Global financial uncertainty has boosted the popularity of collateral management services, but a lack of regulatory framework is slowing the progress of the industry. Melodie Michel reports.
Collateral management can be a priceless tool in financing commodities transactions in emerging markets. When the transaction involves storing the commodity for a certain period of time, and the bank funding the deal has no presence in the country, collateral managers can act as custodians of that commodity for the bank, making sure nothing happens to it until its export and the repayment of the debt by the borrower.
The financial crisis and the rise of Africa in the global commodities trade have pushed these services to the fore, as most international banks are looking for increased security in transactions.Citi, for example, is fairly new to collateral management, but expects to do more of this type of transaction in the future. Global head of commodity trade finance Kris van Broekhoven explains: “Collateral management gives us additional comfort and allows the bank to finance certain flows that it would otherwise not be able to.
“We would look at this in countries like Tanzania or Kenya, which require import financing for commodities, and part of those financing transactions require a certain period of time during which the commodities are held in storage, such as crude oil in tanks, before being sold for cash. During that period we’d like to take security, and given the jurisdiction we’d like to take extra comfort by having collateral management looking after that security.”
However, even when resorting to collateral management services, it is still the bank security that is at risk should something happen to the stored goods. The collateral manager is only liable in case of negligence or breach of contract, but in terms of the overall transaction, the bank is still considered responsible for the commodities. “There is a perception in parts of the industry that if you have a collateral management agreement involving yourself, the collateral manager and the borrower you are secured, but that is not the case. What is required is the taking of security under the laws of the jurisdiction where the commodities find themselves and the mechanism by which you perfect that security is collateral management,” points out Lodewyk Meyer, director at Norton Rose.
In this context, the relationship between banks and collateral managers should be one of trust; yet this doesn’t seem to be the case. The standard of collateral management services varies widely between companies, and in some cases banks are at risk of suffering tremendous losses. In one such famous case seven years ago in Uganda, Cotecna was sued by the Aya Brothers for failing to properly supervise the commodities the firm had placed as collateral for a US$5mn loan from Barclays. The deal was on wheat and coffee, but part of these were replaced by husks during the storage period, a fact that was only discovered by Cotecna upon inspection, and which caused default on the loan.
Although there hasn’t been any scandal of that scale since then, the industry is still struggling to regain banks’ trust. A banker who prefers to stay anonymous tells GTR: “We know that in certain jurisdictions there have been bad experiences, so we take those into account when we assess the suitability of a certain collateral manager. If there has been a bad experience it would be marked against them and we would need to understand what happened. We would also review and check the reports that they prepare for us, and we won’t follow them blindly.”
At Citi, van Broekhoven adds: “As part of the transaction due diligence, we would have to meet with the collateral managers before we appoint them. Citi is unlikely to use collateral management in countries where we do not have a presence ourselves, so we’ll also have our own eyes and ears on the ground.”
According to collateral managers, if the bank chooses the right firm with the right system, it is unlikely to encounter any issues, but some banks prioritise cost over quality, which leads to losses. Duncan Oliphant, co-founder and manager at Titan Collateral Services, says: “With the increase in demand for collateral management you’ve got a lot of newcomers. Banks or clients in some instances are looking at the cheapest deal.
“When you don’t pay much you can’t expect to get much. If the bank chooses a cheap collateral manager for a huge facility, that collateral manager is going to try and make as much money as possible from that facility, paying less than what the big companies pay their staff. Having one guy look after a compound of 10 warehouses will result in a very cheap quote, which will please the banks, but how can one man count that amount of commodities on a daily basis, or verify stock coming in and out of all these warehouses? It may result in major stock losses for the banks.”
This only tends to happen on low-value cargos such as soft commodities, and banks are more willing to pay extra for high-value transactions such as petroleum. And for some collateral managers, suffering a loss because of having chosen a cheap company to do the job can be a good lesson for banks. “When banks prioritise cost over quality they ber their fingers burnt. A collateral manager should be the extension of the bank on the field, to act purely on behalf of the bank and follow its instructions. If the bank wants to give its money to a third party that doesn’t understand the value of the commodities that is its problem, because it’s the bank’s money,” says Ace Collateral Management’s executive chairman André Soumah.
But this type of bank behaviour is still hurting the competitiveness of the collateral managers that wish to provide quality services. Drum Risk Management managing director Peter Hopkins tells GTR: “We are striving to offer a top service, and are fighting against other companies providing collateral management which we know is not even stock management, and of course they’re able to undercut us, but that’s where it’s frustrating. And when a loss occurs the whole collateral management sector loses customer trust.”
