Back to the future

Aidan Applegarth, managing director of CompanyWise* scans a critical eye over developments in structured commodity trade finance and examines where the market is headed.

A spring clean is a traditional way of dusting off the cobwebs of winter inactivity to prepare for the budding new life that awaits. It’s a poignant reminder of life’s cycle of birth, death and regeneration. ‘Out with the old and in with the new’. From time immemorial, man (and – to be politically correct – woman) has celebrated in one form or another the start of the spring equinox. Crops could be grown again; livestock could go out to graze; and the sun would come out more regularly. And with each new flower or spring lamb comes the seed for future generations... and so the cycle continues. The essence in going forward is building on the past.

It was appropriate then that, while undertaking my own spring clean recently, I came across a talk I delivered in December 1995 at the Café Royale in London addressing the future of structured commodity trade finance (SCTF). The discussion itself built on past experience to propose the most likely way forward for SCTF (which some of you may otherwise know under another of its many guises). Reading it these ten years later has been something of a revelation – as much for what transpired as for what did not. For some of the issues that concerned the market then still concern it now, while some of the anticipated innovation remains just that – anticipated. Since these past ten years have seen many changes in the SCTF landscape, in terms of markets, players and personnel, I thought it might be interesting to share with you some of the premises which underpinned my assumptions and to look critically at what came about and what didn’t. Looking at the market today, we shall then make some further assumptions about where it may end up in the years ahead.

Context

It’s worth reminding ourselves in what context the discussion came about. Structured commodity trade finance was in its relative infancy, with a core of banks having in the early 1990s separated the working capital day-to-day commodity trade from the short to medium-term structured pre-export financings, swaps and tollings. Where Latin America had been the focus of the 1980s, and Africa of the early 1990s, eyes now turned to the CIS and Central Asia. The targets remained commodity producers in developing countries whose need to raise hard currency working capital was fuelled by an increasing independence from state subsidies – itself prompted by the break up of the former Soviet Union and by a recent World Bank review which accelerated the demise of the state-owned monopolies, especially in Africa.

The world was changing. Sovereign debt was being replaced by private debt. The old monopolies were being broken up and uncertainty reigned about who was who in the new pecking order. The collapse of some high-profile traders (Woodhouse, Drexel Burnham Lambert, Goodmans, Julian, Arrowchem) was still fresh in credit managers’ minds and SCTF was looking to its survival.

Here then are some of the highlights of that 1995 presentation.

Premise

"Good judgement comes from experience, and experience from bad judgement.”

The incidence of producer failure to perform (ie, to deliver the contracted commodity) is higher during a rising market in a fixed price sale;

The incidence of offtaker failure to perform (ie, to take up and pay for the commodity) is higher during a falling market in a fixed price purchase;

The less there is of a commodity for a repayment top up, the greater the likelihood that more of the commodity will be needed;

Politically, government and parastatal interference in borrowing countries escalates in direct proportion to the benefits being gained by the Western traders and banks.

In most cases of a producer or offtaker failure, the incentives to perform just weren't there. The penalties for non-performance (if any) just weren't severe enough. As for price risk, it has been all too easy to assume that the producer has merely had to continue to deliver more of the commodity to make up for a declining value The result being that today certain producers are still having to apply current crop or output to meet obligations that were due some years ago – while still seeking new money for ongoing working capital.

In order to progress, we have to recognise these imperfections and seek to offer incentives to make future deals work.

Since the mid-1980s, we have moved from an offtaker driven financing, where the offtaker was the borrower and often selected the banks, to a private company exporter-driven financing where the banks now select the offtakers.

Dilemma: although the emerging country still needs working capital, it is now channelled through these new exporters, but neither the traders nor the banks are yet fully comfortable with the change in counterparties.

Weaknesses: the borrower may be inexperienced or at least has to prove himself in the market, before he is accepted. The Western lender is now too remote from the borrower to understand where the borrower comes in the pecking order, and how he may be regarded locally. Private enterprise means the borrower competes for access to limited commodity supplies.

