Summer Training Report

AGRI-COMMODITY FINANCING
ROLE FOR COMMODITY EXCHANGE

2011
Submitted By: Jyoti Mani Indian Institute of Foreign Trade(Kolkata)

Mentor: Anjan Mandal Head Product Development Agri Commodity Division

Indian Commodity exchang(icex)

Table of Contents
Agri-Commodity Financing

1. Introduction 3 2. Structured Trade and Commodity Finance 3 2.1Warehouse Receipt Finance 4 2.2Agriculture Finance 11 2.3 Export-Receivables Backed Finance 16 2.4Agriculture Supply Chain Finance 18 2.5Pre-Payment Financing 23 3. Other modes of Commodity Financing 24 3.1Reserve-Based Lending Facility 24 3.2Commodity Ownership by Financial Institution 24 3.3Leasing 24 4. Approach Needed for Agri-Commodity Finance 25 5. Conclusion 25

Role of the Exchange in Agri-Commodity Financing

1. Facilitating Finance to Traders, Millers and Exporters Through WHR 28 2. Facilitating Finance for Traders and Producers through Forward Contracts 30 3. Collaborating with Farmers Cooperatives, NGOs and Regional Banks 31 4. Exchange Traded Repos 34 5. Conclusion 35

Introduction
As against agriculture loans given against mortgage of land or other assets, agri-commodity finance is provided against the agriculture produce (commodity) as collateral. A typical example of agri-commodity finance is warehouse receipt financing. Arathiyas or traders store the commodity in a warehouse and get finance commensurate to the value of the stored commodity. Any commodity which is freely traded, and preferably traded on an exchange, is potentially good collateral, especially if it is durable. However, this potential can only be realized if the commodity is located in an environment which allows for clear title. Furthermore, there must be the potential for risk transfer: the right type of insurance needs to be available under reasonable conditions and commodity risk need to be manageable. Warehouse receipts are probably the most practical ways of commodity financing, along with forfeiting quality paper. If such finance can be hedged through futures or options, then an even less risky long-term commodity transaction can be created. A viable warehouse receipt-based financing system is a must for emerging markets like India. The receipts can be used as a tool for investing, forward trading, and reducing interest rates, particularly for small-scale players. The commodity movement, i.e., logistics chain, will benefit from wide use of warehouse receipts. Market

transparency, the legal security of contracting, and price discovery will improve as well. If risk can be transferred or consolidated, it can be managed better. The whole commodity chain can benefit from having a structure which enables the use of warehouse receipts and other uses of commodities as collateral. Moreover, this will enable traders refinance themselves at a cheaper rate and for a long tenor. The use of future markets through exchange will allow these traders greater flexibility in taking position. Some of the finance acquired can be used to provide margin cover against the future contract.

Structured trade and commodity financing (STCF)

STCF revolves around identifying and mitigating the risks associated with transactions. This is achieved by structuring financing so that potential risks (structural and performance) are either mitigated or externalized to parties better able to bear them, and in a manner that ensures automatic reimbursement of advances from underlying transaction assets. A key element when structuring a deal is examining the role of the various parties in the funding and reimbursement chain, with a view to ascertaining how each can impact the transaction positively. Because of the risks that commodity markets entail and commodity price volatility, the majority of enterprises involved in commodity production, processing or trade are considered by banks as posing difficult credit risks: can they provide any guarantee or collateral? Will they repay loans on time, and if not, can banks enforce their rights? The risks inherent in structuring commodity finance deals can be mitigated in several ways. For example, security can be taken on collateral and/or trade receivables, in addition to such safeguards as commodity price hedging and insurance (e.g., country risk insurance to cover the risk of an export ban), which can be built into the financing structure. At the heart of structured financing is the goal of meeting the needs of the borrower (in terms of maturity, pledge requirements, repayment schedule, etc.) and of the credit provider (in terms of country risks limits, provisioning requirements, etc.). It is quite a challenging task in view of their opposing, and often conflicting, commercial interests. There are no standardized structured commodity trade finance deals, since one essential principle of STCF is the tailoring of a structure to the needs and circumstances of all parties involved, provided that perceived or real risks are mitigated. However, it is possible to single out five generic models: Inventory/ Warehouse receipt financing, Agriculture financing, Export Receivables-backed financing, Agriculture Supply Chain financing and Pre-payment financing. The opportunity could be as big as Rs.1.5lakh crore, of which just 15% has been tapped till now. Risk perceptions relating to the commodity business, warehouses and their management have improved. Private sector lenders like ICICI Bank and HDFC Bank are the front-runners in warehouse financing while state-owned banks like SBI also have a presence.

1. Warehouse Receipt Finance

If the commodities to be used as collateral are stored in a warehouse, the warehouse operator issues warehouse receipts, in one form or another. These receipts then form the basis of financing. Rather than relying on the producers promise that the goods exist and that the proceeds of their sale will be used to reimburse the credit provider, the goods are put under the control of an independent warehouse operator (the credit provider still needs to ensure himself that the goods have not been pledged previously). The warehouseman becomes legally liable for the goods he stores. If these goods are stolen, damaged or destroyed, through any fault of his, he and his insurance companies have to make up for the value lost (additional insurance can be obtained for catastrophic events).

