Warehouse receipt finance: Warehouse Receipts Financing in Asia Singapore, 29-30 November 2001 Warehouse receipt finance: Going beyond the obvious Lamon Rutten Coordinator, commodity marketing, risk management and finance UNCTAD Lamon.Rutten@unctad.org

FINANCIAL INSTITUTION What is “the obvious”? In pre-export finance: Agreement Deposit PRODUCER WAREHOUSE Warehouse receipts Warehouse Receipts Supply agreement Loan FINANCIAL INSTITUTION INTERNATIONAL BUYER Assignment of contracts and payment in escrow account This can be structured as part of a “green clause” L/C. With such L/Cs, a buyer can provide secured credit to a seller for a percentage of the value of the goods to be shipped. The buyer issues an irrevocable L/C with an additional clause which says that payments up to a certain percentage are available to the seller, usually against delivery of warehouse receipts.

Warehouse Trader/Farmer Input provider Financier What is “the obvious”? In input finance: 5. Controlled distribution Warehouse Trader/Farmer 2. Inputs 1. agreement 4. Payment (could be to warehouse) Input provider Financier 3. Payment for inputs In practice, even these “obvious” forms of warehouse receipt finance are not that simple. Legal and regulatory issues, due diligence costs and the difficulty of avoiding fraud discourage many banks from engaging in warehouse receipt finance.

Dealing with the practical problems of the traditional forms of warehouse receipt finance can seem not worth the effort for many banks. But this may well be because they do not look beyond such traditional financing forms. Much more can be done, and new tools to support financing structures are becoming available. Themes: The relevance of warehouse receipt finance - two aspects From “closed” to open forms of warehouse receipt finance Warehouse receipts as a structured financing support Following the commodity flows New instruments

Risk on another party, i.e., warehousing company The relevance of warehouse receipt finance (1): shifting the risk Credit risk on the borrowing company The credit risks of certain clients may be unacceptable to a financier. And these clients may not have sufficient real estate and other “fixed” collateral to provide the financier with comfort. But at the same time, a potential client may be operating a viable business. If he were able to better leverage his own capital, profits could increase. The relation with the financier may result in a win-win situation. But that does not change the basic problem of the financier: the client is not creditworthy. If the client trades in commodities, a solution may well be possible: shift the credit risks away from the client to a third party, a warehousing company. The bank then lends against commodities, not to a commodity firm. Risk on another party, i.e., warehousing company

(e.g., warehouse receipts) The relevance of warehouse receipts (2): The asset conversion cycle Using warehouse receipt finance, the financier can then enter into a longer-term relationship with a client based on his asset-conversion cycle. The “commodities” that the client handles are, in a way, “turned into money”. And for this, they need to pass through a financial transformation - they need to be replaced by “paper” which represents the commodities, in other words, warehouse receipts. Commo- dities Money “Paper” (e.g., warehouse receipts) Compared to traditional finance, this system has a number of major advantages. Among other things, the financing can become revolving; and the size of the financing becomes an automatic function of the value of the commodities and the client’s accounts receivable - important in the commodity sector, where prices are highly volatile.

FINANCIAL INSTITUTION Opening up warehouse receipt finance More than one warehouse More than one borrower “Empowering” of the warehouse PRODUCER WAREHOUSE Incorporation into more comprehensive financing scheme. Loan FINANCIAL INSTITUTION INTERNATIONAL BUYER Semi-automatic credit if certain conditions are met Longer-term, revolving finance More than one financier (competition between financiers)

Warehouse receipts as a financing support - using both future receivables and inventory (1 - coal, Vietnam) Payments made under 5-year supply contract pass through escrow account; approved by Ministry of Finance. Syndicate of banks Vietnam Power Corp. 5-year supply contract, 2 mn tonnes a year, appr. value US$ 36 million Coal in storage (value: US$ 45 mn) Syndication Coal stocks pledged to lenders Singer&Friedlander/ Korea Merchant Banking Corp. Vietnam National Coal Corp. 5-year, 60 million US$ loan; with annual “put option” at the lender’s discretion (lender can force immediate repayment). Priced at LIBOR plus 200 bp. Repayment: annual, 4x8.5 million, and final repayment of 26 million US$. International buyers Payments assigned (with confirmation); annual value around US$ 30 million. Export contracts with major Japanese and Korean buyers.

