As with any service industry, the evolution of collateral management is closely dependent on events and tendencies in the markets where it operates, more so perhaps than on its own competitive dynamics.
As such, a reflection upon developments, trends and perspectives in the collateral management business can usefully start by applying itself to the current context of trade and commodity finance.
This is particularly true of recent times, when the past 12 months or so have brought about momentous changes, of significant consequences.
We are reminded daily by media headlines of the broad-based rally in commodities, particularly in the food and energy sectors. The rice market has been the latest victim of a panic attack, up 140% year-on-year, while crude oil flirts with US$120/barrel, almost double its year-ago price. Metals values have also extended their upsurge, or stayed at or returned to high levels.
This means that producers, traders and end-users of most commodities need 50-70% more credit to finance the same trade volumes, measured in volumes, as they did a year ago (and a multiple of their earlier, pre-2006, rally requirements). This is of course compounded by volume growth.
With some exceptions, balance sheets have not improved proportionately, leaving companies and financiers looking for security to match these increased working capital needs.
Less widely discussed is the impact of high volatility for commodity companies. Hedging, while prudent by essence, now exposes all players to huge margin calls as prices gyrate wildly. Treasury management has become a critical challenge as a result. Also, cash markets sometimes divorce themselves from speculative interest-fuelled futures exchanges prices, heightening basis risks.
Legislative and regulatory environment
Food inflation has led governments in several exporting countries to restrict or tax overseas sales, allegedly to contain domestic prices or to prevent excessive exports from leading to a depletion of supplies needed at home. Regardless of your view on the wisdom of such policies, it is indisputable that the uncertainties which they create in the market place can only worsen the risk profile of commodities trading.
Other events have been more positive for the trade, such as the passing of new securities and property laws in China, and in Brazil the clarification of key implementation provisions regarding warrants legislation, as well as the liberalisation of the reinsurance market.
Here again headlines tell us the story: financial institutions have had to restore capital lost in the sub-prime storm, by the billions. The allocation of this precious resource is ever more selective and, as a result, Basel II-compliant tools to reduce capital allotment to transactions are the object of renewed interest. Also, the risk profile of commodities firms has been negatively impacted by the balance sheet mismatch, prices volatility and political uncertainties discussed above.
Already buoyed by the advent of the Basel II age, demand for collateral management services has been further boosted by these developments.
Banks are taking a new look at existing clients in terms of their risk profiles, and often introduce new third party controls over existing transactions. Evidently, the above holds even truer where increases in credit lines are requested to accommodate higher prices and/or volume growth.
Stocks held at origins pending the lifting of export restrictions (or just to secure supplies in these times of scarcity) have also created additional requirements for collateral management.
This increased demand has not been undiscerning however, and finance providers remain very exacting in their selection of collateral managers in terms of financial and operational reliability and track record, leading to some degree of consolidation within service providers.
A new mix of clients
Other interesting developments in the market include some shifts in the make-up of the clientele:
Some of the traditional banking players have had to downright reduce exposures due to tighter lending policies, or at least to decline increasing exposures. To fill the void, and also as spreads in general have started to inch up, we have witnessed a return en force of investment funds specialised in trade finance, particularly in Latin America. As commodity trade finance funds have relatively high returns targets for their shareholders, they are usually priced out the market when spreads narrow below certain levels.
Traditionally, such funds use collateral management services as part of their security package, so this trend has contributed to increased demand. As befits largely unregulated institutions, the funds" approach is highly pragmatic.
Should the entrance of investment funds in downright ownership of physical commodities assets confirm itself, it is hard to see how it will happen without these investors somehow partnering with collateral managers.
I have alluded above to the strains on treasury management imposed onto commodities firms by recent volatility. This is no small matter. A perfectly well risk-managed outfit can be brought down by margin calls sucking out its liquidity, and CFOs’ are acutely aware of that danger.
As a consequence, we have seen medium-sized and even large international trading firms newly looking at collateral management as a way to remove inventory financing from their balance sheets into non-recourse structures, and save precious liquidity and corporate credit lines for a rainy day. This also constitutes new demand for the services.
Lastly, of note is the increased usage of collateral management techniques by local banks in emerging markets, in places such as China, the CIS, the Middle East or Brazil.