The integrity of this warehouse operator is secured by government licensing and controls, and by outside guarantees which the warehouseman has obtained from bonding companies (subsidiaries of banks which provide guarantee against defaults) and insurance companies. Commodity trade finance collateralized by warehouse receipts requires relatively much paperwork, compared to unsecured finance, and also involves higher control costs -the fees for the warehouseman and of inspection services, registration fees for warehouse receipts etc. However, it should be noted that in practice, these costs generally amount to only 0.5 to 2 per cent of the value of the deal, which is often negligible compared to the savings on the interest rate paid. Moreover, traders and commodity companies with a weaker capital base and a short or a poor track record can obtain low-costs credits. Warehouse receipts are commonly used by commodity dealers in the process of financing goods stored in a warehouse prior to sale and transportation, or prior to and during processing. The borrower arranges for the storage of goods in an independently controlled warehouse which issues warehouse receipts for the merchandise deposited. Compared to a simple bill of sale (which gives title to commodities to the credit-providing institution), the use of warehouse receipts as collateral provides the additional benefit that the commodities are no longer in the possession of the borrower, and hence, if the borrower defaults, the lender has easy recourse to the commodities. Banks or trading companies normally have few problems to advance funds against commodities that are being stored in a reliable warehouse and have been assigned to the bank or trading company through warehouse receipts. Once the bank or trading company has the warehouse receipt in its hands, it advances to the borrower a specified percentage of the value of the goods represented by the receipt. The amount it lends is primarily based on the acceptability and the ease of control of the collateral, and the identity of the borrower (whether this is a triple-A rated company or a one-person firm) is of very little relevance. It should be noted, though, that once banks have positive experiences with their borrowers, they are likely to be willing to increase the percentage of the collaterals value they are willing to lend. The funds advanced are to be repaid with the cash collected from the sale of the goods.

Advantages of Warehouse Receipt Financing:

a) In the case of a loan default collateral covered by documents of title can be auctioned or sold promptly
and at minimal cost "as is where is" by the lender by negotiation of the document or written notification to the warehouse operator. b) A lender holding a warehouse receipt has a claim against the issuer (the warehouse company) as well as the borrower in the event of the non-existence or unauthorised release of the collateral.

c) The existence of competing creditors and unpaid sellers is often difficult to verify with certainty.
Having a document of title to goods in store can then cut off the claims of such competing creditors.

Types of Warehouse Receipts Warehouse receipts can be negotiable or non-negotiable. A non-negotiable warehouse receipt is made out to a specific party (a person or an institution). Only this party may authorize release of goods from the warehouse. He may also transfer or assign the goods to another party, for example a bank. The warehouse company must be so notified by the transferor before the transfer or assignment becomes effective. The non-negotiable warehouse receipt in itself does not convey title and, if it is in the name of, say, an exporter or a trader, it cannot be used as possessory collateral; it needs to be issued in the name of or transferred to the bank in order for the bank to obtain possessory collateral rather than just a security interest. The difference is important in that, firstly, if the bank has possessory collateral, it has direct recourse to the warehouse storing the commodities when the commodities are delivered to another party, and secondly, in the case of bankruptcy of the borrower, it is much easier for the bank to sell the commodities in a speedy manner. On the other hand, the surrender of the non-negotiable receipt to the warehouseman is not necessary to get release of all or part of the stored merchandise. All that is needed is a delivery order signed by the party in whose name the receipt is issued -or to whom it has been transferred (usually the financing institution) -instructing the warehouseman exactly what types and quantities of goods are to be released to the person named in the order. This makes the use of non-negotiable receipts for short-term trade finance rather easy.

It also causes an extra risk for the bank: the borrower may have surrendered his warehouse receipts to the bank, but as long as the warehouse operator has not been notified of this, the borrower still has the possibility to take the commodities out of the warehouse: a simple order, signed by the party to which the original warehouse receipt was issued, is enough to effect a delivery out of the warehouse. To obtain additional security, banks therefore have to "perfect" their security interest in the commodities for which they have been remitted warehouse receipts by registering this security interest or by entering into a "constructive pledge".

A) A negotiable warehouse receipt is made out to the order of a named person or to bearer. It is a
negotiable commodity paper, and it serves as possessory collateral. When the bearer of a properly endorsed receipt surrenders it to the warehouseman, he receives delivery of goods stored against this negotiable receipt. If the commodities stored have been properly graded, delivery of a negotiable warehouse receipt may replace normal physical delivery. The large advantage of negotiable warehouse receipts is that they can be traded on a secondary market. For this to happen, a bank (or eventually a large trading firm) would have to attach a "bankers acceptance" to the warehouse receipt, indicating that it is guaranteeing it (thus substituting its own credit for that of the issuer). The warehouse receipt, with the bankers acceptance attached, can then be sold to other parties. This could have major economic benefits:

a) Trading in warehouse receipts means trading in titles to goods, which in effect implies trading in
commodities for forward delivery. Although actual delivery would be extremely rare (the borrower would normally prefer to reimburse his loans), the financial value of the warehouse receipt (if properly construed) would follow commodity prices, thus allowing an effective commodity price hedge for domestic producers, processors and others.

b)

Making warehouse receipts negotiable is likely to attract a larger pool of capital to commodity financing, and also reduces the liquidity pressure on the bank which first financed the commodity.