Warehouse receipts as a financing support - using both future receivables and inventory (2 - fish, West Africa) Lending cash to small, poor fishermen is risky. So instead, an international bank did not provide cash to the processor (for onlending), but diesel oil. This was put in a terminal controlled by a local bank. Individual fishermen had passbooks that allowed them to take diesel oil on credit. Reimbursement was through their sale of fish to the processor. This created a continuously revolving, easily administered credit scheme for the fishermen. The processor reimbursed through assigning a part of its proceeds from overseas fish sales. The fisheries sector is one of the fastest expanding commodity sectors. In this case, a processor knew that if it could expand its supply, it had a ready market. The processor did not have its own fishing fleet, but relied on small fishermen. It found that in order to enable these to catch more fish, it should make it possible for the fishermen to go further offshore, for longer periods. This required fishermen to buy more diesel, for which they did not have the money...

Following the commodity flow: upcountry financing - using the warehouse as financing agent 4. Provides credit 3.Lodges receipts with bank Farmer Bank 1. Deposits products 6. Reimburses credit; in return, bank transfers receipts 5.Signs sales contract 2.Issues receipts Warehouse Government (PMB) 9. Delivers receipt; warehouse makes delivery Trader The“Pepper Storage and Ownership Certificate Scheme”, Pepper Marketing Board, Malaysia. A similar scheme is operated for coconut growers in the Solomon Islands. This can act as a model to reach farmers - who are often willing to pay high interest rates.

Note: there are many risks in this financing. Following the commodity flow: upcountry financing Trade has moved from the ports upcountry, and local marketing is no longer financed through local governments. Warehouse receipts can help banks to follow the traders, upcountry. Local buyer Farmers Inspects goods delivered and agrees to delivery Payment in local currency (by end of day) Bring goods to independent warehouse Local warehouse Local bank warrants Inspection company Confirmation on warrants Note: there are many risks in this financing. inspection International trader International bank Information on shippable size of cocoa stock request

Following the commodity flow: upcountry financing; an example of cocoa financing (1) Situation An international trader approaches his bank with a request to arrange pre-export finance for its cocoa operations in country C. The international trader uses a local trader as main buying agent, and this local trader needs credit. The international trader is unable to provide such pre-export finance itself. The bank considers the use of a pre-payment structure, in which the international trader would on-lend bank funds to the local trader. However, it rejects this approach due to worries about the ability of the local trader to procure the cocoa. Instead, it opts for exploring the possibilities of a warehouse receipt financing. This warehouse receipt financing should make it possible for the local trader to buy up-country, do the local processing of the cocoa, and then deposit it at the export warehouses. How can this be structured? Working through a local bank The international bank has a local bank that it is willing to work with. This local bank can play a crucial monitoring and disbursing role in the financing structure. The local buyer has to pay the farmers and small traders who deliver cocoa on the same day that they deliver it. But he does not have the funds himself to do this, nor easy access to affordable credit. In order to overcome this credit risk, the local bank works with a local warehouse. Farmers and small traders deposit their goods in a warehouse (under supervision of the local buyer, who checks quality). They receive a proof of deposit. By mid-afternoon, the warehouse issues warrants to the bank, which then pays those who have proof of deposit. It could also pay directly to the local buyer who then pays his suppliers, but if it pays directly it can be sure that the suppliers have indeed been paid and thus, avoid later legal problems.

…. an example of cocoa financing (2) Refinancing the local bank The local buyer waits until he has sufficient cocoa available for an export shipment, and then informs the international trader. The trader requests his bank to finance this. The bank seeks confirmation from its local banking partner that it is indeed holding the warrants for the commodities, and obtains independent verification of the quantity and the quality of the goods in stock from an inspection company. If all documents are satisfactory, the international bank provides a credit to the international trader. The trader instructs the bank to disburse these funds to the local buyer, through the local bank (which uses the international funds to offset its local currency exposure, and pays the remainder to the local buyer). Warrants are then swapped for a bill of lading, and shipment is made. The role of the local bank The local bank makes sure that the sellers of the cocoa are paid, avoiding eventual later claims on cocoa stocks. For the same reason, it pre-pays the local warehouse company on behalf of the local buyer, and also pays any other charges that may relate to the cocoa exports. It holds the cocoa warrants, and ensures that all documentation for the export is in order. It also ensures that any transport from the local warehouse to the export warehouse is handled properly. This supervisory role would even be more important if (as is often the case) the commodities need to leave the warehouse for processing. The local bank also provides short-term “packing credit” to the local buyer, enabling him to collect sufficient cocoa for a viable export transaction. As it holds the documents until payment has been made by the overseas bank, it also protects the local buyer from default by foreign traders. The local bank can also handle the exchange rate risk for the local buyer. As the local bank is certain of its ability to obtain hard currency re-financing, it can charge a relatively low rate on its local currency credit. The money lend against the cocoa is a function of the market value of the cocoa - current market prices, corrected for the costs of bringing the goods to the market, and eventual quality discounts.