By and large, these banks" exposures to the consequences of the sub-prime crises have been small, and they are looking at the potentially reduced capacity of an international institution to provide trade finance as an opportunity.
Sometimes due to the entrance of a foreign shareholder in their capital (often linked to management know-how transfers), and also possibly as a result of Basel II, large emerging markets banks now have a more sophisticated approach to risk, which leads them to using collateral management services in that process.
Structure of the services and outlook
I have for some time advocated that collateral management has a much broader scope than the inventory custody and warehouse receipt issuing with which it has long been narrowly associated.
This is being increasingly realised, and new practices are emerging as ever more knowledgeable pre-closing discussions take place among all parties.
Entrusting pledged stocks to an independent and reliable third party is of course a key element of the security brought to transactions, wherever possible. But collateral managers can also greatly help by providing, in Basel II terms, "knowledge of the trade process" throughout the life of the transaction, including when goods are not yet, or no longer, in storage.
One example is CPR-based financing in Brazil. A CPR [cédula do produtor rural] is a legislated commitment, pledged to the financier, to deliver a defined quantity of a future crop (to which the financier holds title as per the CPR pledge) to a given location. Common sense and experience tell us that maximum risk is at harvest time, when goods are no longer rooted in the soil, but not yet safely covered by a collateral manager’s warehouse receipt. Yet, such risk can be managed. The collateral manager’s function, here, is to maintain a constant presence in the field and alert the financier immediately of any diversion. If, and this is essential, the CPR, pledge, registration documentation has been properly drawn, and the financier is ready and equipped to act quickly at local courts levels, since the CPR is a title document that follows the goods, the lender can usually recover them from the storage facility where they have been diverted.
Another example, this time when financing imported inventories, is the control of documents, by the collateral manager on behalf of the financier, where regulations prohibit the collateral manager to lease the warehouse (as is frequently the case under custom bonds for instance). Shipping and other documents needed to clear customs or pass through a port gate can be usefully retained and gradually released together with the goods, and, together with close monitoring of the stocks by the collateral manager, provide fairly good security.
Other examples abound. The point is that well-crafted monitoring mechanisms coupled with strong documentation and the ability to act locally (directly or through a third party) can provide fairly strong security over the goods even when they are outside the direct legal control of the collateral manager.
A few key issues need to be looked at carefully in such contexts:
- International trading companies
- Local banks
- A reasonably functional legal framework and system. In this respect, the evolution noted earlier here with regards to China and Brazil are key developments, together with the reported improvement of the situation in terms of enforcement of rights, in particular in China.
- Advance preparations: these structures demand a careful analysis of the whole process of the transaction, based on intimate knowledge (usually through the collateral manager), resulting in comprehensive, while pragmatic monitoring and collateral management documentation between all parties.
- Perfected pledge and other documentation. All efforts will have been in vain if a petition fails in the local courts due to faulty documentation. A knowledgeable local lawyer and strict follow-up of execution are essential.
- Insurance, with adequate risks cover and assignment/loss payee agreements. This still is often too superficially examined by financiers.
- Ability to act locally: speed is essential, as is local readiness to act. In this respect, I would anticipate that collateral managers will need to complete their offering with some degree of back office function, especially in cross-border finance. The challenge will be to deal with liability issues.
Each of these functions present different characteristics, in particular in terms of recourse. The pledge documentation, if well-drafted, empowers the financier to exercise such recourse, not the collateral manager. It is therefore my view that the current tendency to draft clear and separate monitoring and collateral management agreements, as well as insurance policies, is the most conducive to a swift enforcement of the lenders’s rights where it matters (possibly with the collateral manager’s assistance) when things go wrong.
The bundling of such functions under a vague cover-all agreement is in my opinion a totally outdated and low clarity model, which carries a high risk of failure in terms of eventual enforcement of rights as the lines of recourse become blurred.
The recent months have brought formidable changes in the market-place, and collateral management has not escaped the need to adapt and evolve accordingly. It will have to continue to do so, in a cooperative way with all stake-holders, as there is little doubt that it will remain an item of growing importance in trade and commodity finance.
Matthieu Delorme has spent his professional life working in the international commerce of commodities. He has held various trading and management positions in Latin America, Asia and Europe, with leading trading firms, and since 2002 as vice-president, commercial, at Cotecna Inspection Services.