Questions and Answers

What is meant with “credit support”, and how is it different from “collateral management”?

Credit support is the ability by the credit support agency to understand the entire transaction financed by the bank (or by another party), identifying all the risks associated with this transaction, proposing mitigants for each risk, implementation of some of the mitigants and controlling the entire transaction from end to end from the time when the bank releases funds to the time when the loan is repaid in full.  Credit support is generally provided along the supply chain – it can encompass, for example, a transaction cycle from an upcountry warehouse to the export warehouse, or from one country to another one. 

Collateral management is provided on goods that are in one place (which strictly speaking is a public warehouse; if it is a field warehouse it should be called field warehousing) – it covers the discharging of goods into the warehouse, its actual storage, and the discharge from the warehouse.  Collateral management may mean “lock and key” without taking account of what happens before receipt of the collateral or what happens after release of the collateral.

Public warehouse, field warehouse...  what is the difference?

One can distinguish between three types of warehouses: private warehouses; public warehouses (also called terminal warehouses), and field warehouses.

In a private warehouse, manufacturing and warehousing take place under the same roof.  That is, the primary business of the company controlling the warehouse is not warehousing, but manufacturing, wholesaling or retailing, with the warehouse operated as part of its overall business.  There is therefore a close relationship between the warehouse and the owner of the stored commodities.   In certain countries, these companies are allowed to issue warehouse receipts to evidence the presence of goods in their warehouses, and banks accept these as collateral for loans.  But in practice, it is very risky to use commodities in private warehouses as collateral for loans: the bank simply has no control over the commodities (even if they are present in the warehouse, this constitutes a legal risk in that, in the case of bankruptcy of the borrower, the bank will not be given priority over other creditors).

A public warehouse is normally a large storage area, for example in a port, that serves many businesses.  It is owned (or rented for a long period) operated by a warehouseman, who stores commodities for third parties for a set fee.  The warehouseman does not obtain title to the commodities he stores: he does not own them, but acts as their custodian.   While there are large independent warehousing companies that both own and operate their own warehouses, many public warehouses are operated under long-term contracts by independent operators.  The owner gets a fixed rental fee, the operator earns warehousing and other charges.  Public warehouse operators often offer warehouse receipts that are acceptable as collateral by banks; but whether this is really sound collateral depends on many factors, in particular the legal and regulatory regime in the country, and the status of the warehouse operator.

A field warehouse is an arrangement where a collateral management or credit support company takes over the warehouse of a depositor (producer/customer) by leasing the storage facility (or part of it) for a nominal fee, and becomes responsible for the control of the commodities to be used as collateral (employing its own staff, controlling movements in and out etc.).The warehouse belongs to the firm which wishes to obtain the credit, but control over the warehouse is relinquished to an independent operator.   Field warehouses are on or near the premises of the firm depositing the commodities. This permits the depositor to store his goods on his own premises, without much disruption to his day-to-day business, and still use them as collateral for credit.  The credit support company will issue warehouse receipts which, if a number of conditions are met, will be good collateral from a bank’s perspective.

Do Credit Support Agencies own warehouses?

Generally, they do not.  Credit  Support Agencies normally lease warehouses from their owners, and put their own staff in the warehouse in order to manage it.  This can be a so-called public warehouse, e.g. in a port zone or a major commercial centre, which will be used for a long time and for a variety of depositors;  or a “field warehouse”, which is the warehouse of one trader or processor who temporarily passes on the control over his warehouse to the Credit Support Agency, generally as part of a financing transaction. 

Why would a firm use a specialized Credit Support Agency?

The most immediate reason is that the Credit Support Agency will give its client – a bank or an international supplier – a presence on the ground, in a location where he would normally have difficulties to operate and at an attractive cost.  A North African cement exporter, for example, might be eager to develop the West African market, but unwilling to provide credit lines to any of the local importers or open its own offices and warehouse – a Credit Support Agency can then create for it a Secured Distribution Facility.  Furthermore, the Credit Support Agency provides specialized skills to its clients – on countries, counterparties and commodities.  For example, a bank financing a cocoa trader could put one of its own staff on the ground it the country’s cocoa producing region, and this staff could then proceed to weigh the cocoa entering into the trader’s warehouse – but would this banker recognize sub-standard cocoa or understand the implications of the trader’s storage and transport practices?  And in addition – as just one of the many more reasons to use a Credit Support Agency – the agency is used to work with banks, and has put in place a whole series of measures and risk mitigants to protect the bank’s interests (including its own insurance policies).

