After the collapse of one of the world’s biggest commodity trading corporations, Hin Leong Trading, everyone is questioning what could be happening in the commodity trade finance. While some may look at the downfall of Hin Leong Corporation as an oil issue, there are deeper issues exposed by this crisis other than simply oil. This article will discuss the unseen risks of commodity trade finance.
Forms of trade finance
Trade financing exists in many forms. Companies with stronger balance sheets have access to one of the most secured forms of financing called, the letter of credit (LC). A letter of credit is used in international trade to issue an economic guarantee from a bank to a supplier of goods. The supplier presents trade documents to the bank. Companies sometimes rely on this letter when they don’t have enough financing.
A commodity trader can also open LC through a completely unrelated party at a certain fee. This is what some Chinese oil buyers do in the trade market. Sometimes, a company can leverage the balance sheet of a bigger supplier of commodities through an arrangement called credit sleeve. Because thirst in trade financing is never-ending, companies can still do a lot to survive.
Fault lines of trade finance: how do they assess leverage?
- The use of balance sheets in assessing financial lending
Most companies use balance sheets as a tool to assess financial lending which is not effective because they have proven to be blunt. Banks face the daily challenge of verifying the total amount of money companies take from lenders. Because of this, big banks shun smaller commodity traders and shift to strictly servicing the bigger traders. These bigger companies have bigger balance sheets that attract banks. This leads to over-concentration of liquidity in the hands of a small group of established trading houses who can, in turn, extend credit.
- Monitoring and tracking of inventories
The second fault line comes when monitoring and tracking inventories. Banks rely on Bills of lading as title documents used as a basis of security in the financing of goods. With these documents, commodity traders are allowed to see their goods while pledging proceeds to the banks. In most cases, banks are left holding these documents while the goods are already sold. This system has also proved to be faulty because lenders are not always aware when traders are pledging BLs in the banks. Secondly, goods can still be moved without using the documents. They can be discharged through letters of indemnity (LOI). This happens when the cargo has arrived at the destination before BLs. In this case, the seller compensates the seller for discharging goods to a third party without the correct shipping documents.
This goes further in the oil trade. Here, LOI documents are presented instead of BLs in making LC payments. The problem gets bigger when private equity gets more involved in the trade finance space.
In conclusion, the banks should shift their approach to handling trade finance matters.
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