Collateral damage

Feature | 4 July 2016

The prognosis that recent cases of fraud will lead to the
death of collateral management arrangements is nothing but a misdiagnosis. There are plenty of opportunities for prudent risk managers, says William Hold

In recent years, the trade finance world has witnessed countless examples of what can go wrong with collateral management, warehouse financing and repurchase arrangements (repos) for commodities. Across the globe, stocks have disappeared from warehouses and storage tanks, or haven't been available - that is, if they were even actually based in those facilities originally.

Most recently, in Liberia, a significant quantity of rice - amounting to several months' worth of rice consumption for the country - that had been stored and managed by a collateral manager on behalf of several financiers in a large storage facility, could not be accounted for. The rice in warehouses was managed as collateral for various forms of funding offered by the financiers. It was reported in September last year by local media1 that major suppliers of rice from several Asian countries were considering terminating business with importers from Liberia as a result of the disappearance. With details unclear and still emerging, investigations and litigation are set
to rumble on.

Further in the past, the scandal around the port of Qingdao2 starting in the summer of 2014 was even more damning. Concerns initially arose over the large quantities of aluminium and copper stored in bonded warehouses; these had been used as collateral for trade finance deals or acted as the subject matter of repos between various parties and numerous banks. Suspicions around fraud circulated - that the metal had either been used as collateral for several simultaneous transactions or may never have been stored in the warehouse
at all.

There were major discrepancies at the port. One bank, for example, came to hear that the Qingdao port authority believed the total quantity of aluminium in the warehouses amounted to around 60,000 to 70,000 tonnes, even though that bank alone had 73,000 tonnes at the site.

The warehouses were subsequently locked down by authorities when the concerns became widespread across the market, and they still remain locked down more than two years later as investigations, as in the case of the alleged fraud in Liberia, continue. Nonetheless in the meantime, a wealth of litigation and arbitration in connection with events at the port in Qingdao has arrived, some in the order of hundreds of millions of dollars.

The wheat markets have also seen their share of warehouse frauds. In 2010, several Swiss trade finance banks that had financed 350,000 tonnes of Russian wheat, which was to be exported from the Black Sea to Tunisia and Egypt, discovered that the cargoes did, in fact, not exist. According to some press reports at the time, the wheat was part of the collateral that was offered to the banks, who had received documentary evidence that the grain had been inspected and examined. It was alleged in some quarters that false documents had been produced. The damages suffered by the banks was probably well in excess of US$100m. Ultimately, some of the banks called on the inspection company's insurers, but it is doubtful that they were made whole again.

Do you know a safe hiding place?

These three examples underline one key weakness of financing agreements with bulk commodities as collateral, irrespective of how the financing is actually structured. This weakness is the safe custody of the goods; if the goods disappear, so does the financier's collateral, and similarly so does the means to repay the loan. Moreover, in jurisdictions where a warehouse receipt assumes the role of the document of title and ultimately acts as security, if the warehouse operator is not able to indemnify the holder of the receipt for not delivering the goods when they disappear, the warehouse receipt is effectively rendered worthless.

Similar considerations arise with repos. In a highly-publicised recent English High Court judgment which arose out of the Qingdao affair3, the court held in substance that one party was liable to the other for the sum due under the repo, but that the liable party was entitled to damages in a very similar amount against the other party for non-delivery of the metal. In that particular case, it is not clear that the metal had indeed vanished, but the warehouses are in lockdown such that the contract could not be performed, and the warehouse operator refused to confirm that it was holding the metal on behalf of the relevant parties, such that the end effect is currently identical to that if the metal had been stolen.

It falls on collateral managers and other custody agents to bear a substantial amount of risk in terms of the value of the goods in their custody, relative to how much they are remunerated. They enter into collateral management arrangements (CMAs) with borrowers and lenders given the latter do not traditionally want to take physical custody of bulk commodities themselves, due to the logistics involved. These CMAs require the collateral managers to hold the goods on behalf of the financiers and to only release them when they are instructed to do so. Alongside this role, collateral managers have in the past provided additional stock-monitoring services, as well as tallying and inspecting the assets in their care on behalf of the lenders.

Death by risk

The significant risk that collateral managers take on is tempered to some extent by protections through contractual liability limitations and insurance policies, although limitation clauses are not always enforceable (depending on the relevant jurisdictions and facts), meaning collateral managers may still be liable for the consequences of the loss. Moreover, insurers are not always required to pay out under these policies, a further issue for collateral managers. Even if they can avoid being liable for lost collateral and other insurance issues, the associated impacts on reputation and staff costs can be hugely damaging and act as disincentives.

