Commodity finance and risk management Frida Youssef UNCTAD Palais de l’ONU Geneva, 18 Feb 10

I. Commodity finance Introduction Traditional finance vs Structured finance Examples

Introduction: access to finance in commodity trade and development Importance of the commodity sector for developing economies and financial constraints: - Over 2 billion people are estimated to derive their livelihood from production and trade of commodities; - More than 50 developing countries and LDCs depend on three or less leading commodities for at least half of their export earnings. Commodity trade and production is credit-intensive. Risks in commodity finance.

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 involved international 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 to support 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.

Through use of structuring techniques, financiers can control their level of risk Without structured finance: With secured finance: With structured finance: financier financier financier Will the borrower reimburse? How to control collateral? Will the borrower produce? $ $ Potential borrower Potential borrower Potential borrower Goods Offtaker

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. Export receivables-backed financing Supply Chain finance Warehouse receipts finance

Success Factors Along The Value Chain Commodity Sales Storage Transport Manufacture/ Further Processing/ Packaging Transport Wholesale/ Distribution Agri Inputs Agricultural Agricultural Production Storage Value Chain Financing Production / Processing Trade / Export Wholesale Stages • Local producers & processors; Commercial farmers; International input suppliers. Local producers & processors Commercial farmers International input suppliers Small commodity traders Large commodity traders • • Local distributors F & B multinationals Wholesalers. Agri Players Producers Processors Commodity Traders Buyers • Input financing; • • Working capital; • • Working capital/liquidity; Structured trade finance and collateral management, etc.; Price risk management; Foreign exchange. • • Trade finance; • Working capital/basic cash • • • • Price risk management; Financing • Crop risk management weather insurance • • Structured finance: receivables-back finance, pre-payment etc. Needs • • Structured finance: WRS/inventory based finance, etc.. • • • Foreign exchange. Pre-shipment finance Post-shipment finance

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 exporter’s 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.

Buyers (Oil Refineries) EXAMPLE: Receivable-Based Financing Underlying transaction: To trade naphtha and crude oil. Lender: XYZ Bank. Facility Amount: US$ 50 million for credit facility. Exporter: Oil company 5.. Importers: oil refineries worldwide. 7. Tenor: 30-90 days from B/L date. 8. Collateral: Outstanding account receivables. 9. Facility Period: 1 year. 10. Each transaction amount: Over US$5 million. Exporter Buyers (Oil Refineries) Shipment Letter of Acknowledgment Letter of Undertaking (remedial procedures in case of non-performance) Payment at shipment Payment after 30-90 days from B/L date through an escrow account XYZ Bank Assignment of contract/A/R etc.. This financing is given to the exporter once goods are shipped and repayment is done automatically by importer through 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 export contracts and receivables, and by receiving payment in an offshore escrow account.

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

Farmer Banks Warehouse Guarantee agencies Government regulator Trader A simple warehouse receipt finance scheme - open to various depositors. This can act as a model to reach farmers - who are often willing to pay high interest rates. 4. Provide credit 3.Lodges receipts with bank Farmer Banks 1. Deposits products 5.Signs sales contract Warehouse Guarantee, insurance, etc. 2.Issues receipts Guarantee agencies 9. Delivers receipt; warehouse makes delivery Approves Warehouse Government regulator Trader 6. Reimburses credit; in return, bank transfers receipts

An example of using a collateral manager to finance South-South trade Acceptable payment will allow rice to be released from import warehouse Bank Payment when goods enter into warehouse controlled by the collateral manager Rice exporter Rice Importer Warehouse Warehouse Collateral manager takes full control from moment on that goods enter export warehouse, until release (as authorized by the bank) from the import warehouse. The bank will have recourse to him for most losses during this period. Collateral management agreement Collateral manager

Commo- dities Money “Paper” 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. Commo- dities Money “Paper”

WRS in Tanzania - The CFC funded Coffee and Cotton marketing development project which was 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 and Marketing 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.