Does using a Credit Support Agency not just lead to higher transaction costs?
To perform its duties, a Credit Support Agency needs to put its people on the ground, perform a series of due diligence exercises, and pay its insurance carriers in order to lay off some of its risks.  All this has a cost, which of course has to be borne by the client.  At first sight, this does indeed seem to lead to a higher transaction cost.  However:

How does one distinguish between different Credit Support Agencies?

Banks now commonly recognize the value of credit support.  However, they often leave the negotiations with the Credit Support Agency to their borrower, and borrowers are then often strongly driven by cost alone.  This has lead to a proliferation of so-called credit support companies in many countries – often very small operations set up by former staff of one of the international agencies.  Credit Support Agencies indeed differentiate themselves by cost – but this should not be the sole criteria for clients.  Service level (e.g., actual presence in the warehouse, frequency of reporting), domain expertise (will the agency mobilize staff who are experts on the commodity in question), local knowledge (and the ability to detect possible problems early on and mitigate their effects), and very importantly, the level of financial security provided (local or international guarantees?  Scope and size of insurance coverage?) are all very important. 

There are many service providers who seem to be active in this domain, but under different names –  inspection agencies, warehousing companies, freight forwarders, collateral managers, and finally, Credit Support Agencies.  How are they all different?

In effect, these different providers supply different services.   There is nothing wrong with this, as long as the client understands what he is getting.  A company like ACE actually provides stand-alone inspection, monitoring  or collateral management services (along with many other services), as its clients and a particular transaction may require.

Inspection agencies will inspect the quality, quantity and/or weight of goods, often on demand of a financier.  An inspection certificate is generally a requirement for a Letter of Credit-based transaction.  But this is a certificate established at one moment in time, and the inspection company will not provide any guarantee on the continuing presence of the goods.   Monitoring services are in general provided over longer periods, but again, no guarantee on the continuing presence of the goods is given: the company doing the monitoring just certifies the presence of the goods of the agreed quality.

Warehousing companies may provide warehousing services to third parties.  There are some risks here (what is the security that the company provides against the risk that goods disappear?),  but with a good legal and regulatory framework, a warehouse receipt issued by a reputable warehousing company can be a good collateral for any form of transaction.  If this environment exists, such warehouse receipts (or the corresponding silo receipts or tank receipts for bulk, respectively liquid storage) can be pledged or traded, both by the commercial and the financial community.  In effect, one of ACE’s sister companies, ICX Africa, has developed an electronic trading system for such receipts, actively used for trading grain silo receipts by a large parts of South Africa’s grain and banking community.

Freight forwarders often offer collateral management services as an extension of their logistics operations.  Their open cargo insurance policies often cover such services (but a client is well advised to study the details of the forwarder’s insurance coverage).  The collateral management will be in the forwarder’s own warehouse, and will cease once the commodity leaves his premises.

Collateral managers will provide a range of services, including inspection, monitoring, collateral management, and in certain cases, field warehousing.  But they do so in one location.  Credit support agencies, on the other hand, can secure the goods as they move through a supply chain, even if they are being processed.

What kind of commodities and other goods are acceptable collateral for Credit Support Agencies?
For conventional collateral management goods have to be storable (i.e., not degrade significantly over a period of a few months), standardized and gradable (i.e., one can describe exactly what is being stored), and have a ready market (i.e., the price is known, and in case of a default the bank can easily sell the goods at or near this known price).  Field warehousing is a bit more flexible – e.g., one can have a field warehousing operation in a tomato paste manufacturing plant, where the fresh tomatoes coming in and the tins of tomato paste produced both are acceptable as collateral for a financing.  Credit support is even more flexible – basically, as credit support secures a supply chain, any commodity or good  which, in time, is converted into a predictable minimum amount of money can act as the underlying for a loan; this extends to flows of goods like fruits of flowers, where daily sales may bring variable revenue, but over time one can be quite certain that, as long as production continues and quality targets are met, enough will be earned to reimburse a loan. 

