Article For Lyon 1998 Unctad Summit


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World trade financing avenues and possibilities

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Article For Lyon 1998 Unctad Summit

  1. 1. To Be or Not To Be - or Why a Trading House Needs Modern Financial Instruments Shamik Bhose Close to three quarters of world merchandise trade in primary commodities passes through several service providers. Most Shamik Bhose is a commodity commodity trade contracts are worth much more than the traders' trader and Deputy General Manager with Adani Exports. He deals in capacity to hold risk. Issues of capital leverage, risk transfer and credit futures and physicals for soft access are thus of crucial importance to traders. The ways to deal with commodities, including coffee, sugar, these issues are changing, due to the growing fragmentation of trade. oils and oilseeds, and grains. His While resources in origin countries are being privatized, markets work includes hedging on futures become more and more interlinked, leading to a growing need to markets, risk control, and all compete and to carve out market niches. elements of cash trading, such as logistics and financing. He Commodity traders, like currency traders, are quick to perceive a specializes in long-term contracts change in conditions, and profit from it. However, traders' room for and special purpose trades in these commodities; such trades manoeuvre is largest when the macro-economic and political incorporate trade finance or forfaiting environment is stable, which is not always the case. Then, in order to as part of the structure, and the create workable arrangements for credit provision, price discovery, and underlying commodity price risk and risk transfer, traders, transporters, bankers and insurance companies currency risk are hedged. Shamik need to build structures which allow producers to receive a fair price, writes regularly for KnightRidder, and consumers to pay not more than necessary. Dow Jones Markets and the Economic Times. In this respect, the conditions for credit provision are very important. In today's trading environment, Adani Exports Ltd. is India's largest As traders need to leverage their credit providers worry seriously trading house, and India's thirteenth largest service company. It has seen own capital, most trade is financed about the risk of default, and a compounded annual rate of growth through credit. In today's trading security on the credit has become of 135% in the five years up to 1998. environment, credit providers essential: commodities, The company has been given the worry seriously about the risk of status of Superstar Trading House by default and, therefore, sufficient warehouse receipts, or forfaited the Indian Government. Adani security on the credit has become documents. Exports is engaged in commodity essential for commodity trade- trade (soft commodities, minerals financing banks, particularly in the form of commodities, warehouse and energy), infrastructure development, terminal operations, receipts, or forfaited documents. transport services and allied activities. It has a private port with Collateralized credit provides new options to reduce risk, facilitates tank terminals, warehouses and price discovery, and helps to secure trust in the quality and quantity of material handling systems. The goods offered for sale. Any commodity which is freely traded, and company is diversifying into power preferably traded on an exchange, is potentially good collateral, generation. Adani Exports is a especially if it is durable. However, this potential can only be realized member of GAFTA, FOSFA, COFEI if the commodity is located in an environment which allows for clear and other trade associations. title. Furthermore, there must be the potential for risk transfer: the right type of insurance needs to be available under reasonable conditions, and sovereign risk, currency risk and commodity risk need to be manageable. Companies in emerging markets need a system of determining such risks and information on the best practices in managing them. Inspection and collateral management companies can increase the comfort levels of all involved, and they are indeed much used to allay fears on particular aspects of commodity trade. Surveys like that of UNCTAD on commodity price risk management instruments help to improve awareness of the use of these market-based tools. Adani Exports has found that one particularly effective way of facilitating trade finance is forfaiting, which provides risk cover and benefits both the purchaser of receivables (the forfaiter) and the shipper (the exporter). Preshipment or even pre-production finance can also - 37 -
  2. 2. come through the forfaiting route. The debt instruments created are traded in the secondary market as credit derivatives, and are used by many banks to balance their credit profile and free up regulatory capital for more effective use. Commodity traders commonly use warehouse receipts-based financing. Sometimes, commodities like coffee or crude oil which have not yet been produced or processed can be assigned as collateral. Warehouse receipts and the pledge of trade receivables are probably the most practical ways of commodity financing, along with forfaiting quality paper. If such finance can be hedged through futures or options, then an even less risky long-term commodity transaction can be created. A viable warehouse One-off structured financing deals, especially out of emerging markets receipt-based financing and arranged with good counterparties, can also set the precedent for system is a must for less structured forms of finance in the future. emerging markets. A viable warehouse receipt-based financing system is a must for emerging markets. Economies like Argentina, Brazil, China, India, Indonesia, Russia, etc., which have a wide and large, but fragmented agricultural and mineral sector, can benefit hugely. The receipts can be a tool for investing, forward trading, and reducing interest rates, particularly for small-scale players. The commodity movement, i.e., logistics chain, will benefit from wide use of warehouse receipts. Market transparency, the legal security of contracting, and price discovery will improve as well. If risk can be transferred or The use of warehouse consolidated, it can be managed better. The whole commodity chain receipts and pledges of can benefit from having a structure which enables the use of warehouse receipts, and other uses of commodities as collateral. Unfortunately, receivables has enabled State interference often impede the private sector from developing these Adani Exports to refinance necessary mechanisms, in particular