London, May 2015
Is traditional commodity finance dying? Has the slack been taken up or is the commodity finance market underfunded? Are producers and traders getting the right products at the right prices? These are just some of the question we would like you to help us answer in our 2015 Commodity Finance Survey.
Trade finance – and commodity trade finance in particular, which involves lending to and servicing commodity producers, processors and traders – remains pivotal to the workings of a globalised and growing world economy, and to international development. The WTO says world trade will double in the next 15 years and the global population will be in excess of 9 billion by 2050, even though the growth rate of international trade has dropped drastically compared to the years before the global financial crisis. So the question is – in a post-crisis world where banks are less keen on risk and trust is at a premium - where’s the money coming from? Who will finance the growth in trade and how does the commodity trade finance market need to evolve?
The relationship between the financial system and commodity markets has always been an evolving one. This is being especially felt in the market for commodity/structured commodity trade finance where that relationship has become ever closer over recent decades. Consequently, major global banks became instrumental in providing the wholesale funding for commodity producers to commodity processors, traders, and end-users.
At the same time, banks also became increasingly important in a range of commodity related activities – from their central role as dealers in financial and physical markets, holding physical assets and inventories, as well as their involvement in warehousing, shipping, etc..
“Before the crisis, there was estimated to be upwards of $13tr of pre-export structured commodity trade finance bank lending to the market – finance which fitted the commodity flow and where risk was assessed and allocated” says Philip Prowse, partner at specialist commodity law firm Clyde & Co.
In tandem, over the last 15 years commodity trading houses – such as Glencore, Trafigura, Vitol, and Cargill – have expanded their role throughout the supply chain. Whilst not financial institutions, they now provide the logistics (and large amounts of financing) for the smooth flow of physical commodity products around the world – not to mention an increasing share of the lending to commodity firms.
This has taken place in the wake of the global financial crisis beginning in 2008 – with new trends emerging associated with the broad trend of deleveraging by financial institutions as they seek to restore their balance sheets and comply with ever more stringent regulations and capital requirements.
During the crisis a number of European banks had limited access to dollar funding, which forced them to reduce their (dollar) lending books – the currency in which the vast majority of commodities are priced. At the same time, the migration by banks to Basel III has created a more level playing field for bank lending.
“Since the 2008-09 global financial crisis, the situation of poor countries regarding access to trade finance may not have improved as a result of the re/down-sizing of global bank networks.” WTO, March 2015.
Philip Prowse comments: “During the crisis, banks in effect stopped trusting each other and became much less comfortable with taking on risk – particularly in relation to commodity business from SMEs in emerging markets where it is more difficult to ensure compliance with KYC rules. As a result funding flows have dropped significantly.”
With traditional commodity trade financing from banks in retreat, both in terms of lending to commodity firms and their own market- making, proprietary, and other commodity market activities, Prowse suggests that new trading relationships need to be developed if commodity trade financing is to sustain future economic and population growth. These new relationships will require finance, not only as funding, but also as a risk mitigant.
The Commodity Funding Market
Until recently, banks (especially those domiciled in Europe) provided up to 80% of the financing for the trading of commodities worldwide. But, as those banks have had to repair their balance sheets, they have scaled back lending, bringing that share down to around 50% according to Bank for International Settlements estimates.
The traditional trade finance banks have also reduced funding of small and mid-sized companies with low credit ratings because of growing regulatory and political pressure, risk aversion, weaker profits, and bad debt write-offs.
Capital allocation has become a key component of the commodity trade finance business, as banks become more efficient in making sure that risk- weighted assets are used in the most cost effective manner. And with Basel III, the focus on putting adequate capital aside has further constrained banks’ appetites (and their reliance on US dollar financing).
There has also been a marked decline in commodity assets under management and market making activities as investors have reduced commodity related investments, encouraging banks to scale-back their commodities operations. Banks are also accused of no longer being able to deliver decisions in good time for many commodity firms.
A number of banks from the US, Asia and the Middle East have filled some of this funding gap by increasing their share of financing for commodity trading – a natural consequence of markets continuing to shift from West to East. But the retrenchment in part has also been supplemented by increased lending from other market participants; the commodity trading houses financed by the banks, private equity and others.
So as banks have scaled back their involvement, commodity trading houses have grown in importance in providing this essential lubricant in international trade. To some extent this has been exacerbated by the need for banks to comply with increased sanctions and anti-money laundering rules.
The Rise of the RCF
Revolving Credit Facilities – though not trade finance per se – are becoming the new norm for the major commodity trading houses. Glencore’s annual mega-RCF [$15 bn in 2014] is symbolic of this change. However, lenders are yet to fill the funding gap for smaller commodity merchants who do not have access to RCFs on the scale that banks like to provide, and can no longer tap true trade finance linked to individual trades.
“At this smaller scale, where funding is available it is being provided in the form of open account, supply chain finance which often does not reach the smaller suppliers. It’s not tied to individual trades and may not be fully responsive to the needs of upstream parties in the supply chain and to their business needs” says Prowse, who suggests this gap remains “a major challenge, especially for SMEs as without access to trade finance, in emerging markets, SMEs continue to rely on loans in local currency or overdrafts.”
There are several reasons for this, among them:
Lack of credit worthiness.
Small size of the balance sheets of local banks.
Lack of US dollar liquidity.
In the developing world SMEs are the most credit constrained and their options have become more limited. International commodity prices have also been on the decline over recent years, negatively impacting the exports and fiscal revenues of commodity exporters, and ultimately worsening their terms of trade. Thus, the shortage of trade finance remains a major challenge for economic recovery and development.
Another effect of lower commodity prices has been to trigger an increase in pre-financing by traders, whereby they will wish to lock in a significant volume of offtake at fixed pricing. The increase in pre-financing is also a consequence of the retreat by banks from structured trade finance, with commodity trading houses stepping into the void.
New Liquidity Sources
So with traditional finance in short supply, new liquidity sources need to be found, or banks encouraged to resume a greater volume of pre-export trade finance.
Encouragingly, fresh sources of liquidity are being sought and found in the emerging markets, particularly in Asia. This trend reflects the growing regionalisation in the provision of commodity finance and the influence of supranational development institutions.
Larger emerging market banks are likely to gain market share as many OECD banks continue to consolidate their trade finance offerings.
But there is little innovation on show from banks in developed markets. Prowse comments: “Banks were hit in the crisis by the preponderance of synthetic trades on their books. Is the time right to redress the risk balance by returning to traditional trade finance based on lower risk real life commodity trade finance rather than generalised and what some might describe as self-serving open account solutions? Does the market want more club deals? That’s what we want to find out.”
Future Direction of Commodity Trade Finance Survey
Progress is happening, but there is still a way to go. Clyde & Co’s commodities team, working in conjunction with Commodities Now, is keen to understand your views on the future direction of commodity trade finance. The survey should take less than 10 minutes and is completely anonymous. If you provide an email address we would be delighted to share with you the headline results once they are collated.