Even this could be financed through trust receipts Following the commodity flow: processors  Working capital needs for a processor without warehouse receipt finance Raw commodities awaiting processing Commodities in processing pipeline Processed commodities awaiting sale Many companies have a large part of their working capital tied up in stocks of goods - raw materials, inputs, spare parts, goods awaiting shipment. By having an independent collateral manager controlling these goods, the bank can effectively manage the related working capital needs, freeing up the company’s cash.  Working capital needs for a processor with warehouse receipt finance Raw commodities awaiting processing Financed by bank Commodities in processing pipeline Processed commodities awaiting sale Financed by bank Even this could be financed through trust receipts

Following the commodity flow: processors - using trust receipts The procedure to use trust receipts is to enter into an “attornment agreement” with the processor. This works as follows: the processor acknowledges receipt of the goods and the title documents from the bank it recognizes the bank’s security interest in the goods it is receiving it states that it is acting as the bank’s trustee in delivering the final goods to the customer it promises to remit the proceeds from the sale of these goods to the bank in payment of the loan (or to return the goods to the bank, if they remain unsold) it agrees to keep the goods fully insured against all insurable risks. Under the terms of the trust receipt, the borrower acknowledges the lender’s security interest in the goods and acts as the lender’s trustee in delivering the goods to the buyer. The trust receipt, unlike the warehouse receipt, is not a title document, but rather evidence of the lender’s continuing security interest in a title document. Security interests in goods being processed can be difficult for the bank to enforce in a court of law, even with the procedures as described. The commodities go through a physical transformation and/or are mixed with other commodities, so the specific commodities that act as collateral are generally difficult to identify. Therefore, the bank should release goods on a trust receipt only when it has full confidence in the reliability and moral responsibility of the processor. It is thus advisable to employ thrust receipts only for customers with previous smooth dealings.

Following the commodity flow: import financing Working capital needs for an importer without warehouse receipt finance Cereals, sugar, oil products, fertilizer in transit Commodities in central storage Commodities in retail sites Working capital needs for an importer with warehouse receipt finance Cereals, sugar, oil products, fertilizers, spare parts in transit Financed by bank Commodities in central storage Financed by bank Commodities in retail sites Confiscation insurance is available against the risk that the bank is not allowed to export the commodities if they remain unsold, or otherwise is prevented from valorizing the stock.

Following the commodity flow: South-South trade A small number of international collateral management companies offer banks a new possibility for financing part of the commodity chain, from the warehouse at origin (which can be upcountry) to the warehouse at destination. The collateral manager takes possession of the goods at origin, manages their shipment, and then Delivery of commodities Farmer/ exporter Warehouse at origin Finance Bill of Lading Sales contract Bank Shipment Warrant against payment Buyer Warrant Warehouse at destination Release on presentation of warrant controls their storage origin – the goods are only released to the buyer once he has presented the warrant for the goods in store. The collateral manager guarantees the whole chain, thus eliminating of “coverage gaps” that banks run with more traditional forms of financing. While useful for North-South trade, this facility can be of particular use for South-South trade. The arrangement brings collateral management costs, but it can make it possible to avoid the use of letters of credit, and strongly reduces the bank’s credit risks.