This trend has key implications for the evolving role of local exporters and local banks.

Local exporters would benefit from closer ties with the OECD traders, where the traders would step in with their own risk capital to get the ball rolling and clear a path for the banks to become more comfortable. Competition between exporters to satisfy the traders would separate the weak from the strong and enable a handful of bankable names to be brought to the market. There will be some attrition of players giving rise to initial uncertainty but eventually the dust would settle and markets begin to become established and accepted.

Local banks would take an increasingly active part in deals – no longer just a performance guarantor – to the extent that SCTF will no longer be the exclusive domain of international banks in developed countries. Local banks will emerge as participants or even ‘partners’ and will eventually actively compete in the traditional structured products. Both local and international banks will increasingly target the local exporters directly for business, cherry-picking from available sales contracts as to which offtakers are acceptable or not. The offtaker, with a few exceptions, will be much less the driving force.

This will, in turn, have implications for the continuing role of the international banks. New or improved products will emerge to maintain a viable role for these banks, whose focus will be on bringing value-added through securitisation and risk-management techniques. Maybe one day an investment fund will even be developed for structured trade credits (to parcel together a pool of collateralised receivables for distribution through the capital markets).

The letter of credit (LC) would see reduced usage as the world is fast learning that LCs are not perfect instruments for an exporter, nor sometimes for the banks that handle them. The use of LCs will not disappear altogether, but the trend by importers and exporters to reduce their costs will see a reduction in letter of credit usage if the same goal can be achieved by other cheaper means. However, some jurisdictions may continue to insist on LCs to justify hard currency payouts or simply to ensure a tangible source of fee income.

By a process of elimination, South East Asia and the Middle East would receive focus by the end of the 90s.

Outcomes

üThe role of exporters did indeed evolve along anticipated lines;

üThe role of the local banks did indeed evolve to make some of them established
players today;

üThe international banks haven’t had it their own way…

X … but they have failed to really differentiate themselves through securitisation and risk
management;

X An investment fund for structured trade credits is still an idea waiting to happen;

ü Letters of credit usage underpinning deals is indeed reduced;

ü South East Asia did indeed receive focus (but not always for the right reasons)…

X … while the Middle East remains on selective radar screens only.

Oh well, five correct predictions out of eight isn’t too bad. And it wasn’t too difficult either. Each of the correct predictions had sound and reasoned assumptions, so it was analysis rather than guesswork that got it right. There really was no alternative. As for the three deviations, these were founded on supposition rather than known dependency, so it is not surprising to see them fail to materialise.

I had expected the international Western banks to have to differentiate themselves by the added-value of securitised offerings and sophisticated risk management techniques. It seems though that I had overestimated the pace of transformation. The global crisis triggered by the Asian collapse of 1997 to 1999 wasn’t factored in and neither was the event or aftermath of what we know as 9/11. Instead of a thriving market these past ten years, we’ve had a relatively comatose one. Yes, there has been some notable progress since 1995 but it certainly hasn’t been on the scale of the previous decade. Bank mergers, the fragmentation of unified commodity groups, the loss of experienced players and the arrival of many inexperienced new ones has simmered things down. Only in the past 12 months have we truly felt the optimism of a new revival.

As for the Middle East, it is certainly not overlooked but my own involvement with Islamic finance had probably put a more favourable bias on where I saw it going. Islamic finance hasn’t achieved the acceptance I expected, but then when hardened principles are seen to be moderated as markets fluctuate, it can seem duplicitous.

The next decade

So what about SCTF for the coming ten years? Does it have a future?

Let’s look at the current trend.

SCTF today takes a different guise in different banks. In some cases it’s a properly distinguished discipline, in others it features within a composite talent pool. The influence of project finance practitioners is fast changing the face of structured trade deal size and tenor, morphing it into… well, project finance.

