Unlocking potential. Transaction Management Accelerating performance Challenges in Structured Commodity Trade Finance

At BSG we are passionate With ongoing global demand for commodities, there is plenty of opportunity for about design and delivery financial institutions to finance commodity trade. However, the ability of of change that makes a institutions to do so is less widespread. Managing the risk of financing physical difference for our commodities based on their intrinsic value is a tricky business, especially when customers and their one looks at finance structures across the soft (grown) commodities lifecycle. customers. The Transaction Management function behind deals in this sector needs to be particularly mature to ensure that the potentially substantial revenue is actually attained. Financing softs in high-risk areas like Africa demands tight controls.

The soft commodity trade lifecycle

Silo/Warehouse Mill

Transport (including Production Storage import/export) Processing Finished and Harvest product

Trade Finance Products:

Silo Certificate Financing Input Finance / Warehouse Receipt Financing Mill-door Invoice Contract Growing (including import/export trades) Finance Discounting

Key • Lack of harvest due to • Credible storage and transport • Processing • Risks: weather, infestation, facilities, managed by credible facility track grade of poor quality seed, lack Managers (full out-turn record and offtaker The Transaction of fertilisers etc. guarantee) standard • Limited Management function • Producer’s track record • Degrading quality (grade) of output invoices behind finance deals needs and farming ability commodity over time • Credit risk discounted • Quality of harvested to be particularly mature • Infestations, flood damage, theft, grade of across a product etc. leading to loss of commodity offtaker single to ensure that institutions • Harvested commodity • Proof of commodity ownership • Price volatility client are actually able to reap selling price vs. input (legal security held) the substantial rewards costs • Proof of physical commodity • Crop theft location (including in-transit) of financing softs in • Price volatility high-risk areas. • Rising transport, storage and insurance costs • Quantity of commodity financed per season

Figure 1: Soft commodity trade lifecycle

Although many institutions worldwide finance soft commodity trade, few have managed to structure finance for the production / growing process across developing economies where farmers have limited collateral. This lack of large- scale finance to local farmers is a key challenge for the development of countries across Africa. Finding a proven “growing management” partner, which will take a risk-spread view on a group of farmers across geographical areas in a single scheme, is a mechanism that Standard Chartered has employed with great success in South Africa.

But even further along the supply chain, finance in Africa cannot rely on the collateral of a trader, and as such, the intrinsic value of the www.bsg.co.za commodity needs to be used as collateral. Transaction Management Challenges in Structured Commodity Trade Finance

The figure below highlights typical risks and management mechanisms for each:

Finance in Africa cannot rely on the balance sheet Industry Challenges Key Tools collateral of a trader, and as such, the intrinsic value of the commodity Financial losses due to commodity • Collateral management monitoring per needs to be used stock loss deal/trade, with CM companies reviewed up front for Full Outturn Guarantee (FOG) as collateral. • Securities tracked and reconciled daily, weekly and at month end to stock () value • Stock monitoring in storage as well as in transit • Detailed insurance reporting for effective cover • Securities management role to ensure segregated authorisation of stock movement, and validity of security

Financial losses due to inferior • Standard 6-monthly re-finance period, with system generated flags for expiry periods commodity quality • Collateral management review • Securities management function to ensure security validity • Grade definitions and differentials understood within the financing transaction • Transport and storage facilities vetted prior to financing

• Upfront discount calculations to allow for finance Financial losses due to price volatility of up to e.g. 80% of the market value of the commodity (strike price), creating a price risk buffer • Price movements tracked daily from Reuters against a trigger price per stock item, and calls automatically generated to cover the shortfall (hedging) • Ability to capture manual prices e.g. for up- country trades • Mark-to-market transactions automatically generated and reconciled to data from Safex contracts • Interest calculated and allocated per stock item over lifetime of the deal, to ensure full revenue received when stock is released

• Legal agreements transfer the rights of Credit risk management ownership of the commodity to the bank • Credit risk assessed for the offtaker, whilst margin is changed on the trader credit grade • Credit limits set per client, offtaker, county and automatically tracked through each transaction in the system • Limits set per commodity and country, to limit the bank’s impact on the market if it is a price maker, and automatically tracked through each transaction in the system

• Date-based flags to manage stock expiry, Contractual and financial management delivery dates, manual price monitoring, reconciliations, etc. • Full financial reports per deal/trade on a monthly basis • Full limit reporting across financial and commodity limits • Admin fee per deal calculated and allocated to recoup all costs in the “selling-price” • Month-end processes to manage interest allocations and insurance (security/stock reconciliations) • Investor/syndication functionality to ensure ring- fenced fund management and full reporting • Data exports to the relevant back-end systems

Unlocking potential. Accelerating performance

Transaction Management Challenges in Structured Commodity Trade Finance

Creating processes and systems to automate some of these controls is key to rolling out structured finance across areas like Africa. However, systems which Applications tend to be fit- combine workflow, key diary management reminders, collateral management for-purpose, focusing either and re-, stock item tracking (including changing locations and on loan management or corresponding security documents), credit and limit management, as well as collateral management, and hedging, are hard to come by. Without systems which combine these key loan not workflow and and commodity (stock) levels of detail, client reporting is difficult to generate. reconciliation between User management security and segregation of duties is also a key requirement the two. for financial institutions, as is dashboard reporting across the finance portfolio.

Applications tend to be fit-for-purpose, focusing either on loan management or collateral management, and not workflow and reconciliation between the two. As a result, most complex soft commodity structures are managed on spreadsheets. This creates overhead on very specifically skilled resources able to manage deals across the risk spectrum. So the cycle continues, as few institutions have the risk appetite or skill for intense manual management across complex structures.

Institutions like Standard Chartered and Nedbank have invested in bespoke systems to bridge the gap. As further opportunities open up in Africa, and global pressure is exerted to utilise arable land for food and biofuels more effectively, it will be interesting to see how the industry adapts both from the business and IT vendor perspective.

BSG has helped various financial institutions to understand the gap between their current systems and desired control framework, within soft commodities trade.

Unlocking potential. Accelerating performance

Business Systems Group (Africa) Pty Ltd. Registered in South Africa No. 96/12533/07 Registered office: Metropolitan Centre, 7 Walter Sisulu Ave, Foreshore, Cape Town, 8001 www.bsg.co.za