However, commentators in some quarters now consider collateral managers a thing of the past, practically consigning them to the history books. It is true that many collateral managers have left the business due to the increasing imbalance in remuneration versus risk. Indeed, both financiers and traders can now experience significant difficulty in finding suitable collateral managers. Similarly, the high profile failures, not least those outlined above, have concerned financiers, prompting them to judge it just too risky to rely on CMAs; the goods are, after all, often stored far away in places and in circumstances that are usually perceived as being much riskier then the financier's home jurisdiction. In this vacuum, the difficulty in implementing CMA-type arrangements has in some instances caused struggles for traders looking to secure financing.

Collateral goods

For a very long time, a substantial proportion of the world's commodity trade finance has been built on goods being used as collateral for their own financing. In this context, CMAs and similar structures continue to offer a solution, and indeed sometimes the only solution, to a major hurdle for financing.

But the landscape is set for an overhaul. Fresh consideration will need to be given to pricing, allocation, the management of risks associated with CMAs and other topics. The recent prominent headlines in Liberia and China have raised some questions and offered some renewed lessons in the structure and implementation of these agreements, with a view to protecting against the risk of collateral disappearing or not being available.

Goods are used as collateral when there is no other acceptable form of security available to lenders, and this in turn naturally raises issues of safe custody. Steps must accordingly be taken to mitigate both the risk and the consequences of the collateral being jeopardised. In reality, incidents of things going dramatically wrong in collateral management arrangements are comparatively rare, relative to the overall volume of trade financed through them. Equally, there is no way of making sure that risk is completely eliminated in a transaction, especially in cases where several separate well-placed parties collude to perpetrate a fraud.

Nevertheless, more attention will probably be paid in the future to due diligence on the various parties as well as to the potential risks. Due diligence here should address whether counterparties can perform their obligations, as well as address how risk can be mitigated if it turns out they are not able to do so. This will take the form of considering to what extent a party's exposure is or can be mitigated by their counterparties' insurance policies or their own.

New checks, less risk exposure?

The CMAs themselves will become more heavily negotiated documents, as parties to CMAs will also want to give some more thought to how the duties and the risks are allocated, trying to negotiate, for example, mechanisms to shift liability from one party to the other, or make liability subject to certain conditional precedents being fulfilled by another party. The lenders may now insist on further checks and balances, and impose requirements appointing a separate party besides the collateral managers to monitor the stock, and are more likely now to insist on a second set of eyes to inspect the collateral.

As a further contractual party to the arrangement, the stock-manager would also potentially be liable in case of the collateral's disappearance. They would also be an additional source of indemnities - a major consideration given collateral managers are often thinly capitalised. However, stock-mangers will also have to ensure that the risks they bear are justified by their fees. With this instruction of an additional party, it is inevitable that transaction costs will increase, and these need to be taken into account by collateral managers and by the other parties to the transaction; ultimately, the cost will be borne by the end-user.

Insurance will no doubt play a more central role in these kinds of financing structures in the future, with considerable thought likely given as to how the appropriate insurance coverage will be structured. The recent issues around CMAs have prompted insurers, who either provided coverage for the financiers or covered the collateral managers, to review the policies they underwrote in an effort to assess the impact of hitherto unforeseen risks. As a direct result, policies could be subject to rewriting and premiums subject to change upon the renewal of the policies. We could also see the development of insurance products specific to CMAs and associated financing structures.

Logistics are another factor set to change. It may become less common for collateral to be stored in premises belonging to the borrower - this had been a weakness that raised the risk of borrowers or people associated with them being able to access the collateral. Financiers may instead insist that the collateral is stored in an entirely separate location, not belonging to the collateral manager nor unrelated parties.

Financiers however, will likely not be acquiring storage facilities as a solution. Instead, collateral managers will have to invest in or lease storage facilities, increasing their costs of doing business and increasing the costs of implementing a CMA. That is, unless the lenders or the borrowers lease the facilities for the purpose. In both cases, the costs will be passed onto the trader.

The future of collateral management

As fees charged by collateral managers were often very low in the past relative to the goods' value and the exposure, we could see a fee rise to incentivise collateral managers to perform their services. The size of the rise will be influenced by how much of the risk can be mitigated, and whether the collateral manager has developed cost efficiencies.

The decline of CMAs has been greatly overestimated. With new approaches and new processes, CMAs in all their various forms will in all probability continue to be a standard feature of trade finance packages and in particular, opportunities will arise for parties who are able to manage their risks efficiently and still offer their services at competitive rates.


William Hold is a senior associate in Holman Fenwick Willan's Geneva office

"Commentators in some quarters now consider collateral managers a thing of the past, practically consigning them to the history books"

"Many collateral managers have left the business due to the increasing imbalance in remuneration versus risk"

"More attention will probably be paid in the future to due diligence on the various parties as well as to the potential risks"



  1. See Liberian Observer article "Rice importer under US$22m probe":

  2. See TFR article "Phantom metal - the Qingdao port scandal":

  3. Mercuria v Citigroup:

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