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 country’s 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 primary cooperative 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.

II. Price risk management Describing briefly organised and over-the-counter markets Hedging tools

Over-the-counter market Hedging Market used for risk management is divided in two part Commodity exchange Over-the-counter market Although the basic ways to use these tools can easily be learned, hedging strategies can become quite complex. { The need to pay margin deposits/guarantees Even with a good mastery of these instruments, some difficulties exist, due to: 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

Tools for Commodity Risk Management Specification of price or minimum price in contracts 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 sell a commodity at a a ”strike” price on or before a specified date – pay a premium at time contract signed

Concept of price risk management Financial markets provide possibilities to hedge against price risks. These hedging instruments are: Futures Options (put, call) Swaps

Futures Futures are kind of standardised contracts for future delivery of an asset (that could be commodity). There are: Helpful to hedge price risk exposure Useful for some marketing strategies An ideal benchmark price Lock-in a future price Initial position can easily be reversed Give a good benchmark price to barter Protect the value of inventories or finance storage Delivery is not necessarily implied No need to negotiate contract specifications These kinds of contracts are regulated by exchange’s authorities, and there execution are guarantee by clearing houses.

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 the fulfillment of contractual obligations Contain the expectation of physical delivery Only a small fraction of futures contracts result in actual delivery of the underlying commodity

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: Call option Put option US call: the right to buy at any time during the period. US put: the right to sell at any time during the period. European call: the right to buy, but only at the end of the period. European put: the right to sell, but only at the end of the period. Main use are for: Obtaining short-term finance Part of marketing strategy Protection against unfavourable price movements An over-the-counter financing In regard of longer-term trade relationships Limits the size of the maximum loss but do not eliminate the opportunity to take advantage of favourable price movements

Swaps A swap is a purely financial instrument under which specified cash-flows are exchanged at specified intervals. Obtain easier and cheaper access to capital Lock in long-term prices Guarantee income streams From financial operations or new investments No or less-strict margin calls Long term instrument Low administrative costs once structured Combination of price hedging and investment securization Tailor-made It should be noticed that swaps are purely financial tools, which means that no delivery of physical are requested.

Coffee Cooperative in Tanzania Multiple payments to farmers throughout the year Minimum price when deliver coffee Supplementary payments based on price at which coffee 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

Role of UNCTAD UNCTAD has been a pioneer in helping commodity-developing countries address the commodity “problematique” including by advocating the importance of increased access to, and diversified sources of finance. One recent example, UNCTAD as part of its technical capacity activities (funded by the EC All ACP project), been looking at financing tools such as Factoring (discount of receivables) that would enable the integration of small scale farmers into the supply chains, such as of the tourist industry (the mainstay of many Caribbean territories’ economies) and supermarkets. Yet, nowadays, the problematique extends beyond the commodity sector 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 sector development. In other words, the challenge for UNCTAD and for all relevant stakeholders is of a greater magnitude today than it has ever been. To address the challenge, concerted and considered efforts are required at all levels, national, regional and international and from both the public as well as the private sector (including financiers, insurers, research, academia, enterprise, civil-society, etc).

Role of UNCTAD UNCTAD activities targeted to both public and private sectors include: • Building perspectives on broad trends in financing and pinpointing the implications for development of commodity sectors and the institutions that serve them. • Advising on the structuring of financing mechanisms • Engaging in institution- and capacity-building and policy advice to implement 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

Thank you frida.youssef@unctad.org

The practicalities of risk management: the markets

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) Commodity exchanges provide Standardised contracts Strict controlled financial streams Efficient market (due to the normally great volume of trade, clear information, control...) As shown, main commodity exchanges are located in USA and UK. There are the most efficient and can therefore provide good international benchmark prices for the commodity they trade. Good international benchmark prices for the traded commodities Secured trade

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 tailor made then not competitive).