Basel III brings new requirements on the provision of commodity trade finance, including collateralised lending. By adopting the latest technologies, banks can meet the new rules – and potentially benefit from preferential capital treatment too. Liz Salecka reports.


For banks involved in commodity trade finance, Basel III brings a number of tougher regulatory requirements, ranging from the need to hold back more capital to improved operational risk management.

Moreover, rules governing collateral-backed deals have been tightened up, with a much greater onus now being placed on banks to demonstrate that they have a legal stake in the collateral being financed and that it is under their control and being effectively monitored.

This has given rise to increased interest in, and use of, collateral management technologies by banks seeking to prove that they are on top of the job.

“In commodity trade finance, being able to access transactional information on commodities being financed and conduct collateral monitoring on an ongoing basis is key, and this has not proved a problem in the past. What is different now with Basel III is that it is unacceptable if that information is not transparent – nor auditable,” explains Aidan Appelgarth, global head of commodity structured trade finance operations and risk at HSBC.

“In the past, commodity trade banks have used Excel spreadsheets, but now collateral management technologies are replacing them, and this is being driven by a real need created by Basel III,” he adds.

“The use of spreadsheets creates a plethora of operational risks. However, a technologically-advanced platform mitigates these risks while at the same time providing scalability as well as transparency,” adds Albert Hofman, head of alternative commodity solutions at risk and collateral management software company Triquesta. “Efficient risk management goes hand in hand with technology – spreadsheets do not meet risk managers’ and regulators’ current and future demands.”

Meanwhile, at MIT SA, a Swiss-based software house specialising in trade finance solutions, Jean-Luc Spinardi, director and head of sales and marketing, explains that Basel III has put an accent on three different pillars of collateral monitoring: organisation, staff and operations.

“A bank needs to put in place the appropriate organisation to allow the accurate monitoring of collateral using proven processes, and the use of automated processes is a key point in this area,” he says. The requirements also call for the creation of a specific collateral management department as well as the need to ensure sufficient staffing levels. “When it comes to operations, a system based on data integrity has to be put in place to allow powerful risk reporting, the goal being to perform effective risk assessment and, at a later stage, to allow the extraction of historical database figures.”

The benefits

The use of collateral management technologies is expected to play a big role in helping banks verify their controlling interest in underlying collateral to regulators, as well as demonstrate that they have precise, effective collateral monitoring processes in place.

As collateral management solutions can capture and hold details on banks’ ownership stakes in collateral, it can help them to certify their legal recourse to the assets being financed. In the event of counterparty default, this guarantee can also enable banks to sell the underlying assets quickly and, therefore, secure a higher recovery rate.

They also offer enhanced monitoring of collateral in areas such as pricing through the provision of daily and intra-day market feeds.

“Prices can fall in just one day – and the bank may need to take action,” says Luke Nestor, CEO of collateral management software company Rockall Technologies. “Commodities can be subject to a lot of volatility in terms of pricing, and this is a big concern for regulators today.”

He adds that as commodities are priced in a variety of currencies, their value is also impacted by adverse currency fluctuations, and this calls for a system which enables real-time monitoring of exchange rates too.

Meanwhile, Spinardi at MIT points out that commodity valuation can prove complicated because of the different pricing formulas used.

“There may be a mix of different price formulas that can be applied to the valuation of a certain type of collateral including fixed pricing, floating pricing, multi-commodity pricing and hedging. A bank has to take all these parameters into account to evaluate the collateral used to back a financing and ensure the most relevant and consistent valuation,” he says. “It is very important for a bank to be able to explain the methodology they have used for the valuation, to justify the integrity of the data used, and ensure frequency of valuations.”

Banks involved in commodity trade finance also need to be able to ascertain where the collateral they are financing is located at any one point in time, be it in a warehouse, at a port or in transit, as this affects the degree of risk to which they are exposed.

“There is always the logistics side of things to consider,” says Robert De Picciotto, board member at Brady, which offers trading and risk management solutions to the commodity and energy markets. “If a bank knows that the goods it has a pledge on are in a warehouse, then it will have a level of control, but they could be in transit at sea. This brings a different type of risk, which also varies depending on where the ship is.”

“Timing is very important in this area as during any one financing the very same goods will fall into different risk categories,” adds Spinardi. “For example, goods may be pre-financed by a bank, meaning that performance risk, among other risk, needs to be accounted for until the goods are stored or shipped on a vessel.”

Collateral management technologies can also help banks ensure that the limits they have set for collateral financings are not exceeded. Limits are typically applied to:

  • Type of collateral – banks place limits on the extent of their exposures to certain types of collateral;
  • Geographies – banks need a global view of their business to ensure limits are not exceeded for particular geographies;
  • Type of organisation – limits are applied on exposures to certain business sectors;
  • Individual clients and their subsidiaries.

Technological enhancements

Today collateral management technologies are being enhanced on an ongoing basis to meet growing requirements for additional features and, in particular, demand for greater integration with both internal and external systems.

