Commodities are generally agricultural products, energy, and precious metals mass-produced and delivered in bulk quantities. Usually, the place of a commodity’s production is different from its place of consumption.
Commodity trade finance aims to bridge gaps between the two destinations.
Commodity trade finance is a part of the broader framework of commodity finance that covers the entire value chain from production to trade. The trade financing aspect focuses only on the supplier-buyer equation.
What is Commodity-Based Finance?
Commodity-based finance involves financing the end-to-end trade of commodities, which includes working with an array of stakeholders-- producers, traders, organizations, and companies or professionals. This financing type offers financial assistance for the entire commodity chain.
The risks associated with commodities like low margins, price volatility, and transactional risks underline the importance of learning about commodity finance.
In some cases, organizations may work with other companies, providing expertise in commodity finance. It can help improve profit margins and tackle volatility problems in the commodity market.
What is the Meaning of Commodity Trade Finance?
Commodity trade finance is a subset of commodity finance (This financing type offers financial assistance for the entire commodity chain). It is more focused on addressing problems related to handling goods and supporting their physical trade process.
Commodity trade finance is often structured as a revolving credit facility, which provides businesses with a line of credit that can be drawn upon as needed. The funds provided by commodity trade finance can be used to cover a variety of costs associated with commodity trading, including the cost of purchasing the commodities, the cost of transporting the commodities, and the cost of storing the commodities.
One of the key features of commodity trade finance is that it is typically secured by the underlying commodity. This means that the commodity itself serves as collateral for the financing, which can help businesses obtain more favorable financing terms.
Overall, commodity trade finance is an important tool for businesses that trade in commodities, as it provides them with the necessary funding to complete trades and manage their cash flow. By providing businesses with access to capital, commodity trade finance can help facilitate trade and support economic growth in commodity-dependent regions.
The primary entities involved in commodity trade finance are:-
Primary processors: These professionals require short-term financing for their business operations.
Traders: They will need short-term financing for 30 to 180 days.
Producers: The producers usually need long-term financing to finance their fixed asset development. Here, the repayment will depend on the cash flow.
What is Structured Commodity Trade Finance?
Structured commodity trade finance is a subcategory of commodity finance where the primary objective is to reduce financial risks. It also involves financing cross-border commodity processes, where traders and producers handle the commodities.
Also called structured commodity financing, this finance mechanism covers multiple methods for the traders and producers involved, which include:-
- Warehouse financing
- Revolving credit facilities
- Pre-export finance
- Borrowing base facilities
This financing method can also be considered a form of lending where a bilateral loan will not suffice. Structured commodity transactions aim to improve trade security and make lending more convenient for the parties involved.
The producers receive financial assistance from structured commodity financing for excellent cash flow. It helps them maximize output and allows them to repay loans.
Traders use structured commodity financing to reduce risks and limit exposure to a particular commodity or country while doing business.
The mechanism helps them handle risks associated with commodity prices, supply, and demand.
Lenders can help producers find new markets and get interests on their loans.
How does Commodity Trade Finance Work?
Commodity trade finance provides financial assistance to the trader, from purchasing the commodities to selling the finished goods. The application of the economic structures will depend on factors like the borrower's financial condition and commodity flow type.
Here are some common financial structures involved in commodity trade finance:-
The trader and the supplier agree to purchase a commodity, which the trader sells to the buyer. Later on, the trader can visit a bank and ask for financial assistance for the purchase.
The trader must submit proper evidence and necessary documents to explain the import or export of commodities, after which the bank will offer financial support.
A borrower might ask for financial aid from another party for conducting business. In these cases, the borrower's financial condition and reputation are critical. The financier will consider the borrower's historical track record of handling finances. They will provide the capital once they trust the borrower to pay the entire amount later.
These financial structures enable banks to provide financial support against a pool of working capital assets like future receivables or inventory. These assets will work as a security and be valued periodically- weekly, monthly, or fortnightly.
The borrower must regularly and accurately report to the financier in this process. This is because the financier might conduct verifications and checks on the said assets.
Commodity Trade Finance at Crossroads
Fraud and fluctuating commodity prices have affected the commodity trade finance sector in the past few years.
This has put financial institutions and trading firms in a dilemma- whether to invest in commodity finance. Many commodity traders went bankrupt and were accused of fraud.
That's why prominent commodity finance experts and banks have reassessed their trading strategies and reduced aggressive lending practices.
They are also revising their business models and optimizing their business targets to avert heavy financial losses.
FAQs On Commodity Trade Finance
What are the Types of Trade Finance?
The types of trade finance products are different from traditional products and include:-
Trade credit: An agreement between the seller and the buyer where the buyer has to pay for the goods within two-three months of shipping. Term loan: Here, the borrowed amount needs to be paid back in installments within 10 years at a specific interest rate.
PO finance: After receiving a purchase order (PO) from a customer, the finance company can pay their supplier directly. They can then get the payment back from the buyer.
Receivables discounting: Borrowers can sell financial documents like bills and invoices at discounted prices and receive payment.
What is Global Commodity Finance?
Global commodity finance involves all the mechanisms and activities associated with international commodity flows. It is also a type of trade finance category split into energy, soft commodities, mining, and metals.
It involves traders, commodity producers, borrowers, and lenders who develop and sell commodities. In addition, it can also help the associated professionals to re-sell an item and gain profit.
How do Banks Trade Commodities?
Banks have excellent financial capacity and experience to handle market risks. So, they also represent other commodity sector players who handle logistics and commodity production operations.
Banks provide futures on currency exchange rates that help companies secure their finances in the international market. In addition, banks also work as the counter-party for companies and traders using derivatives, which also helps in effectively using swaps.
What is a Trade Finance Fund?
A trade finance fund represents a company's financial instrument to handle its international trade practices. Usually, trade finance practices assist companies in obtaining financial support. Companies may also receive cash payments depending on the accounts receivables. This financing strategy works best for companies with local and global customers.
The main objective of trade finance funds is to reduce payment risks by introducing a third party within the transactions.
What is Supply Chain Finance?
Supply chain finance is also known as reverse factoring. It is a set of strategies for optimizing financial expenses and improving business performance for sellers and buyers. These strategies work well if the buyer's credit rating is better than the seller's.
It allows the buyer to access the capital at a lower price. Moreover, it enables buyers to negotiate effectively and enjoy extended payment periods with lower expenses. These strategies benefit companies operating in automobiles, manufacturing, retail, and electronics.
How is commodity trade finance different from other types of trade finance?
Commodity trade finance is specific to the trade of commodities, while other types of trade finance may be used for a broader range of goods and services. Additionally, because commodity trade finance is often secured by the underlying commodity, it can provide businesses with more favorable financing terms than other types of trade finance.
What are the risks associated with commodity trade finance?
Commodity trade finance can be subject to a variety of risks, including commodity price volatility, political and regulatory risks, and counterparty risks. To manage these risks, businesses that use commodity trade finance may engage in risk management strategies, such as hedging and insurance.