Warehouse Receipt Recognition to Help Lenders & Borrowers

Pledge financing in commodity trade is not new to India. It had been in practice for the last three decades. However, it got a new lease of life due to emergence of collateral management companies in the middle of the last decade. The grassroots servicing was ensured through fee-based structures. The market meltdown in 2008-09 impacted increasing operational concerns in commodity financing and thereby raised the importance of monitoring commodities as security.

Physical availability of commodities assures not only that the advances are adequately collateralised but also the proceeds of the advances are properly utilised by the customer to purchase or process the commodities. Security of commodities can be ensured in two ways by the lenders: pledges or by way of ownership. Ownership or title to a commodity as a means of security is theoretically the best option for a lender. Yet, often banks prefer that their customers own the goods, given the responsibility and costs that ownership can sometimes involve. On the other hand, a pledge involves the delivery of possession of goods as security until payment. So, creation of the pledge involves two parts: the transfer of possession and the intention to pledge. In addition, the borrower must retain ownership of the goods. 

Two terminologies in the context need to be clarified: ‘constructive possession’ and ‘possessory pledge’. Constructive possession (often relevant with context to the collateral management) is a term to describe a situation where an individual has actual control over commodity without actually having physical control of the same assets. At law, a person with constructive possession stands in the same legal position as a person with actual possession. The other terminology ‘possessory pledge’ is much easier to deal with security given in the form of a possessory pledge as the identity of the collateral is incontestable and the intention of the borrower to pledge the collateral is clear, avoiding disputes as to ownership and competing claims. When the commodity is stored in a remote location or in many locations, third party control allows a borrower to utilise inventory collateral efficiently as a basis for advances. To assure that physical availability, the role of the collateral manager becomes all the more important. 

In certain cases, field warehousing (where instead of moving the goods to the warehouse; the warehouse is moved to the goods) the lender and the borrower enjoy the benefits of warehouse receipt financing. In doing so, the possessory pledge is converted to a relatively convenient and cost-effective form of security with a much higher degree of legal protection and practical control than is afforded by a registered charge or security interest. Warehouse receipts are often assumed to be a document of title similar to a bill of lading. Therefore, warehouse receipts are one way in which rights of constructive possession may be given to a pledgee. This is because Warehouse receipts are viewed as documents of title, the transfer of which can transfer ownership of the goods themselves. 

The laws relating to documents of title to goods held by recognised bailees and the rights of good faith purchasers and encumbrances holding such documents are maturing in India. In the next few years, WHR recognition will provide a powerful tool for lenders to lend and borrowers to maximise the collateral value of the commodities. 

Published in The Economic Times 

Futures Markets Have Turned into ‘Alternative Casinos’

You cannot beat a roulette table unless you steal money from it. —Albert Einstein 

The plot of the commodity futures market reads like that of Prometheus in Greek mythology. Prometheus was entrusted with the task of moulding mankind out of clay. He then stole fire from heaven and delivered it to the mortal kind. The commodity futures market in India was envisaged as a cornerstone for agricultural market reforms. However, the objectives have been lost out. Commodity futures have been turned into “alternative casinos” trading on precious metals and energy products with little relevance to the original market reform objectives and limited to a handful of participants. The regulator who came out of the hibernation during licence raj, instead of bringing order into the chaos, has often resorted to selective policing without any long-term vision towards market development and reform activities. The commodity futures market has been turned into a “speculators’ den”.

The efficient-market hypothesis had emerged as a prominent theory in the mid-1960s. Since the financial crisis, the hypothesis has been dismissed as being a useless way to examine how markets function in reality. In India, its usefulness shall remain a big question mark with participation and product promotions coming primarily in the bullion, crude, metals and some narrow agricultural commodities contracts. 

The volumes on commodity exchanges continue to grow with the entry of every new exchange and new equity stakeholders. The unhealthy bulge in market turnover (credited to the unholy nexus of market makers and exchange promoters) is often tom-tommed by the regulator as growing muscular strength of the market. It is also unlikely that the commodity regulator does not notice the financial year-end volume spike in one of the exchanges (year after year) owing to tax accommodation provided to the speculative class. 

While the false trumpet of growth is being played, the holding structure of the exchanges have been manipulated through the backdoor. The regulators over-activism in the equity structuring have transformed some of the commodity exchanges from a demutualised to a mutualised structure. For the first time in the history of any country, an exchange reform (demutualisation) reversal has taken place.

All over the world, acquirers have been quite happy to drop or demote the names of the commodity exchanges that they buy. For example, CBOT (2006) and LCE (1996). In India, this had not happened owing (perhaps) to the reluctance of the powerhouses. Else, we would have seen NCDEX being called JP Exchange, ICEX as Reliance Exchange and Ahmedabad Commodity Exchange as Kotak Exchange. 