The larger banks have so fragmented the product that as even syndication teams now run with specialist commodity trade deals, we seldom see anymore an individual running from start to finish with the whole package. Gone are the days of the rounded account officer who could also originate, negotiate, structure and execute a deal, and bring it to market. Instead several people see a piece each of the pie, but few see or know the whole pie well enough to extract full leverage.

The more sophisticated the markets become, the more they seek hybrid solutions. That’s already in evidence among the deals highlighted in 2005.

The more established an economy becomes the less it looks to SCTF and the more it looks to the capital markets. Asia is a case in point. Why go to the trouble of collateralising or disclosing with fine toothed combs to the trade banks, when investors will come bundling in for the kudos of holding your equity or commercial paper? Of course, that presupposes you can get investment grade status – which I expect will be the ambition of many (though achievement might be something else).

The real question mark for me is what will be driving the process going forward: the market or the internal self-posturing of the banks? By that, I refer to the restructuring of banks to suit their own internal agenda rather than the markets they serve. If the market were indeed in the driving seat, we’d see more uniformity in the way that banks organise themselves to serve it. Since there is so much disparity, we have to assume that in fact banks are doing their own thing. I don’t see this changing in the near future, which means that gaps will naturally arise between what the market wants and what it gets. That presents opportunity for a tiered system of offerings, where some players will continue to forge a niche where the big players aren’t, while the wholesale giants will continue to think that bigger and longer is better… until it all goes wrong.

So, more of the same seems likely.

As for the notion of pooled collateralised financings, it is a concept looking for a need. Heralded during the low liquidity times of the early to mid 90s, it was under consideration as a means of restoring much needed funding to emerging market producers, at a time when bank funding looked in decline. The concept is straightforward enough.

Collateralised financings

Let us assume that a producer who has not concluded any international sales contracts has a stock of marketable commodities (be it metals, coffee, cocoa, etc) and wishes to raise working capital against it. Without the export contracts perhaps only the local banks will lend against the collateral, but given the poor liquidity in many producing countries some enhancement would be needed to translate the stocks into a source of international funding. By packaging from various producers a pool of acceptable warehouse receipts as collateral to a special purpose vehicle, it is possible for the local banks to raise finance by having the special purpose vehicle issue ‘asset backed securities’ – which in turn could be enhanced by a reputable financial institution (which basically adds its name to the securities and distributes them among investors in the capital markets). Taking this one step further, the same approach could be applied to the securitisation of export receivables as they arise.

That's in its simplest form, and of course there is more to it than that (minimum workable amounts, acceptability and monitoring of security, legal ownership, political risk, contravention of current World Bank and IMF negative pledge clauses etc), but the concept had already been practised in 1995 and appeared to be gaining acceptance. The devil though is in the detail of implementation, which requires the political will in some countries to drive through essential change.

This structure could be applied equally to the creation of eligible instruments for discounting in the acceptance markets, or could support commercial paper programmes.

In time, the fund managers in co-operation with SCTF could develop funds to suit particular investor profiles – specialising by commodity or group of commodities, by geographic region or by a balanced mixture. Back in 1995 some trading companies had already anticipated this development by establishing investment trusts to support limited recourse facilities developed in-­house, but for greater investor acceptance, perhaps the weight of one or two major financial institutions under the umbrella of a single investment vehicle would be a more saleable and cost-effective solution. Clearly, there would need to be some tailoring of such a fund – would it hold the commercial or just the political risk, how would it avoid ‘back-door recoveries by traders’, who would determine the cocktail of risk…etc, etc.

The advocates of such funds highlight the benefits of liquidity and risk spreading, while the sceptics talk of limited upside but unlimited downside. There is merit in both points of view, but until another global crisis triggers the need for such a ‘cumbersome’ solution, I don’t see such a universal offering getting off the ground. Maybe there’s scope for a local fund somewhere though.

Much depends on how SCTF shapes itself within the market of tomorrow. Will it continue to fragment and morph under the dominance of something else, or will it be able to restore its own identity and drive through synergies that impact across a range of business lines, not just structured finance. It has the potential to offer so much, but seems still somewhat underused.

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