In sum, Credit Support Agencies can help secure credit for storable and for perishable commodities, for goods in warehouses, silos and tanks, and even for commodities like fish, cattle or flowers,  and for manufactured goods like processed food, metal products, pharmaceuticals, mobile phones and cars.

How is the value of the goods under collateral control determined?

The value of the goods under collateral control cannot be the value in the contract between buyer and seller, even though mistakenly, many banks take this to be the value.  Rather, it should be the market value of the goods – the price one can expect to receive when sold within a reasonable time and in a “realistic” location (that is to say, a location to which the financier, with help from the Credit Support Agency, could move the goods in case of a default).   This value is easiest to determine for goods that are already in an approved delivery warehouse of a commodity exchange – and indeed, commodities traded on an exchange are favourite sources of collateral.

But goods that are not (yet) in such warehouses still have a value, and so do goods that are not traded on exchanges.  As it will know how a good’s value is built up when it moves closer to its final market, a Credit Support Agency can help a financier establish a real-time realistic value for the commodities he finances, thus permitting the financier to determine a proper “borrowing base” against which he can set the borrower’s credit line.   For commodities with highly fluctuating prices (e.g., flowers), the credit support operations will be based more on the continuous flow of goods (and thus, continuous earnings flow) into a sales mechanism such as an auction than on the prices per se. 

What transaction volumes are necessary before it starts making economic sense to use a Credit Support Agency?

This varies greatly from commodity to commodity, and from country to country.  There is a fixed cost to establishing a presence in a warehouse, but once a Credit Support Agency is present in a warehouse, variable costs are limited.  This would allow the provision of secured credits even to small farmers – and indeed, this is done by one of ACE’s sister companies, the National Bulk Handling Corporation (NBHC) in India.  NBHC has master agreements with a number of banks under which it acts as the banks’ agent in providing credit to those who deposit commodities into its warehouses.  It accepts the deposit of even one bag of commodities, and will, on request of the depositor, arrange a credit line using this deposit as a guarantee – and within two days, without even having entered a bank office, the depositor will receive his credit.  Minimum limits to this form of warehouse receipt finance are more likely to come from banks than from a Credit Support Agency: many banks do not have efficient commodity financing systems, and require a fairly large transaction size to make a deal worthwhile. 

More in general, a Credit Support Agency’s services normally make financial sense to the large majority of commercial traders, formal sector processors and banks.  Only very large traders (of which there are only a handful) with very easy access to international credit lines may see little benefit in using credit support; and even in their case, the 2008 situation of high commodity prices is changing the picture as their credit lines are becoming tight while the off-balance sheet structures which ACE can arrange for them allow them to free up some of their capital. 

Are credit support services at all relevant for farmers?

Yes.  In developed countries, cooperatives regularly use them.  One United States cooperative has even done a US$ 200 million securitization on the basis of grains in independently controlled silos.  In developing countries, the farmers’ ability to use credit support services depends on their own organization (cooperatives will easily be able to reap benefits, for individual farmers it can be more difficult) and on the focus of the credit support agencies active in the country.  But indications are that when an effort is made to reach small farmers (i.e., when a development agency supports the activities of a professional credit support agency in this domain), they can benefit greatly.  For example, farmers participating in a warehouse receipt credit programme implemented by a United States Non-Governmental Organization, TechnoServe,  in Ghana's Brong Ahafo Region in the 1990s were able to increase, over four years, their profit on grain sales by an average of 66 percent per annum. This was despite the fact that only local bank finance (at 42% interest rates) was used.   

If Credit Support is so useful, why is it not used commonly in developed markets?

In the late 19th and early 20th century, warehouse receipt finance played a major role in enabling the development of United States agriculture.  The Federal government recognized the importance of this financing tool, and boosted the ability of local banks to lend to the agricultural sector by opening a special discount window for loans by warehouse receipts.   There were similar financing systems, with government support, in Europe.  But in the course of the 1920s and 1930s, financial reporting improved with the development of credit bureaus like Dun & Bradsheet and of rating agencies, and with a better organized accountancy, auditing, tax and legal system.  It thus became much easier for banks to judge companies on the basis of their balance sheets and track records, and much easier to pursue reluctant creditors.  

