COMMODITY FINANCE: Emerging risk cover - Trade & Forfaiting Review

Feature

posted 1 Jul 2000 in Volume 3 Issue 10

COMMODITY FINANCE
Emerging risk cover

SG has developed a portfolio cover programme for commodities that involves repackaging trade finance risks based on emerging market oil receivables and transferring them to the capital markets. Pierre Palmieri and Marie-Aimée Boury from SG Commodities and Trade’s brand new ‘Alternative Finance’ team explain further below.

SG has recently completed the first issue under its ground-breaking portfolio cover programme. The transaction involves the repackage and transfer synthetically to investors’ risks embedded in a portfolio of trade finance assets based on oil receivables held on emerging market debtors.

The transaction provides SG’s commodity and trade finance division with a new, flexible and cost efficient source of credit and country risk hedging and gives investors the opportunity to diversify their investments in A1+ CP investments. Denis Childs, head of commodities and trade at SG says: “It is a major advance in credit and country risk management for commodity businesses and we have already started looking at extending such a programme directly to our commodity clients.”

Investigating the options

The risks transferred are generated by SG’s commodity and trade finance business in the oil sector. SG has been actively developing this activity since 1974. In the context of strict country limits and active balance sheet management, the commodities and trade finance division has set up an ‘alternative finance’ team whose goal is to find ways to reduce or cap SG’s exposure without limiting activity. It was decided in late 1998 to set up a task force between the securitisation and alternative finance teams to explore different options, including securitisation, insurance and credit derivatives.

One of the challenges, among others, was to transfer a big chunk of risks held on emerging market debtors, as opposed to usual securitisation programmes backed by trade receivables wherein exposures on emerging countries are very limited.

Work started with Standard and Poor’s to develop a methodology adapted to these specific types of assets. Several researches and studies were undertaken to assess the risks generated by this activity on a worldwide basis. Although SG’s historical data on its own portfolio is very good, Standard and Poor’s needed larger studies corroborating the results from SG’s own track record. Data was difficult to gather as it was dispersed between different parties – insurance companies, banks and supranational organisations. The study covered the past 15 years and took six months to be completed.

Due to the characteristics of the underlying assets, it was decided very early to look for solutions that do not require any sale of assets but to repackage and transfer the risks synthetically. Since the assets are short term and volumes are fluctuating, the structure needed to be revolving and was thus designed as a programme. The credit derivatives market was explored but was not then the perfect target as the liquidity of the short-term credit default swaps (CDS) market and the novelty of this asset class constituted real constraints.

It was eventually decided to set up a commercial paper programme issuing notes rated A-1+ by Standard and Poor’s to raise cash which would in turn be invested in eligible investments matching the maturity of the notes issued, thus eliminating the need for any liquidity line. The cash raised is used as collateral in case of losses exceeding a first loss retained by SG. SG adapted the structure to this specific type of assets and avoided any tax or regulatory constraints that may arise in this activity undertaken on a worldwide basis.

This technique, inspired by structures used in synthetic collateralised debt obligations (CDOs), is the first of its kind in the type of assets and risks conveyed.

Flexible use

Thanks to the excellent historical performance of SG’s portfolio and Standard and Poor’s in-depth understanding of the underlying assets, it has been possible to set up eligibility criteria that allow a great flexibility in the use of the programme. Besides, thanks to the A1+ rating this programme allows SG to cover its portfolio at a competitive cost and gives investors the opportunity to diversify their share of A1+ CP investments.

The portfolio is denominated in US dollars and is composed of risks generated in more than 50 countries. The initial size of the programme is US$200 million but should quickly grow to US$500 million. Indeed, now that this programme is in place, risks are transferred and SG’s origination teams are able to go after more trade finance business within the same internal limits.

Extending the scope

SG’s commodity and trade finance department is also looking to further enhance the programme by stripping the first loss retained in this programme and selling a mezzanine tranche to different and non-correlated risk takers, reducing further its own final exposure. Such a scheme will offer investors the opportunity to buy high yield short-term paper showing excellent historical performance.

Now that the programme is in place and running, which constitutes a first major step, work has started to extend it to other commodity trade finance assets. SG is also approaching other rating agencies to secure a second rating in the perspective of significant issuance increases. Indeed, SG is working to extend the programme to external clients looking at credit and country risk hedging: exporters and traders have been very receptive so far.