financing (PXF), the latter being further split between export receivables financing and prepayments Other forms of structured finance applicable to the commodity sector, including securitisation, are also discussed As structures are evolving in the direction of using more third-party credit enhancement, Part 3 is dedicated

to insurance and guarantees Part 4 presents the applications of structured commodity finance within the range of financing alternative available to the commodity sector Part 5 concludes

1 United Nations, ‘Integrated implementation framework – tracking support for the MDGs’, G20 London Summit trade finance commitment.

2 An anonymous banker quoted in Miles, T, ‘WTO to alert G20 on trade finance worries’, Reuters, 19 October 2011.

3 Results of ADB survey reported in International Chamber of Commerce (ICC), Rethinking Trade & Finance, 2013.

4 Steven Beck, Head Trade Finance of ADB, quoted in ICC, Rethinking Trade & Finance, 2013.

5 See for example the ‘Report of The High-Level Expert Committee to The Leading Group on innovative financing for agriculture, food security and nutrition’, December 2012.

6 ‘Yuan passes euro as 2nd-most used trade-finance currency’, Bloomberg, 3 December 2013.

7 Presentation by Aidan Applegarth, Head of Trade and Commodity Finance, Union Bank of Switzerland, IBC Conference on Structured Trade and Commodity Finance, London, 1995.

8 Blas, J, ‘Overview of the commodity market’, Perspectives Pictet, 6 February 2013.

9 This was notably the case of a financing arranged in July 2001 jointly by Standard Bank London and Glencore

to fund new capital investment by Russia’s Severnaya Neft (Nord Oil).

Part 1 Traditional commodity trade finance

giving credits to those who stored their grains there In Ancient Greece, there were ised maritime financiers who provided shipping finance that did not need to be reimbursed

special-if the ship sank During the rule of the Mauryan dynasty in India (321 to 185 bc), bills

of exchange were invented, and these were used by merchants to exchange letters of credit between cities Medieval merchant banking was essentially invented as a means to provide grain trade finance Thus, trade finance is at the root of the banking system To this day, banks continue playing a vital intermediary role in supporting trade by reducing informa-tion costs, effecting payment from buyers to sellers and extending credit to trading parties.Structured finance emerged first as a technique to finance commodity trade Therefore, it

is essential to first understand the building blocks of trade payment and financing techniques (bills of exchange, letters of credit and so on) More complex forms of letters of credit are then presented, followed by an update on the role of forfaiting and factoring in financing trade What should eventually become apparent is that structured commodity finance did not emerge suddenly as a fully-fledged financial technique, but rather developed as an extension

of the field of application of ancestral trade finance techniques, combined with a new ‘can do’ philosophy

1 Davies, G, A History of Money from Ancient Times to the Present Day, 2002, Cardiff, University of Wales Press.

Chapter 1

Building blocks of trade finance: payment

methods

This chapter presents the principal means of payment used for cross-border sales, followed

by an overview of the traditional instruments used by exporters and importers for raising pre-shipment and post-shipment financing

There are five principal payment mechanisms for settling international trade transactions:

• open account;

• advance payment;

• documentary collections;

• documentary letters of credits (L/Cs); and

• bank payment obligations (BPOs)

Importers (buyers) and exporters (sellers) have divergent interests in the selection of the payment mechanism because the level of security and risk that these mechanisms provide

to the buyer and seller varies subsequently, as shown in Exhibit 1.1 The same goes for the level of banks’ involvement and the respective cost of these payment mechanisms The main characteristics of each of these payment mechanisms are described in the following subsections

Open account

Open account is the most secure payment method for importers but also the most risky for exporters The exporter ships the commodities and payment is made at some specific date in the future by the importer without any negotiable instrument evidencing the import-er’s contractual obligations Open account is probably the cheapest payment method for international trade but it places the onus on exporters for both the credit risk and the cost

of financing

There is no bank contribution to the transaction since the importer pays the exporter directly, generally via bank transfer The role of banks is limited to moving the payment due from the account of the importer to that of the exporter As a result, there is no protection for exporters in the event of non-payment As will be discussed later in this chapter, and in Part 3, there are various ways for exporters to manage these risks

Open account trade is typically used when an exporter has a well-established commercial relationship with a creditworthy importer and when the importing country experiences little

or no political or economic instability It is also a valid trade payment mechanism when an exporter is shipping goods to a parent company or a subsidiary, or when the repercussions

on the exporter of a total loss on the goods are minimal Otherwise, exporters will only

Traditional commodity trade finance

want to sell on open account when they are faced with excessive inventory or when market demand for their commodity is weak

Trade can also take place on a consignment basis, which adds yet another hurdle before the exporter can be paid The goods are shipped by the exporter, but the importer, acting

as agent for the exporter, will pay the exporter only after the goods have been successfully re-marketed locally or regionally (net of the agent’s fees) The exporter, therefore, must bear all market risks and the exporter may even have to take unsold goods back (and pay for related transport costs)

Advance payment

In contrast to open account, advance payment (also called ‘cash in advance’ or ‘payment

in advance’) is the most secure payment method for exporters, but also the most risky for importers, since the commodities are not shipped until payment is received in full Under this payment method all risks are put on the importer, which must pay for the commodi-ties prior to shipment There is no guarantee that the commodities will be delivered as and when agreed With advance payment, the exporter retains total control over the transaction Again, bank involvement is limited to effecting payment

Exhibit 1.1

Risk profile of trade payment methods

Open account Documentary collection

Documentary credit Advance payment Bank payment obligations

Source: Authors’ own

Building blocks of trade finance: payment methods

Cash in advance can be used when the importer’s credit status is doubtful and/or when the political or economic conditions in the importer’s country are unstable Cash in advance for the full value of the shipment is used mainly for small purchases This payment method can be expensive to the exporter since importers which are forced to pay in advance may ask for a discount In practice, importers generally will not accept to effect full payment before shipment, and will make only partial payment in advance and try to negotiate other means

of payment for the balance, such as an L/C (see ‘Documentary letters of credit’) Moreover,

in some countries advance payments may be illegal due to foreign currency controls iting foreign payments prior to shipment or may simply be too onerous for tax reasons

prohib-Documentary collection

Documentary collection is a method of payment by which an international sale tion is settled through an exchange of documents The importer’s bank (the collecting or presenting bank) acts as the collecting agent for the importer by effecting payment to the exporter’s bank (the remitting bank) for the benefit of the exporter once the stipulated set

transac-of documents have been received This payment method is supported by a draft1 plus related documents, including:

• shipping documents (such as a bill of lading (B/L));

The remitting bank transmits the exporter’s instructions and documents to the collecting bank in the importer’s country The collecting bank will seek payment from the importer and will not release documents until the importer has effected payment or accepted the drafts (as the case may be) For its part, the remitting bank does not assume any risk nor does it make any undertaking to pay the exporter

Under a documentary collection, banks control the flow and transfer of documents, and regulate the timing of payments They must ensure the safety of the documents in their possession but are not responsible for their validity and accuracy, as they do not have any legal obligation to verify the documents In practice, however, the remitting bank will at