So in the course of the 20th century, the use of warehouse receipt finance declined much in importance in western countries.  Nevertheless, credit support remained important for certain companies – for example, those with highly seasonal working capital needs, or in financial distress.  

Should one not first create a proper legal system before a Credit Support Agency can become active?  If not, what can be the worth of any contract, receipt or other piece of paper?

Credit Support Agencies build solutions that provide risk management within the specific conditions of a particular country or a particular commodity sector.  If there is a good legal and regulatory environment and contracts can easily be enforced, then the credit support solution can be an easy one.   If such conditions do not exist, and worse, there is political instability, then a sound credit support solution may still be possible, but it will be more complex and more expensive.  For example, the solution may require a continuous presence by the Credit Support Agency on the ground , the acceptance of the contract parties of an international arbitrage procedure, and a deal structure that relies on frequent turnover of the stocks (i.e., short transaction cycles within a longer-term loan structure) rather than control over the stocks alone.  Complex situations also require a more intensive due diligence process, including for understanding the long-term interests of the local counterparty in continuing the commercial relationship with its supplier.  

ACE’s international experience puts it in a strong position to assist governments in the development of better legal, regulatory and policy systems with respect to field warehousing and collateral management.  However, practice shows that such reforms tend to be slow processes.  Commercial realities are often such that it makes no sense to wait for an optimal situation to be reached before looking for practical solutions to immediate problems.

Some Credit Support Agencies seem to operate in very risky countries.  How is this possible?

Credit Support Agencies, with their strong ability in risk management, can provide a lot of value to the commodity sector and banks for operations in conflict countries.  Among other things, commodity import and export flows are often of critical value to the country, and are likely to continue in spite of the many obstacles that are in place.  True, complex situations require an alert Credit Support Agency which will react fast and appropriately to changing conditions.  One of ACE’s competitors was once confronted with a small problem in its rubber warehouse, which happened to be near what then was a war zone in Liberia: a mortar shell had landed between the rubber that was ready to be exported, but had not exploded.  The company flew in a demining expert who defused the problem, and the financing transaction could continue revolving as it had before.  A good Credit Support Agency knows it has to be ready for any eventuality. 

Does Basel 2 recognize the operations of Credit Support Agencies?

Basel 2 makes special provision for commodity financings in which risk management is outsourced to specialized agencies.  Such financings will be subject to much lower provisioning requirements, if certain conditions are met.  This will result in much lower costs of capital for the bank and therefore, considerably more efficient use of its capital.

Is a Credit Support Agency useful when one uses Letters of Credit (L/Cs)?

Letters of Credit are a relatively expensive tool, and moreover, leave both buyers and sellers  exposed to considerable risk (for example, the seller may obtain falsified documents under which payments will still be executed; and the buyer may find some reason to refuse delivery when market prices have fallen since the signature of the contract).  The use of a credit support agency can avoid this kind of risk in a trade transaction, and moreover, do so at a cost considerably less than that of opening a L/C. 

Nevertheless, there are also some forms of L/Cs which make use of, in particular, warehouse receipts.  With “Green clause” L/C’s, 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 (which can be for commodities that are still up-country).

Depending on the transaction L/Cs may also be used to conclude the work of credit support agency. Taking an example of an export transaction where a bank is to finance an exporter, the bank will require an L/C opened by the buyer to protect itself against payment risk. This does not protect the bank against performance risk as the L/C is only functional if the goods are delivered in accordance with the terms and conditions and documents evidencing such delivery are presented on time. The financing bank will therefore require the services of credit support agency to ensure that the exporter has goods that meets the requirement of the buyer and will be able to meet all the conditions of the L/C, only then the bank will finance.

We hear a lot about the global food crisis and increasing food prices.  How can Credit Support Agencies help resolve this crisis?

Credit support agencies smooth transaction flows.  If food prices increase, traders or buyers may no longer be able to access sufficient finance to afford their usual cargo sizes (banks’ credit limits are expressed in nominal amounts).  The involvement of a credit support agency will permit the trader or buyer to increase his credit lines and maintain normal trade flows.

Moreover, in the case of ACE, it has used the expertise built up in managing the credit risks of trade transactions to move upstream, in order to secure contract farming operations.  With ACE’s support, investors can fund such operations much more easily and at much lower risk, making many new food production projects possible, both for exports and for import substitution.