in emerging markets. itself at a cheaper rate, and for a longer tenor. The use Adani Exports has used UNCTAD's paper on "Collateralized of futures markets allows commodity financing with special reference to warehouse receipts" to make up its mind on the use of these instruments. Adani is now actively greater flexibility in taking using futures contracts and approaches banks to offer finance against positions. warehouse receipts and the pledge of receivables. This has enabled us to refinance ourselves at a cheaper rate (compared to interest rates at origin), and for a longer tenor. The use of futures markets allows us greater flexibility in taking positions. Some of the financing acquired can be used to provide for margin cover against the futures contracts. Simultaneously, Internet e-mail has brought down our telecommunications costs, and trading screens are providing us with valuable information on a real-time basis. We have taken advantage of our port terminal, logistical capacity, ideas on the arranging of freight, Adani has been able to and our local procurement abilities to create further assets. We have add value by using banks, been able to avoid selling FOB or CIF, because we were able to shipping companies, maximize potential and minimize risk by offering cargoes of futures brokers, and tank agricultural commodities ex-warehouse in the consuming countries. and warehouse operators Adani has been able to add value by using banks, shipping companies, futures brokers, and tank and warehouse operators to go further down to go further down the the marketing chain. marketing chain. Surprisingly, the risk was Surprisingly, we found that the risk was minimal (other than for fraud, minimal. which can happen in any case): all the contractual obligations involved in our going further down the commodity chain were transparent, and enforceable. A GAFTA or FOSFA contract to ship soft oils or grains, and a charter party document for freight provides one form of - 38 -
  3. 3. Protection, proper insurance, and proper documentation for the warehouse receipts/pledge of receivables, as arranged by our banks in the consuming countries where our commodities are stored, another. Daily reports through Physical trade, shipping email and price benchmarking against listed prices on the computer screen and warehousing, futures allow us to actively monitor our positions. By selling futures against a and options, collateral and physical position, or a cash long position, we could convince our banks to finance a greater percentage of a cargo's value. The underlying structures are credit, Internet and trading solid, with only some risks if markets suddenly become extremely volatile. screens, price discovery Physical trade, shipping and warehousing, futures and options, collateral and and market research all credit, Internet and trading screens, price discovery and market research all come together to create come together to create added value. added value. Companies in emerging markets can improve their possibilities to make use of these modern financial instruments by a number of means. One is to form a trade financing/forfaiting association, at an international level - similar to the existing trade associations like GAFTA. The creation of a common information web warehouse, or a databank on the internet, would also be of much use. Note that, for example, the creation of the Bandx Exchange on the internet has created the possibility to trade telecom band width (and in the future, similar systems may enable the trade of customized weather options). Traditional ideas and Such a web site can allow companies to browse for the best deals in commodity financing, trading warehouse receipts, renting warehouse space and practices have been swept so on. It could furthermore act as a central clearing house for all information away by the fax, email related to commodity trade finance, posting factual histories of default and and trading screens. A fraud, highlighting country risks, and allowing service providers and users to web site can allow interact cheaply and effectively. companies to browse for It is no longer possible for traders and bankers to act in isolation. The futures the best deals… markets have become more competitive: investment banks and hedge funds are on the prowl looking for arbitrage possibilities, and they bring awesome fire power to the trading floor. Traditional ideas and practices have been swept away by the fax, email and trading screens. The information revolution has made the market transparent and, in a way, is leading to a new "Global Paradox": that of specialization versus consolidation. The new global commodity trading environment gives room to small niche market players, but Traders will also to large integrated companies. All are connected. Ultimately, a collection increasingly have to of small, regional commodity futures exchanges will come up and connect with make their profits by the established ones. National banks and insurance companies will merge; but absorbing a larger part trading companies and trading banks will specialize. In this whole process, the State is withdrawing from primary trading functions in all emerging markets. of the value-added in But what looks like a wild frontier today could be the genesis of a new horizon the commodity chain. tomorrow. Only the best can survive in the reality of a global market. The best need not be the biggest, but size and reach do help. Large traders will fill the gaps left by the withdrawal of the State and change the trading system by investing in the integration of origin and final destination. In other words: they need to master logistics, financing, and the various resources required for shipping and marketing commodities. This is compelling traders to invest in assets, which is a risky business. However, as these assets will be used to leverage future earnings, good trade banks can provide financing solutions, such as structured commodity bonds, or pre-export finance against specific production or contracts as collateral. Old value-added chains have been destroyed. Those economies which do not tune into this reality are missing the paradigm Pretending this change shift. Old value-adding chains have been destroyed; economies follow the capital markets, not vice versa, while telecommunications, travel and did not occur, and hang information have transformed commerce. The "Borderless World" is a reality. on to old, fossilized Pretending this change did not occur, and hang on to old, fossilized systems, systems, would be suicidal would be suicidal for emerging economies. The siren has already sounded - for emerging economies. are all emerging economies paying attention? - 39 -