Posts Tagged ‘trade finance’

Islamic Finance in physical commodities trade

Islamic FinanceCommodity traders increasingly turn to Islamic Finance instruments in search of attractive financing terms, while entities adherent to rules of Islamic Fianance are eager to step in considering a relative shortage of Sharia’s compliant instruments that allow for effective liquidity management. Until present Islamic Finance compliant financial institutions have been employing commodities from the London Metal Exchange to structure short-term funding transactions with much success. Nonetheless this activity seem to not fulfill their ambitions any longer.

Furthermore banks from GCC countries appear to be eager to fill the gap left by some of the European players that decided to limit their exposure to commodity business, due to liquidity constraints (particularly in USD currency terms). This is not an issue that raise concerns of GCC based banks at the moment.

Generally speaking, we could argue that much of initial growth of Islamic finance was fueled by the needs of commodity trade. Particularly to satisfy increased financing needs of oil-importing Islamic countries in 70′s. Nowadays Islamic Finance is  forecasted to reach a size of 2 trillion USD over this year. What position it as one of the most prospective areas of financial industry as a whole. For those who did not manage yet to familiarize themselves with its basic tenets, its main characteristic is that no interest rates can be charged whatsoever nonetheless mark-up’s and shares of borrower’s profit are allowed. There exists a number of standardized products to enable the financing of projects and trade. Some instruments employed are quiet complex examples of financial engineering, combining a number of Sharia’s compliant financial instruments to create a product that provides acceptable risk/return ratios.

Interesting project regarding physical commodities trade is developed within JLT Free Zone in Dubai. The Zone was brought into existence  as a strategic project of Dubai’s government in order to provide the physical market (including trade platforms and storage facilities) and financial cluster  for creation of commodities market place in Dubai.  Despite the fact that The Dubai Multi Commodities Centre is focused on trade of  Gold, Diamonds, Pearls and Tea, more typical commodities for Western based commodities traders as Oil or Copper are also exchanged.  DMCC  provides excellent facilities to track ownership of commodities in question to make sure that a factual sale of assets has occurred. It is important from the view of Islamic Finance principles adherance and from the perspective of people involved in physical trade.

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Physical Traders: Shortly on different types of lending in physical commodity trade

There is as many types of credit analysis, as there are banks. The same relates to credit rationale behind lending in trade finance. The trend has been also emerging since some time already of banks increasingly taking a role as an arranger of financing taking funds effectively from third parties or capital markets. Still, when tackling the question of financing a physical commodity trade we can discern some main approaches relating to the issue of repayment, namely: balance-sheet lending, cashflow lending, asset-backed lending and credit-enhanced lending.

Vast majority of commercial bankers prefers balance-sheet lending approach when assesing a repayment risk. Here a lot depends from dependability of accounting standards in the country in question (commodities trade after all strongly involves dealings with emerging or even frontier markets) and reliability of auditing bodies. However even if both of these factors are acceptable on the grounds mentioned before, financial professionals are aware of the facts that balance sheets are historical documents and that auditor’s judgement might be fallible.

Crudely speaking, the fundamental principle of balance-sheet accounting is that the shareholders funds with everything they can borrow equals liabilities that subsequently uphold the cost of all of the assets of the firm (fixed assets as buildings and mines or the current assets as inventory, receivables and cash in the bank).

As general principle, financiers look at the relationships between certain key items on the balance sheet, to asses if the balance sheet can support current or future levels of debt. Attention is being paid to the ratio of
the shareholders funds (such as equity, reserves/retained profits) and its liabilities, especially the current year portion of debt. There are also other ratios employed, as the quick ratio, leverage ratios, or liquidity ratio.

Banks also look on the valuation of the company’s assets (whether its proper or not), as well as levels of inventory in relation to company’s turnover, so they can see that company’s revenue from trade covers the costs sufficiently to make a profit at the bottom line.

In cashflow lending, financiers strive to identify cashflows of the firm, and then make sure to “put them aside” to get paid before everybody else. If possible even before the costs which company bears. It is a fine approach in commodities business, since certain specialized assets in emerging/frontier markets whose value could have assured an asset-backed lending are difficult to price. Hence in cashflow lending, financial companies seek debtors of company in question or the receivables due from companies of superior credit quality to the borrower. It is also seen as an advantage if they come from developed markets. So here banks secure a cashflow from a purchaser the client is trading. In such situation a creditor gets paid from revenues, not from bottom line profit.

In this scenario the main threat to the lender comes from the borrower’s performance risk. Question is posed, whether the economic activity of borrower will carry on and whether receivables due will keep on flowing. There is also certain structural risk to the creditor depending on how well cashflows coming from sales are going to be secured, so no other creditor may take advantage of them first. Assignment of the export contract is one of the ways, it is being done.

As far as asset-backed lending is concerned it should be to certain degree related to cashflow based lending, with additional physical collateral in place which liquidation should secure a repayment. Therefore the point is to take security over the raw materials and inventory, either in the producing country or offshore. In asset-backed lending a lender controls the collateral. The key issue remains for a lender to perfect his title to the goods. Here it is possible in certain cases to apply a SPV to take debt off the balance sheet. One way or the other in such situations, some banks seek to establish their own collateral management in the field (to dislike of trading houses, who tend to fully rely on their own people/business partners).

The credit-enhanced lending is about someone else possesing a good credit rating guaranteeing all or part of the facility. The role of third party guarantor is often being taken upon by Export Credit Agencies, whose role is becoming increasingly difficult because of pressures from home governments to make money on one hand and to back up trade with the high risk countries characterized by high default ratios in support of political agendas on the other. The credit enhanced lending also includes credit wraps and political risk insurance, where banks and traders decide for a commercial underwriting of the transaction. Naturally it generates further expenses and is possible to implement only when the deal is structured in a way that is acceptable to the underwriter.

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Physical Traders: Trade finance in physical commodities trading, approaching financiers and negotiating better terms

Physical trade 6Realizing how important part trade finance plays in physical commodities trading, I would like to write shortly about the factors banks and financial boutiques pay attention to when financing cross border commodities trade. Knowing the key factors makes it possible to adjust them within the limits of our business according to the expectations of financiers. Here I will start with the basics and in following articles on this blog I will strive to elaborate on more complex issues trade finance is concerned with, such as structured trade and commodity finance.

There is no better argument when negotiating advance financing than a proven track record. What we need to show is that we have done it before. That we have been in business, and that we have a capacity to deliver. How can we do this? Simply by presenting financial track record or our bank statements showing the incoming and outgoing cashflows.

Another important thing when we look for advance financing is to prove to the bank that we are not going out of business any time soon. One of the ways to prove it is to show that we are profitable, that it is not in our interest to back out when they open a Letter of Credit for us. Banks also may want to know about the state of our tax affairs and on how we handle our situation with other suppliers. If everything is in order in these departments, we are in stronger position to negotiate the more advantageous terms.

Presenting a credit history is mainly a significant factor because of the insurance banks seek to apply to such transactions. They can present our credit history to their underwriter and get better terms, what implies better terms for us.

It also works good to start small with our new financial partner, build trust and reliance on smaller trades and slowly proceed towards larger ones. So it is not only about our track record, but a track record with a given financial partner.

If our trade financing relies on existing purchase order, it is beneficial if our buyer is ready to communicate with our financial partner. So the prove of the purchase order is not only a document issued, but that there is a direct assurance from the side of our buyer, even if not contractual one, to perform.

Find out about physical commodities trading companies.

Physical Trader Blog