This issue of Finance and Markets Global Insight reflects the ongoing evolution of global financial markets as financers and businesses continue to grapple with the two key themes of innovation and regulation. There’s discussion on the implantation of the revised regulatory framework for derivatives and securitization, as structurers deal with variation margin implantation, and debate around Article 17 of the Securitization Regulation concerning the exclusion of self-certified mortgages. We see how the Nordics are implanting PSD 2 and look at European Central Bank guidance to banks on dealing with non-performing loans. We also weigh up the booming initial coin offerings market, and consider the European Commission’s consultation on the impact of FinTech and its role in driving a more competitive and innovative European financial sector. This issue also reports on a new set of framework principles for social bonds to encourage interest in environmental, social and ethically sound investments, the European Union’s plan for retail financial services and the FX Global Code. It also brings a US perspective on the risks inherent in trade and commodity finance.

In brief…

Wild fluctuations in commodity prices can pose challenges but also provide opportunities for intrepid financiers. Loans, letters of credit, factoring, credit insurance, pre-export financing and prepayment arrangements are common trade finance products. While a broad array of credit products exist to facilitate trade finance transactions, lenders should be aware of the unique risks inherent in these deals. Although each structure carries risks, these issues can be amplified if the transaction is secured either directly or indirectly by commodities. From diligence to documentation, however, there are tools that creditors can use to minimize losses and write-offs.

Addressing legal and compliance risks

Offshore legal risks in trade financing arise from the creation and perfection of foreign security, compliance with local rules and regulations, export license requirements, tax matters and the ability to enforce an international judgment in a borrower’s country. Compliance risks include breaching anti-money laundering (AML) laws, customs and related regulations. Violating these laws can result in monetary penalties and reputational losses and prevent a lender from collecting on a transaction.

Diligence is of paramount importance as creditors underwrite a trade finance transaction. If commodities are grossly overvalued or undervalued, this can be indicative of an AML or customs issues. Where the commodity is being exported, lenders should require the export contract be executed on satisfactory terms prior to the initial funding. If the borrower uses key input suppliers to produce the commodity, lenders should ascertain the reputability and historical performance of such suppliers.

For more complicated transactions, lenders can structure a letter of credit or other trade-finance offering to involve an intermediary or correspondent bank as a means of reducing legal and compliance risks. A correspondent bank that has an established relationship with the lender, is situated in the same foreign jurisdiction as the borrower and is familiar with local laws and regulations of that foreign jurisdiction would be an ideal intermediary. In exchange for its services, correspondent banks would assess fees, which would factor in the risk profile of the underlying commodity.

Containing production and economic risks

In financing the production of a commodity, lenders should also confirm that the borrower has a consistent track record for producing a quality product. Lenders can further mitigate this risk by monitoring the commodity’s production levels and the borrower’s cash flows during the term of the financing. They can use a lockbox or other collection mechanism pursuant to which the commodity purchaser would deposit the sale proceeds directly into an account under the lender’s control. Additionally, a lender can add leverage and debt service coverage ratio covenants into documentation to monitor the financial performance of a borrower. Finally, in instances where the sale of the commodity provides the primary source of repayment for the financing, as part of their diligence, lenders should confirm that the price of the commodity has been established with buyers for a certain length of time to protect against adverse market fluctuations.

Managing country and political risks

Lenders also need to assess the political climate and the significance of the commodity in the local economy. Lenders will not generally require political risk insurance as a condition precedent to the financing. However, in some jurisdictions, if there is a conceivable threat that political instability would halt production of the commodity or otherwise impair its sale, lenders may require this insurance to mitigate potential losses even though it can be costly.

In commodities finance scenarios, lenders can reduce losses by performing thorough due diligence, engaging intermediaries in foreign jurisdictions, adding structural controls such as lockboxes and requiring enhanced insurance protections. They can also include financial covenants to monitor a borrower’s economic performance. While there is always a certain level of risk in a financing, a more mindful approach in structuring the transaction upfront will reduce write-offs after funding.