Simply making warehouse receipts negotiable is not enough to create a secondary market. Potential buyers also need trust in the system. This implies that: a) Warehouse operators permitted to issue negotiable warehouse receipts should be specifically licensed by the Government to do so, and their functioning should regularly be checked. only one party has legal title to the commodities held as collateral. One possibility would be for the warehouse operator to register every change of ownership of the warehouse receipt; when the system is more developed, a central registry (preferably in a government department) probably becomes more efficient. c) The warehouse receipts have to convey clear and unequivocal rights to the entities holding them. It is probably best if the various warehouse operators in a country agree to one common document warehouse goes bankrupt, the owner of the receipt has to be able to lay immediate claim on the commodity. e) The system needs to be sufficiently flexible to allow a normal functioning of the cash markets, with the original borrower using the commodities, for example for exports, thus reimbursing his loan.

b) There has to be a tracking system for the warehouse receipts, to ensure that at each moment in time,

d) Legal Contract needs to be appropriate for this type of financial transaction. For example, when the

Contrary to non-negotiable warehouse receipts, negotiable warehouse receipts cannot easily be claimed in part: if a buyer is found for, say half of the goods in storage, the negotiable warehouse receipt would have to be redrawn to allow continuing warehousing of the remaining half, which entails considerable extra cost. This makes them less suited to the financing of continuing operations, that is, in cases where the pool of commodities in the warehouse continually changes. Negotiable warehouse receipts are in practice mainly useful for stocks that are held for longer periods, e.g. security or seasonal stocks, or for stocks of commodities that are more or less fungible, e.g. metals or grains. One of the main costs of warehouse receipt financing for banks are those related to the time needed to check and set up the financing facility. For example, if a bank holds a non-negotiable warehouse receipt issued to a borrower, and the borrower goes bankrupt, the bank has to be able to execute its ownership rights without undue difficulty, even if its name does not occur on the receipt. This discovery process entails personnel and legal costs which may be difficult to estimate in advance, in addition to the large investment of time trying to make a transaction of this kind secure. Role of warehouse receipts in various forms of commodity finance

The financing of domestic production, trade and distribution

One of the principal problems of domestic commodity marketing in many developing countries is the lack of credit throughout the marketing chain. Agricultural producers are often forced to sell a significant part of their crop directly after harvest, to obtain the cash they need for social ceremonies (this is normally the season when celebrations are held). This causes a glut in the marketing chain. By itself, this would not create major problems, were it not for the fact that traders also do not have the money to store large amounts of commodities for a longer period -even if pre-export finance is provided to some of the larger exporters, this may not go far down the marketing chain. This exacerbates seasonal price movements, and may lead to inefficient marketing behaviour (ports become congested directly after harvest, and are underutilized later in the year). An expanded use of warehouse receipts can solve or at least abate many of these problems. Warehouse receipts can also reduce the credit needs of importers. Where traders are unwilling to provide buyers credit to importers, they can use warehouse receipts to ensure cash payments for products exported to the country. Warehouse receipts will show the ownership of the commodity The financing of commodity processing Processors are among the key beneficiaries of improved financing systems. The value of the commodities they have to keep in stock is often high, especially in relation to their processing margin. This problem is even stronger in developing countries than in developed ones, as poor road infrastructure and logistics make just-intime delivery prohibitively difficult. The processor owns commodities, but naturally, their storage in an independently controlled field warehouse is impractical because the processor requires the goods for further processing to make the final sale. In such cases, and if the bank has a great degree of trust in the processor, it may be willing to release the goods to the processor against the signing of a trust receipt in which the processor: -acknowledges receipt of the goods or the title documents (warehouse receipts) from the bank; -recognizes the banks security interest in the goods he is receiving; -states that he is acting as the banks trustee in delivering the goods to the customer; -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 are not sold); -agrees to keep the goods fully insured against all insurable risks.

In releasing the goods that acted as collateral to the processor, the bank loses its physical possession of the goods -this is replaced by a mere security interest, which may be more difficult to enforce if problems arise. The signing of the trust receipt does not prevent the dishonest misuse of the goods or the proceeds. The bank will therefore release goods on a trust receipt only when it has full confidence in the reliability and moral responsibility of the processor. Although some larger processors (for example, ITC in India) manage to obtain international finance which is to be reimbursed by the proceeds of the sales of their locally-sold products, in general it would appear that locally-based banks are best placed to evaluate the commercial reliability of processors. One regional bank in East Africa is already providing funds on this basis to cotton processors, and it would appear that there are possibilities for local and regional banks to expand this type of funding. If the funding is to a producer or exporter which has to have its commodities processed (with the processor "tolling" the commodities for a fixed fee) before sale is possible, banks also have to ensure that the processor cannot seize the commodities if, for example, the producer or exporter has financial problems. In practice, this makes it very difficult to finance this type of operations if the bank does not have an office or representative in the country concerned.

Warehouse Development and Regulatory Authority (WDRA):

It is the apex body responsible for regulating and ensuring implementation of the provisions of the Warehousing (Development and Regulation) Act, 2007 for the development and regulation of warehouses, regulations of negotiability of Warehouse Receipts and promoting orderly growth of the warehousing business. Main functions of WDRA: a) to issue to the applicants fulfilling the requirements for warehousemen a certificate of registration in respect of warehouses, or renew, modify, withdraw, suspend or cancel such registration; (b) to regulate the registration and functioning of accreditation agency, renew, modify, withdraw, suspend or cancel such registration, and specify the code of conduct for officials of accreditation agencies for accreditation of the warehouses; (c) to specify the qualifications, code of conduct and practical training for warehousemen and staff engaged in warehousing business; (d) to regulate the process of pledge, creation of charges and enforcement thereof in respect of goods deposited with the warehouse; (e) to make regulations laying down the standards for approval of certifying agencies for grading of goods; (f) to determine the rate, levy, fees and other charges for carrying out the provisions of this Act; (g) to call for information from, undertaking inspection of, conducting enquiries and investigation including audit of the warehouses, accreditation agencies and other organizations connected with the warehousing business; (h) to regulate the rates, advantages, terms and conditions that may be offered by warehousemen in respect of warehousing business; (i) to maintain a panel of arbitrators and to nominate arbitrators from such panel in disputes between warehouses and warehouse receipt holders; (j) to regulate and develop electronic system of holding and transfer of credit balances of fungible goods deposited in the warehouses;

(k) to determine the minimum percentage of space to be kept reserved for storage of agricultural commodities in a registered warehouse (l) to exercise such other powers and perform such other functions as may be prescribed.

