Today, I will be using a very modern tool to get an additional view of commodity finance, which is industry that is very old.
The term ”commodity” is a commonly used expression but it is always good to try and come to an acceptable definition. First, we asked our new modern friend ChatGPT, who gave the most commonly accepted (correct) answer in mere seconds.
Different definitions: Chat GPT vs the human view
According to ChatGPT, the definition of a commodity is, “A commodity refers to goods that are uniform in quality and characteristics, interchangeable and widely traded in the market. Commodities are often traded on exchanges, and their prices are determined by supply and demand dynamics in the market.”
I would define commodities as goods that are widely useable and easily tradable with an identifiable value which is equal to all buyers. The use of a commodity is identical anywhere and by anyone and therefore, the implicit value is identical for any user.
For the definition of commodity finance, ChatGPT says, “Commodity finance is often provided by banks, financial institutions, and specialized commodity trading companies. The goal is to support the efficient and smooth functioning of the commodity markets by addressing the unique financial requirements and risks associated with the production and trade of commodities. Commodity finance, which involves the financing of physical goods, has been a part of trade and commerce for centuries.”
My definition of commodity finance in its original form is financing self-liquidating trade transactions. Whereby a borrower reaches out to a lender with a trade transaction to buy goods from a supplier which are sold to a buyer.
Commodity finance: How does it actually work
The borrower’s own money, together with the loan from the lender, adds up to enough cash to cover the supplier’s bill for the goods. Once the goods get to the buyer, they just pay for what they’ve received.
These proceeds are firstly attributed to repay the loan of the lender including the cost of the loan. Any extra cash left over is for the borrower to cover other expenses and keep as their trading profit.
The tenor of the loan is short-term and follows the normal cash conversion cycle of the underlying trade transactions.
You can create several variations on this basic model, always ensuring that the self-repaying feature of any setup is maintained.
As an example, you can aggregate all single transactions of a borrower into a pool of goods and subsequent receivables, and this structure would be called a borrowing base facility. With the basic principle, you should be able to come to the best structure for any counterparty by closely following their pattern of trade and/or processing.
In very simple terms as a lender, you know your counterparty (borrower), you know the supplier(s) and the off-taker(s) of your counterparty and you know the specific characteristics of the underlying goods as well as the (market) value.
You know the tenor of the transaction, which matches the tenor of your financing, and you are the first to get repaid (including your cost) by receipt of the proceeds of the sale of the goods.
This intricate knowledge should make for swift and easy risk analysis and execution.
Risk calculations in commodity finance
But not everyone has the same access to risk tools. Banks have a unique opportunity to calculate the risk weighting of the assets of an exposure. From a credit risk perspective, the high-level formula is:
Probability of Default (PD) x Loss Given Default (LGD) x Exposure = Exposure at Default (EaD).
- The PD (in %) is the likelihood a borrower will default in a given time frame.
- LGD (in %) is the proportion of the exposure that will be lost in case of a default.
In other words, the bank has the administrative tools in hand to have exposure to a counterparty with a high PD (non-investment grade counterparty rating) and a low LGD (risk mitigation by taking security) coming to an equal EaD as if you have an exposure to a counterparty with a low PD (investment grade counterparty rating) and high LGD (unsecured).
Commodity finance, when done properly, has excellent capabilities of lowering LGD which creates an advantage for banks versus any other potential private lender.
This is the “short and easy” story and there is much more detail available in the Basel documents. However, it fundamentally boils down to the points made above.
According to the Asia Development Bank in its brief No. 256 of September 2023, the trade finance gap (trade finance not financed by banks) increased to $2.5 trillion in 2022 (10% of global merchandise trade). A quick initial conclusion would be that banks are not, or not adequately or sufficiently, using the administrative tools they have.
Not all trade finance is commodity finance, but a substantial part of this gap is related to commodity finance. Estimates show that there is an earnings potential of $50-200 billion to be picked up by banks if they set up a framework for the proper recognition of collateral that commodity finance intrinsically has to offer.
Commodities and finance: A fit, but not yet
Commodities were the first to appear, but as soon as finance emerged, they quickly and naturally connected. Judging from the ADB brief it might not currently be a match made in heaven for all, but this could change again in the future.
Commodities and finance have brought us to where we are today and they are needed to bring us to where we want to go tomorrow.
Commodity finance is in the industries’ DNA and certainly so at TCF Partners. We know the requirements and the risks and are ready to support the commodity finance market to function as smoothly and efficiently as possible.