The question in years to come will be whether the commercial pressures and governance structure of a mutualised entity will undermine the commitment of the exchange’s resources and capabilities to effectively fulfill its regulatory and public interest responsibilities to an appropriate standard. 

A recently promoted national commodity exchange is said to be in advance stage of talks with an individual market maker to give a 3% stake in order to ramp up precious metals’ volume. This can never be proven, albeit efficient use of camouflage techniques. Indeed the game is now dictated by those perennial twin forces responsible for altering the landscape of commodity exchanges — greed and exchange valuation. 

Hopefully, the plot of commodity exchanges should not turn into a Greek tragedy.


Published in The Economic Times

Look Beyond Annual Contracts in Commodity Buying

The prices of key commodities (raw materials) such as milk, palm oil (for soaps), coffee and copra (for hair oil) have risen in the past one year with a volatility that will strain the margins of many FMCG firms. These companies need predictability in the flow of raw materials and stable prices to remain competitive. They have extensive exposure on the buying side but far less volatility on the selling side because terms and prices generally cannot be linked to the material price spread. MNCs in the FMCG segment have taken brand building, distribution, product innovation and marketing to a very sophisticated level while they have kept commodity sourcing (under volatile conditions) out of the strategic game plan. 

Before the economic crisis, raw material prices knew only one direction: upwards. Now the situation has changed. They go up and down in an irregular fashion and without any discernible pattern (for example, tomato and onions, which are raw material for ketchups). Traditional commodity management had relied extensively on procurement via strategic sourcing and this was primarily viewed as a means to lower raw material costs. Companies may also use financial hedges to smoothen price volatility, a practice that can actually inflate average cost due to the cost of the hedges. 

Some large Indian companies which started operations during the last ten years in the FMCG segment are more aligned to handle the volatility of prices. The centrepiece of the approach is the integration of procurement and sales activities to help manage the net exposure. 

The Indian FMCG sector has a market size in excess of 1.3 trillion. It has a strong MNC presence (P&G, Levers and Reckitt Benckiser) which is characterised by a well-established distribution network and intense competition. Most of these companies’ positioning are still based on consumer behaviour. The commodity price volatility has resulted this orientation to be relooked at. 

More often than not, an enterprise approach to managing raw material risk varies from ad- hoc to intuitive to unstructured approaches in a majority of the cases. This has resulted in managements often committing mistakes when it comes to managing commodity (raw material)risks or finding themselves uncertain and lost when it comes to building resilient business strategies around the sourcing models. Moreover, with the exception of sugar and wheat, none of the commodities that are consumed by the FMCG sector can be hedged on the futures. That too with the sword of ‘sudden contract bans’ hanging on the head. 

On the flip side, successful enterprises of India today have adopted a more structured approach that encourages their management’s confidence in an integrated trading model. Facing increasing commodity volatility, companies must move away from rigid and fixed systems. Annual contracts are no longer appropriate or up-to-date with the currently volatile raw material cost. In a dynamic cost environment, market prices instead of annual contracts will allow companies to quickly and accurately assess the price opportunities and adapt prices accordingly.

Published in The Economic Times

Commodities are in the blood for a few communities

Commodity markets are routinely regarded as fundamental economic institutions and the long-standing and quite varied ethnic and linguistic perspectives on traders are often overlooked.

In market yards, one often encounters enquiries about one’s community and the place of origin after the initial introduction. Further, on exploring the softer dimensions of trade, one can observe a subtle ‘in-group’ favouritism. It seems to point towards a tacit understanding or norms about how to treat members from the same community.

Traditional trading communities in India have been dominated by Aggarwals and Guptas of the north, Chettiars and Nadars of the south, Gujarati Jains and Baniyas, Muslim Khojas and Memon in the West and Marwaris all over India. People from these trading communities are not only seen to be very good at getting the best deal in negotiations but are also known to honour a contract since they know the importance of business more than any professional in the trade. 

The commodity market exists on the cusp of informal sectors of society and regulated markets. In many countries around the world, specific subgroups of the population carry a reputation for being particularly adept at running commodity trading. For example, the Jews in the bullion trade.

While a large number of communities are part of the market, one can always find trading traditions in India finding its roots in the practices of the Baniya and Vaishya communities. The predominance of a community can also be observed in a particular geography. One should not be surprised to see a large number of Kutchies (from Gujarat) trading pepper in the heartland of Cochin’s Jewish Town. They are a vibrant community which has managed to assimilate fully with the local culture while retaining its identity. The ethnic and linguistic identity continues to determine the basis of trade, albeit in a different way. Commodity traders also operate in mutually interactive community networks with ethnic, religious, family or linguistic ties with an opportunistic concentration towards profit. In this respect, the trading habits of Indians are not very different from those of Chinese and Arab traders. The Nadars are expert traders mainly located in south India. In Calicut, they have a belief that whatever they earn in Calicut is spent their itself. This is expressed in their saying in Tamil: Kallikkottai kaashu Kallai paalam thaandaathu(money earned in Calicut will not cross Kallai bridge.) It may not always be the case.

There is a possibility that different ethnic groups might disproportionally adopt commodity trading not because of a comparative advantage in that occupation but because of differential access to other opportunities (or lack thereof) for the group. At times, these trading communities pay for protection and market access and have found conducive freedom to trade. Whenever the protection becomes too expensive, they usually have the leeway for moving elsewhere (for example, Assam and Bihar).

Approaches to commodity markets have often focussed on the formal properties of transaction systems as frameworks for organising behaviour. However, within wider ethnographic contexts characterised not only by economic exchanges, ‘community arenas’ act as nodes of information flow. The transfer of trust is crucial to minimise transaction costs in a market that is characterised by moving commodities over long distances and delayed payment (seller’s credit).

Sometimes, the specificity of the market environment equally facilitates the use of ethnicity for commercial purposes such as the delimitation of market niches. 

Published in The Economic Times

There can’t be a bigger farce than tendering

Commodities worth billions of dollar are transacted all over the world through tenders, which look transparent yet remain citadels of corruption. There cannot be a bigger farce in the transaction economy than a tendering process in the 21st century.

From presidents of various countries to a peon of a government department, everyone knows that the tender system is corrupt, farce and irrelevant. Then why are we continuing with such a system? The system of tendering has gratified the greed of so many powerful and influential persons all over the world (including international multilateral institutions) that an alternative transaction mechanism of commodities and services has not been allowed to emerge.

In times of crisis, government has encouraged import tenders (for pulses and edible oil) through public sector undertakings. While the process has remained transparent, the collusive practices of the supplier have caused price bids to remain at a high level. Army procurement, crude procurement by oil companies, state civil supplies, Commonwealth Games and NHAI all work under a tender system, which has become useless over the years. Not only crores of rupees are lost by way of suboptimal price discovery, the corrupt goes scot-free while honest officials (at times) gets embroiled in false charges. Transnational companies in commodity-rich African countries have developed it into an art form where tender processes are always followed but spirit is suffocated.

The objective of any transaction is to achieve the best price at that point of time. However, the tender process has focussed more on the objectives of accountability (in the spending of public money) and transparency (in the steps of the decision-making processes). A best available price in the real world cannot be ascertained. If the best price cannot be ascertained, then the loss to the exchequer cannot also be conclusively proven. Government procurement is often carried out by the process of tendering. Commodities do not work on a fixed price and therefore the 1991-92 case of palmolein oil import in Kerala was a game of oneupmanship to score a political point rather than addressing a fundamental issue.

The guidelines of the Central Vigilance Commission (CVC) on the tendering process make an interesting reading. It says “as post-tender negotiations could often be a source of corruption, it is directed that there should be no post-tender negotiations with L-1, except in certain exceptional situations.” Nothing wrong except that the guideline forgets that the cornerstone of price discovery is the interactions that take place between sellers and buyers.

In actual life, an inadequate knowledge of the available commodities or services is made up for by the experience with the persons or firms supplying them are one of the most important facts which enable one to solve the immediate problems. The function of competition is here to teach who will serve well: which company and which supplier. Thus tender conditions are often made to suit those who are actually known. On the other side, these companies will ensure that the pre-bid conditions are also made to suit their own interest.

Gigabytes of guidelines have been written on corrupt, coercive and collusive practices in the tendering process and its prevention. Generally, trustees (officials) of the tendering process have tried to ensure the process is followed in letter and the fundamentals of price discovery are conveniently ignored. This has caused corruption to multiply but can never be proven. In recent times, this outmoded method of transaction has been improved by E-tendering and E-auction. Though the change in the bidding process has improved, some of the transparency issues and the methodology of transaction remain irrelevant. Simple corruption has also given way to E-corruption. 

Published in the Economic Times

Trade-based money laundering on the rise

The term ‘money laundering’ is said to have originated from mafia ownership of Laundromats in the US. Gangsters there were earning huge sums in cash by extortion, prostitution, gambling and bootleg liquor. They needed to show a legitimate source for these monies. 

Money launderers now resort to the use of apparently legitimate commercial transactions to camouflage their laundering activities. There has been an increasing amount of interest of late in commodity trade-based money laundering. Deception is the heart of money laundering. This is being increasingly used to move the cash proceeds through a process by which the transactions appear very genuine. 

Commodity trade-based money laundering has been growing as an alternative remittance system that allows illegal and unaccounted money with an opportunity to earn and move the proceeds disguised as legitimate trade. Increasingly, the domestic commodity trade is being used for bribing politically exposed persons (PEP) and government officials. 

In India, sometimes the task is achieved by purchasing commodities (above the market price - ‘placement’) from a so-called genuine supplier (often a conduit of PEP or relatives of officials), transferring them to another entity where the commodity is sold (‘layering’) and the proceeds are remitted to the intended recipient (‘integration’). The large companies (with bigger reputation and brands) sometimes use the channels to oblige the powerful. Since the size is often small compared to other genuine transactions, this never gets discovered. 

Trade flow volumes have increased significantly as a result of globalisation. An Exchangebased transaction in India is also showing double digit growth. Such large trade flows and paper trade growth provide ample channel, through which transactions can be obscured due to the presence of complex transactional structures and co-mingling of illicit funds with the cash flows of a legitimate business. 

Global trade is used by larger criminal and terrorist organizations to move value around the world through complex and sometimes confusing documentation that is frequently associated with legitimate trade transactions. The illicit trades are often blended in with legitimate ones, which make them difficult to single out and the source of their funding hard to trace. The scope and prevalence of the practice is tough to determine with any precision, but it is clearly on the rise. Values have moved through this process by false-invoicing, over invoicing and under-invoicing commodities that are transacted in the domestic market (no more restricted to imported or exported commodities). 

Relaxed oversights by domestic authorities along with weak procedures to inspect goods and register legal entities provide sufficient opportunity for such activities. Moreover, inadequate information technology systems and lack of adequate coordination and cooperation between regulators often lead to misuse by the launderers. 

As money laundering methods become complex and sophisticated, it is necessary that agencies, authorities, investigators and prosecutors alike should equip themselves with the evolving knowledge of money laundering typologies. Instead of just issuing instructions to abide by PMLA (Prevention of Money Laundering Act, 2002), the regulators must equip themselves with the market-based forensic knowledge of such activities. 

Investigations have shown that one of the most effective ways to identify instances of trade-based money laundering is through trade data for anomalies that would only be apparent by examining both sides of a trade transaction. Sometimes commodities being traded do not match the business involved and on other occasions, false reporting provides adequate indicators of trade-based money laundering. 

Published in The Economic Times

More time needed to clear confusion on warehouse receipts

Two terminologies — commodities demat and negotiable warehouse receipt — in the commodities market has created more confusion in the last seven years than in any participatory facilitation. 

The jargons have led the market to a state of confusion because these are perceived more as “insurance policies” underwritten by an exchange and the warehouseman (as applicable) for the users rather than instruments of facilitation. 

Brokers and investors are confused about “commodity demat” as they often draw a parallel to the seamless stock market functioning. In case of commodity demat, the mere act of recordkeeping in the electronic form has not conferred the qualifications of “security” on the commodity. The statute of “security” to the demat commodity has remained elusive under the Depository Act. Therefore, the funding of a demat commodity has conferred an inferior legal protection on the lender when compared to the demat funding of stocks. 

On the other hand, a warehouse receipt (WHR) is not negotiable under the common law. A WHR is an instrument issued by a warehouseman, reciting receipt of certain goods therein described and evidencing the contract between the parties along with the details of warehousing. What is being envisaged (however, not yet grasped) under the WDRA Act, 2007, is to confer on the document in a certain way the same sort of limited and peculiar negotiability which is possessed by a bill of lading. 

A WHR can only be an evidence to the title of the goods and not a promise to pay while a “negotiable instrument” means paper evidencing a debt ultimately reducible to money and not calling for the delivery of other property. 

The law regarding the document of title is trying to borrow the feature of negotiability from the law of negotiable instruments but it must always be remembered that the two classes of instruments — negotiable instruments on one hand and documents of title on the other — must in certain respects be different and be governed as they are today by entirely different bodies of law. 

The negotiable instrument is a promise to pay or an order to pay money while a document of title calls for delivery by a bailee (warehouseman) of certain particular goods. It is better to keep this thought in mind that a warehouse receipt is a document of title not a negotiable instrument and that there is a separate body of law governing each. 

If at all, WHR becomes negotiable, it will pass greater freedom from hand to hand chiefly by the reason of the fact that the transferee thereof does not need to notify the bailee (warehouseman) of his acquisition of title while a transferee of an assignable document of title (WHR) acquires no rights against the bailee except by giving notice.

By assigning negotiability on WHR will not provide the document with a status of “negotiable instrument” but can be referred as a “negotiable document of title”. It is going to take a while before the cloud of confusion is removed and we see a clear blue sky on the commodity horizon in India. 

People asking questions lost in confusion,

Well I tell them there’s no problem, Only solutions,

I’m just sitting here watching the wheels go round and round,

I really love to watch them roll, No longer riding on the merry-go-round, 

— John Lennon’s ‘Watching the Wheels’ 

Published in The Economic Times