CHARACTERISTICS OF GOOD COLLATERAL Anything which is readily saleable, movable, exportable, can be traded on one of the exchanges, has sufficient value and can be assigned to a financial institution can serve as a collateral for a loan.But not every commodity is equally useful for collateral purposes. The value of a collateral is determined by: a) The quality of the commodity

b) The transparency of the market c) Liquidation costs

d) The price volatility of the commodity e) f) The durability of the commodity The location of the commodity

The quality of the commodity The quality of the commodity needs to meet the markets requirements. This has to be verified by an independent agent. This implies that the perceived quality of a commodity for collateral purposes is not determined only by purely physical factors, but also by the possibility to verify the products specifications and the reliability of the verifier. The specifications and means of verification obviously vary from commodity to commodity.

The transparency of the market Ideally, the commodity should be quoted on an exchange on which a sufficient volume is traded; or alternatively, it may be quoted by a well-established price information vendor, with an over-the-counter risk management market developed on the back of this price information. This permits not only a correct identification of the commoditys value, but also a protection of the value of the collateral against price declines: finance can then be provided against a much larger part of the value of the commodities, as no "cushion" against price declines needs to be calculated in Sesame, for example, is not quoted on an exchange as it is difficult to use it. In most cases, the maximum a bank is willing to finance is 70-80 per cent for a commodity like coffee where there is an organized futures market; where there is no relevant futures market, for instance in the case of rice, only about half of the total value of the commodity is likely to be financed. Rice is also not often used as collateral because there is no organized futures market If no liquid futures exchange exists for the commodity, a minimum condition for using it as collateral is the existence of an independent and transparent pricing mechanism. For example, for major agricultural commodities, it is relatively easy to find prices (using independent sources such as Mandi Prices), even if they are not traded on an exchange. On the other hand, commodities with a narrow and non-transparent market, even if they are high-value (e.g., minor metals) are difficult to use for collateral purposes. In any case, even in the case of a commodity for which no reliable price quote exists, the commodity can be used to add to other

guarantees -for instance, a trader may buy rice from a government agency in Pakistan and pay against warehouse receipts, with back-up guarantees provided by the government treasury.

Movability It is an important precondition for using commodities as collateral. A factory with a high value, or even farmland can be used as a collateral but in the case of a default it would not be possible to ship it to its final buyer (so it would not be considered a "good" collateral by an international credit provider) whereas this can be done with any commodity soft metals and fuels. Liquidation costs When financing, a lender will take into consideration not only the possible decline in the market price of the collateral over the time of storage, but also the cost of actually liquidating the merchandise, should it be necessary to do so. If there is a default and the merchandise in a certain warehouse becomes the property of the bank, the bank will want to sell the goods as soon as possible. In such a situation, some banks and traders estimate that on average about 3040 per cent of the market value of the goods may be lost, because of discounts that have to be taken on the price, and because storage until the time of sale, transportation etc. have to be paid. These liquidation costs will be less if the goods can easily be sold on an auction or delivered to an exchange. The price volatility of the commodity Those who store a commodity are exposed to the price fluctuations of this commodity. An example is provided by the case of a commodity distributor who buys a certain commodity for a certain price and holds it in storage for 6 months for on sale to his domestic customers. The distributor does not know what the price of this commodity will be the day he decides to sell it. For a number of commodities, a large part of this risk can be covered by using futures or options contracts. The more volatile the price of a commodity, the riskier it is to store: that means that if commodities are used as collateral and a default occurs, the value of the commodity may no longer cover the advances made by the bank. For this reason, many banks, for example most agricultural banks, insist that the commodity producers and traders they lend to cover part of their price risks. By itself, hedging will not provide sufficient protection when a transaction is pre-financed without collateral. For example, consider the case of a trader buying X bags of coffee from a seller for a fixed price. The trader provides pre-finance to the seller, and enters into a hedge to ensure that the coffee, once delivered, can be sold at a profit. However, if coffee prices increase dramatically, the seller may well default on his obligations, leaving the trader both with a hedge-and a physical trade loss. Also, if an exporter hedges on commodities which are being used as collateral, this provides no security to a bank: if prices decrease, the exporter may well cash in on his hedge profits, and default on his reimbursements to his bank which then will have recourse only to the commodities, much reduced in value. For this reason, the bank or trade house providing the finance will normally insist that it manages the hedge account, i.e. that profits on the hedge (which compensate the reduction of the value of the collateral) will directly be paid to the bank or trade house. The durability of the commodity Generally, if the goods are perishable or out-of-season, a very low percentage of the value of the goods will be advanced. For example, sesame, if stored over a certain time, loses its oil content and becomes worthless as collateral. On the other hand, if the commodities involved have a ready market and the logistics of exports are well-organized, financing on the basis of the "flow" of commodities is possible. For example, United States banks provide working capital finance to Mexican vegetable growers; the banks have title to the vegetables grown, and reimbursement is through the use of an escrow account on which United States importers deposit their payments. The location of the commodity

A commodity has the highest collateral value if it has been extracted, refined and is in the warehouse or it has left the warehouse and is on its way to the final buyer (freight forwarders certificates, combined transport documents and even railway bills can be acceptable for collateral purposes if the borrower has a reasonably good reputation).