Locals vs expats
One of the things banks should look at when choosing a collateral manager is its local setup, and particularly whether it uses a local or an expat supervisor on warehouses. “The whole point of collateral management is to be independent from the storage facility, therefore we will not bring in anybody who lives within 50km of the storage facility. The politics and the corruption in most ports anywhere and in particular in the developing world, as well as major factories and storage spaces, is massive. If you employ somebody locally who may already know someone in the storage facility, they won’t be as independent,” adds Hopkins.
Titan’s Oliphant also points out that “the model of using expats ensures that they are not open to local competition or influence from politicians or military or any outside interest, and can also be removed”, but warns that removing the language barrier is paramount if expat supervisors are to gain the trust of their local employees.Among other things banks should consider are whether the supervisor has expertise in collateral management for the specific commodity traded, and whether the firm has good insurance.
One way to ensure a minimum standard in collateral management services would be to introduce guidelines or regulations for the industry, but despite the growth in popularity of these products, there doesn’t seem to be a united effort to do so. “As related to the provision of collateral management services, there are no direct regulations which I am aware of. Indirectly, collateral management is regulated in some African countries,” says Norton Rose’s Meyer.
“The regulators are not looking at bringing in rules for the industry that I’m aware of. The banks could get together and define collateral management transactions. It could be an informal arrangement, or you could have an industry body that meets once a year to agree on what a collateral management transaction consists of. It’s a shame, but if any regulations come into place it will be far down the line,” adds Drum’s Hopkins.
It’s also important to know what body should regulate collateral management, since that body would have to convince the banks that the system is trustworthy. According to Ace’s Soumah, the only bodies that can regulate the industry are countries’ central banks. “Only the central bank can regulate collateral management because you are talking about a financial instrument. A warehouse receipt is not a storage receipt. Most of the warehouse receipts are controlled by the ministry of agriculture or chamber of commerce, but that can’t work. They should be regulated by the ministry of finance through the central bank, because it’s not just a piece of paper, it’s a financial instrument.
“Issuing warehouse receipts is like giving a blank cheque, so there are a lot of opportunities to create fraud if there is no trust. You have to convince the banks that the system is strong enough,” he tells GTR.
Regulations would help the trust issue, with banks being able to refer to a certain minimum standard and having a recourse in case of negligence. But until these come into place, banks’ best bet is to make sure their contract with collateral managers is crystal clear as to what is expected.
“It’s the duty of the bank to pay a lot of attention to the description of scope of work so there’s no confusion as to what we expect the collateral manager to do and not to do. If there have been problems in the past, that is probably where it started,” Citi’s van Broekhoven says.
At Norton Rose, Meyer explains that misunderstandings on the terms of the contract are the most common source of problem. “Collateral management should not be confused with stock monitoring. Collateral management is all about perfecting security, taking delivery of the stock and keeping it on behalf of the bank so that the third party, ie the borrower, cannot access those goods. There is often confusion between the two, and that may cause potential tension in the relationship between the parties,” he points out.
Adapting to the rise of warehouse receipts
While regulations on collateral management per se are still insufficient, governments and multilaterals have been pushing for the creation of a legal framework around the use of warehouse receipts.
Norton Rose director Lodewyk Meyer says: “Regulation of the storage of soft commodities in particular and creating an environment where you can move the risk from physical control to a form of warehouse receipt or certificate which entitles you to access the commodities has been set in motion.
“I’ve had various conversations in African markets, wondering if that may not be the way to regulating the risk to the financial institutions of losing money because of the inability to access stock. As opposed to taking physical control over the stock to mitigate the risk of the borrower not repaying you, you’d rather hold a paper certificate which gives you equal rights. In my view, if there is to be reform, that would be the most appropriate route.”
And contrary to what one may think, widespread use of warehouse receipts would not make collateral management services obsolete: they would just move from constant supervision to regular auditing.
“The implementation of this certificate would create an opportunity for collateral managers to provide a service to whichever the regulatory body is, because they would still need to monitor quality and access. The fact that you’ve transferred the physical risk to a paper risk does not negate the need for quality control, so maybe their role would move from policemen to inspectors,” adds Meyer.
Titan is one company that has already started to provide third-party auditing services for banks that want extra security on their collateral management contracts. The auditing of storage facilities involves full stock audits and quality checks on a quarterly, annual or bi-annual basis, and Duncan Oliphant believes it is the way forward for international collateral managers.
“The evolution of Titan fits in with the increase in demand for collateral management. Because there’s been a bigger demand, the banks have been stretched as far as the services they can expect from collateral managers. Facilities have been bigger and the quality of services is possibly getting smaller. It’s no longer just a scenario of appointing a collateral manager and taking their word for it.”