“One of the key things banks are now looking to achieve is improved integration with their own systems so that data can be fed from one system to another,” says Rockall’s Nestor.

HSBC’s Appelgarth adds: “Collateral management technologies should be fully integrated with banks’ core systems to ensure they are auditable and regulators can run checks. Any risk control measures implemented outside a bank’s core systems will not provide the level of transparency required.”

Greater integration with the external systems of relevant third parties is also being sought.

Here, Spinardi explains that MIT has developed its trade risk active control (TRAC) collateral management system to enable banks to centralise varied data from third-party providers such as collateral management companies, pricing providers, brokers, vessel information providers and port authority information providers. “The technology enables all this data to be fed into one collateral management system to provide the bank with a clear picture of the circumstances of a transaction at any one point in time for risk assessment purposes,” he says.

Rockall Technologies too has developed a methodology it can deploy to provide banks with data feeds from collateral management companies. “Banks now want to be able receive feeds from the collateral management companies they are using on inventory held, warehouse receipts and suchlike,” adds Nestor.

Meanwhile, De Picciotto notes that there is scope for even further integration with other external systems: “One of the biggest needs today is for greater integration with external sources such as the systems used by companies responsible for certifying goods and documents,” he says. “A lot of work can still be done in the area of document management and the transfer of documents such as letters of credit and associated papers. Solutions exist in these areas, such as Bolero, but as of yet there is no real integration with them.”

Finding the right solution

To date, global banks with commodity trade finance businesses have taken the lead in the use of collateral management solutions.

HSBC, for example, commenced implementation of a collateral management technology in 2011, which is based on a third-party provider’s software. The solution, which was trialed in the first quarter of 2012, is now in “live production” at a number of key sites and being further rolled out.

“We worked with the technology solutions provider to modify and tailor their product to our specific business needs,” says Appelgarth. RBS, meanwhile, has been using a collateral management technology, built using third-party software and in-house solutions and expertise, for a number of years.

“Banks need to be using the latest technologies to minimise risks and enhance reporting. One important question they must ask now is whether they should build this type of solution in-house or use a third-party provider solution,” says Anand Pande, global head of trade at RBS. “Either way, they can no longer depend on spreadsheets because of the risk of manual error.”

At Brady, De Picciotto acknowledges that some of the largest banks, including BNP Paribas, have developed their own collateral management technologies.

However, he also notes that most smaller banks are still investing in third-party solutions that they can tailor to their own requirements. Whatever happens in the future, the options open to banks looking to invest in collateral management solutions are growing.

“The collateral management technology market has now become much broader, and more technology providers are now offering solutions,” concludes Appelgarth. “It is prudent to have a collateral management solution in place, which is auditable and brings automation.”

Mitigating Basel III’s capital impact

Although commodity trade finance often represents a relatively smaller component of many banks’ lending business, this too has been stung by the increased capital requirements of Basel III.

“Basel III will add 2.5 to 7.5% to capital costs for all types of trade finance and other loans, depending on buffers, surcharges and the systemic importance of the bank. This means that for risk assets the capital requirement will now be 10.5 to 15.5%,” explains Pande at RBS.

“In commodity trade finance, a lot of lines are uncommitted, and clients can draw on them, depending on trade flows. There will now be a cost of capital for any unused lines so it is likely that banks will seek to minimise their availability.”

However, despite this, regulators have allowed some leeway for banks involved in commodity trade finance, which take a charge on the collateral they are financing.

If they can prove that this ownership stake will result in a lower loss level default (the loss experienced if a counterparty defaults), they may see their capital requirements cut.

“To ensure the effective stewardship of capital, commodity trade finance businesses are looking at their trade flows and ways to transactionalise them. By taking a collateral interest in commodities they are financing, they can reduce the risk profile and, therefore, the capital required,” explains HSBC’s Appelgarth.

“In commodity trade finance, banks can go to regulators and show them that in a loss scenario, they have a charge on collateral which has value and, therefore, the loss given default on this business will be lower,” explains Pande. Where there is a lower loss given default, the capital requirement should come down.

However, having an ownership stake in the collateral being financed is not enough. Banks must now be able to verify their legal recourse to the underlying assets to regulators and prove that the business has a lower loss given default – and this is where collateral management technologies come into the picture.

“By using a collateral management solution, banks benefit from a showcase they can use to demonstrate lower loss given defaults when asking for preferential treatment under Basel III,” says Pande. Banks need to look at historical data and prove that losses against such transactions are lower.

“Regulators are also asking for additional data points to show that a bank does have a charge on the collateral and that it has good control over, and is monitoring, that collateral.”

The improved capital efficiency of collateralised lending, which is supported by the latest collateral management technologies, is also expected to help commodity trade finance departments compete more effectively for funding against other bank departments.

“Basel III has brought a renewed focus on the capital underpinning all of a bank’s businesses and commodity trade finance must be able to hold its own ground when competing for capital against other lending businesses,” says Appelgarth.