New tools for warehouse receipt finance There are new possibilities for banks interested in engaging in warehouse receipt finance: * possibilities for securitization, nationally and in international markets; * newly available insurances and guarantees, from official agencies (e.g., the World Bank’s trade financing facility, or OPIC’s currency inconvertibility coverage) and private insurers (monoliners’ wrapping, multiliners’ performance risk and other guarantees)

Prudential/ Bancomext Securitization: sugar-backed bonds in Mexico Collateral manager Sugar millers Sugar Enabled Mexican sugar millers to raise inventory finance in US capital market - private placement first, by Prudential Securities, then by the government-owned Mexican bank Bancomext. Control Warehouse receipts Warehouses Buys WR for sugar (domestic price) with an agreement with the millers to repurchase them at a later stage Prudential/ Bancomext Buys back the WR Issues unrated short-term (less than one year) securities with the underlying repos and sells them to international investors through an offshore investment fund Repays investors from proceeds of selling back the sugar Institutional investors

Warehouse-backed bonds for sugar financing, Mexico Since the 1994-1995 peso crisis, few Mexican companies had access to international bank loans and capital markets. Sugar companies need much finance. A few already had access to straightforward warehouse receipt financing in dollars, from foreign banks, at an average cost of Libor plus 300-400 basis points, plus warehousing, surveillance and other transaction costs. In 1996, Prudential Securities developed a financing alternative for Mexican sugar mills: Mexican mills, which convert raw cane into refined sugar, could finance production by selling their finished product after harvest time to Prudential, agreeing to buy it back later (this was called a repo-reverse repo scheme). Prudential issues securitized bonds backed by the income stream generated by mill repurchases in the off-season. Risk were mitigated in a number of ways: Price Risk and Exchange Rate Risk * Fina (a Mexican development bank) provided a sovereign guarantee for up to 40% of the domestic value of the purchase (domestic prices were about 30% above world market prices). * Exchange risk was hedged by a daily marked-to-market margin call system based on the domestic price and the dollar price of the sugar. These two variables tended to compensate each other toward the end of the year, when most of the repurchases occurred, as domestic prices rise in the off-season. * The agreement was structured as a margin loan to the millers, who had to put up additional tonnage if the price of sugar fell during the funding period. The securities were supported by 125% over-collateralization. Performance Risk The focal element to the structure was the sugar itself. The fact that its ownership actually passed to Prudential--unlike in standard warehouse financing--meant that negotiations and legal battles for assets were avoided if a mill goes under. Prudential certified participating warehouses itself and contracted out extensive inspections of the sugar. The overall cost of the product was an interest rate of about 11%, including Prudential's fees and commissions and the fees to warehouse inspectors. Companies reported that their all-in cost of funding, including related transaction expenses and the warehousing costs, brings the cost to 13-14%. Some 400 million US$ was placed under this structure. 1999 was the last year that Prudential did this, and in 2000, the scheme was taken over by Bancomext, which successfully continued it.

Insurance for the cover of currency inconvertibility risk Petrobras is Brazil’s state-owned oil company, responsible for the country’s oil exploration and exploitation, and also active in distribution and imports. Petrobras 100% owner PIFCo is a Special Purpose Vehicle, without employees, established in the Cayman Islands in 1997 to facilitate Petrobras’s imports of oil and oil products. It buys from international suppliers, and sells to Petrobras on deferred payment basis. It provides in its financing needs (payment to suppliers now, receipt of money from Petrobras later) by selling notes to institutional investors. Petrobras International Finance Company Ltd. (PIFCo) Bank of New York The Bank of New York is the Trustee, responsible for managing the financial flows of PIFCo. PIFCO sells senior notes Investors buy 450 million US$ worth of 7-year notes. UBS Warburg was “bookrunner”, responsible for the sale. Investors Steadfast provides a political risk insurance guarantee Steadfast Insurance Company Steadfast is a wholly owned subsidiary of Zurich American Insurance Company. It provides insurance against the risk that Petrobras may not be able to convert Brazilian reais into US$.

Conclusion If financiers feel that it is not worth their efforts to learn about warehouse receipt finance, this may well be because they look little further than the traditional form of warehouse receipt finance based on trilateral agreements between a bank, a borrower and a collateral manager. In effect, warehouse receipts can play a crucial role into a wide variety of financing schemes. These may not be easy to structure, but often, can be used for sectors which have little or no access to affordable finance. Hence, banks and other financiers which develop the relevant skills - quite different from those required for relationship banking or balance sheet finance, and closer to investment banking skills - can reap attractive margins.