2. Agriculture Finance
Agriculture Finance can be broadly classified into: i) Crop loan

ii)Term loan for land and water resources development, mechanisation of agriculture and crop diversification such as plantation, horticulture. iii) Post harvest investment on storage, trading, processing and transport.

Risk Mitigation MODES OF LENDING Lending through Joint Liability Groups (JLGs) Joint Liability Groups (JLGs) of rural producers can be used to mutually guarantee each other's loans. This method uses the principle of mutual guarantee by a group of borrowers for each others loans. Under this method: Five to six individual borrowers are asked to form into a group. The group is formed by their mutual choice. The promoting institution does not participate in the group formation. Unlike the Grameen or SHG method, where the groups meet regularly, with significant emphasis on the group processes, in this method the groups meet only when required. Apart from guaranteeing the loans to each other, and thereby introducing peer monitoring, there are no other significant group processes involved. The group members are of a similar socioeconomic profile with not more than two family members. All the members of the group mutually guarantee the loans given to the other members of the group and remain jointly and severally responsible for the repayment of all the loans. Loans are given to individual borrowers. Loan amounts to different members of a JLG can vary. The lending institution collects a cash security equal to 10 percent of the loan amount of each borrower, from all

the individual borrowers. This amount is returned to the individual borrowers only when all of them have paid back the amounts due. Repeat loan is not sanctioned unless all five of them repay their earlier loan

The following are the main reasons behind promotion of JLG concept. Ensure self-appraisal of loan proposals. JLG makes all the members appraise each others loan proposals and deny loans to those who are not creditworthy and also reduce the amount in case some farmers have made proposals which the others think they may not be able to make good use of, before recommending to the lending institution for loan. Ensure proper utilization of loans availed from the lending institution: Since all the members have taken the responsibility for repayments, the members tend to see that every member uses the loan as proposed. Information about diversion comes to the lending institutionfrom many channels and corrective action can be taken early so that the recovery takes place in a smooth manner. Group liability and peer pressure: All the group members take responsibility jointly against each loan extended to group members. Since all the members are involved in the similar activity and likely to have cash flows during the same period, the recovery of loans becomes smooth. JLG with members coming from the same family are not effective in exerting pressure. The joint liability is a substitute for co-obligation or collateral. Ensures common benefits to members: Since members form in to informal groups, there is a possibility that they derive benefits like sharing experiences, procuring materials in a bulk quantity at lower price, market the produce in bulk to get benefits in terms of transportation and price. The lending institution can also facilitate technical assistance to members of JLG in an effective manner. Less transaction cost In JLG approach, the transaction cost to the company and borrowers is less, as compared to pure individual lending. The crop loan product is designed for repayment of principal in one or two lump sum instalments, typically four weeks after the harvest is expected. This gives the farmers time to market their produce.

Lending through intermediaries Many lending institutions have experimented with agricultural lending through various kinds of intermediaries such as commission agents (commodity brokers), input dealers and seed production organizers. For example, consider the lending by BASIX to farmers in Raichur district in Tamil Nadu. BASIX tried lending through commodity trade intermediaries known as ahratiyas or commission agents in the Raichur district in Karnataka. This place has a very large mandi (agricultural produce market) and over 150 commission agents compete with each other fiercely for the farmers business. These ahratiyas do not normally buy or sell on their account, but rather aggregate the produce of a large number of farmers to fulfil the demand from large buyers, typically agro-processing companies. They tend to develop long-term relationships with farmers, and often extend them loans at the sowing season for inputs and general expenses. These loans are extended at an interest rate of between 2 to 3 percent per month or 24-36 percent per annum. However, if a farmer repays within four to five months, no interest is charged. The arrangement was extended beyond Raichur to other mandis as well. However, it was found that in other mandis, the number of ahratiyas was much less and they were collusive rather than competitive. Moreover, even in Raichur, it was found through surveys of the ultimate borrowers, that the ahratiyas were charging them interest rates higher than the mandated 24 percent. Moreover, depending on the ahratiyas relationship and risk

perception, they were charging anywhere from 24 to 36 percent. Further, many of the ahratiyas started defaulting on BASIX loans, and though these were secured through collateral, due to the cumbersome legal processes in India, it was not possible to get repayments easily.

Lending in collaboration with agri-business companies Agricultural lending in collaboration with agri-business companies of various kinds: Input suppliers such as seed, fertiliser and pesticide companies and their distributors; Hybrid seed producing companies and their seed production organisers and Agro-processing companies oilseeds, cotton, spices etc. These companies all have different reasons for collaboration with credit institutions.

CROP INSURANCE Rainfall failure is a major risk factor in agricultural lending. While India has had a number of crop insurance schemes, these have not been working very well. The claims are far higher than premia collected and the government has spent hundreds of crores in the last ten years in subsidising premium payments and settling claims. In spite of this, farmers are not happy with the schemes due to delays in claim settlement and the use of rather large areas for the purpose of declaring drought. One quite innovative form of crop insurance is insurance of crop loan portfolio. This was pioneered by BASIX in India. Here the company paid INR 750,000 worth of premium to insure its crop loan portfolio of Rs 17 million in there of its branches, with diversified rainfall patterns. This insurance was designed by the World Bank team, the cover offered by ICICI Lombard and was re-insured by Swiss Re, in a first deal of its kind in the world. As rain was good in this year in the insured areas, there were no claims. The importance of weather based farmer level or portfolio level crop insurance is that it transfers credit risk to insurance risk and sine the latter is diversifiable across various agro-climatic zones in a large country like India, the overall risk gets reduced. The way forward in agricultural finance has to be to offer a joint product, a crop loan and weather insurance, the risk for the latter being borne by an insurance company which is in a position to diversify the risk across a number of regions. This takes away the problem of high co-variant risk from crop lending.

Institutional credit (Scheduled commercial banks) to Agriculture and Allied activities:

Year (endJune)

Up to 2.5 Acres Number of Accounts Amount

1 1997-98 1998-99 1999-00 2000-01 2001-02

2 2104 2308 2342 2382 2679

3 2288 2787 3338 3740 4352

*Accounts in thousand *Amount in Rupees crore Above 2.5 acres to 5 Above 5 Acres Total Acres Number Amount Number Amount Number Amount of of of Accounts Accounts Accounts 4 5 6 7 8 9 1811 2413 1420 4827 5336 9528 1878 3181 1659 5862 5845 11829 1871 3467 1581 7209 5794 14014 1860 3642 1599 7135 5841 14516 1933 4371 2359 7578 6970 16300

2002-03 2003-04 2004-05 2005-06 2006-07 2007-08

2494 3711 4478 5004 5963 6605

4834 7953 10833 16823 23246 25352

1934 2695 3172 3670 4008 4463

5578 7340 10550 17619 21588 23215

1983 2259 2535 3670 4379 4932

11445 16592 19735 32682 49335 48140

6411 8665 10185 12344 14350 16000

21857 31885 41119 67124 94169 96707

Comparison of Lending by Credit Institutions to agriculture and allied activities:

Year 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09

Cooperatives 8484 9876 12483 13254 14159 15099 25678 27295 30569 34040 40049 45009 48123 54019 57643 58787

SCBs 5400 7408 9274 10675 11537 14663 16350 16440 18638 25256 36203 48367 80599 115266 113472 -

RRBs 752 1083 1381 1748 2103 2515 2985 3966 4546 5879 7175 11927 15300 20228 23838 26499 *in Rupees crore

Conclusion: Agriculture being the major livelihood in rural areas in India, credit institutions other than banks has to get into agricultural financing in a bigger way. This is all the more true as the banking system is not able to adequately reach farmers and the cooperative credit system in most of the states is nearly defunct. For these lending institutions to be successful in agricultural financing requires a change in the approach banks and other institutions have followed, they will need to design new financial products and get accustomed to repayments at harvest time, not on a regular basis. They will have to learn to experiment with new channels such as farmers groups, input suppliers and output buyers. They will have to devise methods of risk mitigation such as weather based crop insurance and the use of commodity derivatives. In order to ensure recovery of loans, they need to facilitate the farmers in increasing their productivity and reduce the risks. These credit institutions will have to encourage local value addition through lending to agro-processing enterprises, many of which may not be micro. These institutions will have to learn to enhance the farmers capability to get better price for their

produce by designing new products such as warehouse receipts and commodity derivatives. Organising community based institutions to take this responsibility for their members and capacity building of the institutions engaged in livelihood promotion become inevitable. If these new credit institutions can acquire the capability to offer these products and services, a huge business opportunity awaits them.

3. Export receivables-backed financing

This model entails the provision of pre-export loans or advance payment facilities to an exporter, with repayment being obtained from the exporters receivables resulting from the sale of the pre-financed exported commodities. Under this model, banks take the following combined measures:

a) Taking security over the physical commodities in the form of a local-law pledge or similar security
interest; b) Assigning the receivables generated under the commodity export contracts;

c)

Establishing an escrow account in a suitable (usually offshore) location into which purchasers of the commodity are directed to pay the assigned export receivables. This creates an automatic reimbursement procedure. The financing is thus based on the payments to be made by the buyer once the goods are exported. This enables exporters to use future trade flows to raise self-liquidating exportbased financing at better cost and tenor. It also enables financiers to externalize country and credit risks by the assignment of export contracts and receivables, and by receiving payment in an offshore escrow account.

The main risk that needs to be carefully mitigated remains the performance risk of the exporter. This is the risk of the exporter failing to supply the goods as envisaged in the commercial contract. When dealing with a new or uncertain borrower, a bank usually asks for a personal guarantee (rights on the borrowers house for example), or splits the risk by taking goods as a security on the loan and financing up to 80 per cent of the value of the underlying security. Even in such secured loans, however, the bank will first verify that the client has the potential to deliver. In some cases, banks refuse to take any risk on new clients and deal only on a fully cash basis until trust is established with the new client. However, fraudsters can always find a way to abuse this bank logic.

Export Credit
Year (as on March 31st) Export Credit(Outstanding) (Rs. Crore) 2000 2001 2002 2003 2004 2005 2006 2007 39118 43321 42978 49202 57687 69059 86207 104926 9.0 10.7 -.8 14.5 17.2 19.7 24.8 21.7 Variations ( %) Export Credit as % of Exports 24.5 21.3 20.6 19.3 19.7 18.4 18.9 18.4

2008 2009 Jan 27, 2010

129283 128940 124360

23.9 -.8 -3.6

4. Agriculture Supply Chain Finance

An agricultural supply chain encompasses all the input supply, production, post-harvest, storage, processing, marketing and distribution, food service and consumption functions along the farm-to-fork continuum for a given product (be it consumed fresh, processed and/or from a food service provider), including the external enabling environment. These functions typically span other supply chains, geographic and political boundaries and often involve a wide range of public and private sector institutions and organizations.

Modern agricultural supply chains are networks that typically support two major flows: Physical product flows, which are the physical product movements from input suppliers to producers to buyers to final customers; Financial flows, which are the credit terms and lending, payment schedules and repayments, savings, and insurance arrangements Logistics and communications are embedded in all of these flows, and poor logistics and communications are often a major source of risk facing an agricultural supply chain. The underlying objective of agricultural supply chain management is to provide the right products (quantity and quality), in the right amounts, to the right place, at the right time, and at a competitive costand to earn money doing so. The agri-supply system includes farmers and a diverse range of firms, including backward-linked input suppliers and forward-linked intermediaries, processors, traders, wholesalers and retailers. The main activities for direct supply chain entities are as follows: Input supply. This includes the production and distribution of material inputs such as fertilizer, seeds, packaging, etc.utilized in the primary production, processing and/or trade of the focal commodity. Farm production. This stage is concerned with primary agriculture production and ends with the sale of a raw commodity at the farm gate. These transactions may occur literally at the farm gate or at some other point where the farmer hands over ownership of the product to the next supply chain participant. Depending on the crop, some type of primary processing (such as the shelling or bagging of dry grain) may take place at the farm level. Processing. The processing stage involves the transformation of agriculture raw materials into one or more finished goodsthrough drying, canning, freezing, or many other methods. Raw commodities, of course, are also traded and distributed and thus this stage may not apply to every crop. Domestic and international logistics. The logistics stage is concerned with the delivery of marketed commodities to their final market destination. There are many private and public sector entities that provide support services such as finance and insurance, advisory services, and logistics and information. Conditioning the entire supply chain are the domestic and international enabling environments. From a domestic perspective this includes: fiscal and financial sector policies, pricing and investment incentives and institutions, the regulatory and legal framework etc. From an international perspective, the enabling environment includes international trade regulations and agreements, other international protocols, and the policies/regulations of nations and trading blocs with whom the focal supply chain sources and sells inputs or products. In supply chain analyses, success is measured in terms of the supply chains performance -the ability to deliver a product or service to end markets. This success, in turn, depends on access to critical support services; the ways in which firms are organized vertically and horizontally and the structure of relationships among firms; the ways in which firms access information, learning and increased benefit flows, and the power over the terms and conditions of transactions, and the business enabling environment.

Risks Involved in Supply Chain Finance: An agricultural supply chain is subjected to multiple potential risks. In the face of multiple potential risks, the resilience of primary producers, agribusiness entities, and institutions for collective action, supply chain coordination, and public-private cooperation is a critical consideration. In order to understand current competitiveness and future potential of a sector, we should have proper understanding of the ability of the players to anticipate and respond to shocks. A commodity sub-sectoral developmental strategy that ignores considerations of risk and risk management will be indeed incomplete. While assessing this, one can consider the adequacy of existing risk management measures and supplemental measures. RISK Weather Related Risks Natural Disasters (including Extreme Weather Events) Market Related Risks EXAMPLES Periodic deficit and/or excess rainfall or temperature, hail storms, strong winds Major floods and droughts, hurricanes, cyclones, typhoons, earthquakes, volcanic activity Changes in supply and/or demand domestic and/or international prices of outputs, changes in market demands and/or quality attributes, changes in that impact inputs and/or for quantity food safety

requirements, changes in market demands for timing of product delivery, changes in enterprise/supply chain reputation and dependability Logistical & Infrastructural Risks Changes in transport, communication, energy costs, degraded and/or undependable transport, communication, energy infrastructure, physical destruction, conflicts, labor disputes affecting transport, communications, energy infrastructure and services Poor management decisions in asset allocation and livelihood/enterprise selection, poor decision making in use of inputs, poor quality control, forecast and planning errors, breakdowns in farm or firm equipment, use of outdated seeds, not prepared to change product, process, markets, inability to adapt to changes in cash and labor flows, etc. changing and/or uncertain financial (credit, savings, insurance) policies, changing and/or uncertain regulatory and legal policies, and enforcement, changing and/or uncertain trade and market policies, changing and/or uncertain land policies and tenure system, weak institutional capacity to implement regulatory mandates .

Management and Operational risks

Institutional and Policy risks

. Prominent Risks Affecting Indian Agri- Commodity Supply Chains Price Volatility Loss of Product Quality because of Logistical issues M M L M L-M M L Constraint to Market Access Adverse weather disrupting production

Coffee Mustard seeds Cotton Maize Spices Tea Wheat

H H H H M L H

L L L M M L L

M H L H L-M H M

Supply Chain Finance Opportunities

Various types of service providers may play an important role in enabling producers and marketing entities to better manage risks either through investments, adopting better management practices, or by transferring certain risks to others. Financial institutions may play especially important roles provided that they well understand the prevailing risks faced by prospective clients and tailor their credit, insurance or other products accordingly. There are a number of unique characteristics to rural and agricultural markets that constrain both the supply and demand for market-based finance. These challenges include high transactions costs for both borrowers and lenders, high risks faced by potential borrowers and depositors due to the variability of incomes, exogenous economic shocks, limited tools to manage risk, lack of reliable information about borrowers, lack of adequate collateral, and inhospitable policy, legal and regulatory frameworks. In all cases, lending for agriculture can expose (formal and informal) lenders to high levels of liquidity risk and covariant risk. Liquidity risk is greater because of the seasonality of crop production and the likelihood that all farmers in the region will seek a loan or access to their savings at the same time (in the event of expected or actual risk-related losses). Lenders also have high exposure to covariant risks such as climatic risk and market (e.g., price) risks that are endemic to agriculture and that effect all farms and firms in a given region who borrow for similar purposes. Financial institutions such as commercial banks, credit unions and MFIs are direct providers of financial services, and tend to focus attention on the series of transactions to bring a product from inputs to the final market, rather than a given stage in the chain. A supply chain approach to the provision of financial services focuses attention on the kinds of financial flows and the opportunities and risks associated with the provision of formal and informal financial services, whether direct or indirect Supply chain finance operates with the same logic as other financial transactions. Lenders face the risk that borrowers will not pay back. Successful financial relationships must include some form of client screening, client monitoring, and contract enforcement. Appropriate incentives must be in place to ensure that the costs to borrowers who default are higher than the cost of repayment. In some cases, supply chain participants working in cooperation for production, processing and marketing are better situated to enter, screen, monitor and enforce contracts than are the more formal providers of financial.

Approach financial institutions can consider designing their lending products and policies, and customizing their products in accordance with the need of chain participants for various activities like production and trading. Transaction Point Risks: Retail price falls due to competition because margins are thin Input Supply Finance Opportunity: Short-term lending product of only one to two months to limit the exposure of the lender

Transaction Point Risks:

Production Finance Opportunity:

a) Inputs for production are late or Monthly phased disbursement lending product to limit the
incomplete exposure of the lender Monitor minimum prices announced by the government. Govt. financed credit guarantee facility

b) Farm gate price is below cost of

production

c) Loan term is longer than production and Adjust the term of the loan product to match the seasonal
marketing cycle production and marketing cycle

d) Yield is lower than expected

Design the loan product to pre-finance only a portion of the total cost of production. Opt for loans based on ginnery receipts so as top lend only post harvest Design the loan product to disburse in phases where financing is only released as the tasks in the production and marketing cycle are realized Buying Agents/Traders Opportunities:

e) Operational acreage borrowed for is not

realized

Transaction Point Risks: a) Transport is inadequate.

Offer finance and operating lease for trucks Finance only against forward contracts provided in advance of borrowing from regional traders. Price insurance products compensating for low price years from earnings of high price years through a commercial insurer Opt for loans based on warehouse receipts so as to lend only post delivery.

b) Price is below cost of procurement.

5. Pre-payment financing

This modality is structured as a purchase of goods, with payment made in advance. It allows the buyer (off taker) to raise a loan from a bank and use it to effect pre-payment for the producer/exporter. Such commodities may already be in a third-party warehouse or about to be assembled with the proceeds of the facility. By making the pre-payment, the buyer obtains title to the commodities under the contract, thus reducing legal/regulatory constraints. The buyer transfers all his rights under the contract to the bank. The banks security would lie in the assignment of the pre-paid export contracts, including a charge on the commodity, either in the warehouse or as and when assembled. Pre-payment finance is generally limited-recourse finance (repayment can be split, say 20 per cent with full recourse and 80 per cent with limited recourse). In other words, the buyer only has the obligation to repay if the supplier fully meets his commitments under the contract. This means that the bank must closely evaluate the performance risk of the supplier and the legal environment in the country for pre-payments. Will the offtaker really have title? Is this enforceable? Will it have priority over unpaid sellers rights and the claims of local tax authorities, employees, warehousemen, etc.? If the beneficiary is not itself the exporter, are the intermediary parties under an obligation to perform? Is a government or central bank consent necessary? Given the likely importance of the warehouseman, the bank will carefully monitor his operations. The bank will also examine possible measures in case it has to take possession of the product (is the product easy to sell? Can it export? Does it have to be sold through public auction?). In difficult situations, pre-payment structures are often the best solution, as they enable a bank to share key financing risks with the off taker and reduce the risk of non-payment. In addition, having legal title to the goods, rather than just holding a pledge, would normally give the off taker direct control over the goods. If, for example, the local company goes into bankruptcy, the commodities being financed will be assigned to the off taker without the need for lengthy bankruptcy proceedings.

Other Modes of Agri-Commodity Financing

There are other quite innovative modes designed to help commodity traders to manage their working capital requirements:

Reserve-based lending facility

Reserve-based lending (RBL) is a financial product tailored for upstream companies. An RBL facility typically includes a borrowing base mechanism based on the estimates of cash flow streams derived from the oil assets used as collateral. It is a product aimed mainly at medium-sized exploration and production companies in the development stage with a good track record, allowing them to source finance in international bank markets. Instead of classic structured export financing, RBL has a flavour of both project finance and trade finance, where borrowing is linked not just to what a company produces but also to its reserves.

Commodity Ownership by financial Institution

A way to provide secured financing to buyers of agricultural commodities in the absence of Warehouse Receipt (WHR) was developed by EBRD, in consultation with lending agencis, to meet the funding requirements of traders and processors in developing countries. The Client, an ad hoc subsidiary of a major international financial institution, takes actual ownership of the financed commodity, warehouses it under strictly defined terms and conditions until it is sold to traders or food processors referred to as the Borrowers. Because of lot many issues involved in the implementation of WHR financing for smaller traders and mill owners , the financial instrument is intended to fill the need for secured working capital lending to the agribusiness sector immediately downstream of the primary sector. It caters to companies involved in the initial processing of agricultural commodities, ranging from flour milling to seed crushing or sugar refining. A number of them are SMEs which would find it difficult to raise the required financing to purchase and store their raw material at reasonable conditions. This mode of financing has worked well in many African and Asian countries. Of particular significance is the fact that many credit institutions contributed meaningfully to the increase and diversification of agricultural commodity financing in these Countries in the absence of an economically sounder alternative.

Leasing
Another mode of agri-commodity financing which can act as alternative to traditional debt financing of capital investments is Leasing. