Commodity Finance and ‘The Gerald Corollary’.

-The merchants and traders have landed on the shores of Lake-Leman since the 14th century, many came, quit or will come, but the Banks will remain.

I became quite interested by the pre-pay and its debt-like risks in 2014 as the traders emerged lending to customers as opposed to arbitrage-flow the commodities.

As commodity traders business started to depart from ‘pure commodity trading desks built on perceived arbitrages to the pre-export financing, lending project financing, structured commodity solutions became de-facto doctrine of commodity trading, the ‘new-cool’.

With the new doctrine, came new risks.

Essentially the traders become a trade & structured finance arm attached to the flow.

1) Who, company, financial situation, KYC ? 2) what risk is the counter party managing and 3) execution & timing….. 4) The constraints for commodities ? If you move ahead further 5) who will be handling collateral management, facility agent ? 6) How do you exercise your titles ? and all areas where newcomers to the business can easily get ripped off.

With the doctrine, came a corollary: positive carry (the income earned on the attached commodity-flow must exceed the funding cost of holding the securities).

Beyond the traditional exposure to price and currency risk, commodity traders become increasingly exposed to:

  • Credit

We are exposed to counterparty credit risk, which is the concern that counterparties might not pay us. Risk can be mitigated by having customers prepay us for product, using letters of credit, buying credit insurance through a third-party insurer, selling the receivables (factor and discounting) but never choosing to give open credit to counterparties.

  • Liquidity, funding risks (the convexity)
  • Negative carry (incoming cashflows that are smaller than the offsetting position obligations).

There are so many trades with irregular cash flows (seasonal as an example). Let’s call it normal-carry.

I happen to know a private who lends to traders. He lends $10M clips at R% with asset backed security….he makes a lot of money and has only had one sideways/bad deal…

The trader appears happy to pay this rate for the “liquidity” that is deployed into commodities…. since avoid the hassle of its existing bank loans. Welcome to the gray zone of the commodity finance.

The trader takes some unsecured risk (credit exposure) because this simple loan with a wrong princess, according to his words, is far less risky than be Long pre-pay arrangement kiss goodbye’.

What are the two things about a trader that should frighten the most a lender ?

-Arguably; not having a risk management in place or an incompetent one because both will open the possibility of protracted financial losses and frauds (or a combination thereof).

Gerald Metals

Epitome of the ruthlessness in commodity trading, the trader advanced nearly $200,000,000 in pre-financing to iron mines in Brazil and Sierra Leone between 2014 and 2015.

Gerald Metals.jpg

Gerald Metals Short Run Marginal Curve & Sunk Costs via jacquessimon506.files.wordpress

  • Not only the CFR price to China plunged but the short run marginal cost curve shifted to the right, (e.g sunk-costs).

.If you think a trader not having a good risk management is scary, try one not fully comprehending their exposure.


Trade cycle accounting

-Jacques S, Structurer

Calgary | Houston | Genève


© 2018 Navigating the Commodity Markets with Freight and Spreads

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