Chapter 7 Trade financing techniques
Commodity financing
Commodity financing is a technique
employed by companies to finance the
importation of raw materials or other critical
input for production. As with other trade
finance techniques, the core process is
designed to finance the working capital
which would otherwise be tied up in the raw
materials or other inputs.
Commodity financing is often used where
the underlying goods are raw materials,
sometimes perishable, easily moved and
saleable in their current state (rather than
as a finished product), tradable and where
a terminal market exists to hedge price risk.
Metals and oil-related products are both
typically financed this way.How it works
There are many different ways of structuring
a commodity financing transaction. At its
simplest, commodity financing allows one
party to purchase a commodity from the
producer and hold it until the goods can be
sold on. It eliminates credit risk for parties
along the supply chain, as the financier acts
as the trusted party to provide payment to
the producer and guarantee payment from
the final recipient. The financier is protected
by taking security over the commodity for the
period it is being financed.
The nature of the commodity being
financed usually determines whether
the financier wants to take control of the
commodity itself as security for the finance,
and also what sort of financing is required.
When arranging commodity finance,
both parties must take care over a number
of details.
Whether security is required by the
financier. If so, will title over the
commodity suffice, or does additional
security need to be arranged? A number
of banks secure the financing on a pledge
of the goods. This means the borrower
fulfils the transaction, but the bank retains
ownership in the event that the transaction
is not repaid. (Technically this is not the
same as taking title.) This would, though,
give the bank the option of selling the
commodity in the event of default. Insurance will also need to be arranged.
Identifying the potential risks which need
to be insured against needs careful
attention, especially when a commodity
is being transported internationally. This
is particularly the case when goods are
being exported to new markets, where
local business practices and customs
regulations may differ. Where warranties
or pledges form part of a transaction, both
parties must take care to comply with the
details, otherwise insurance companies
may refuse to pay, in the event of loss.Advantages
Third-party finance frees up working capital
otherwise tied up in commodities and
raw materials. This has potential benefits
throughout the supply chain, especially
where finance may be needed to extract
the resources, whilst the entity extracting
the raw material may have a poor or
limited credit history and access to limited
local finance. It is particularly beneficial to
traders in these commodities, as traders
typically have limited equity bases and
therefore limited opportunity to access
other more traditional sources of finance.
Commodity finance typically involves
financing stock at the outset. This then
converts into a receivable. When the
receivable is repaid, this brings the
transaction to a close. In effect, this
structure closely aligns the funding to the
commodity being financed.
Banks and other financiers may be
happier to lend against unprocessed
materials, as they have a wider potential
market if they need to realise the security
to repay the loan.
Finance is available on a whole range of
commodities, from agricultural products
through precious and non-precious metals
to oil-related products.Disadvantages
If the price of the commodity is volatile, it
can be difficult to arrange finance for its
purchase (without also tying in a hedge of
the underlying commodity).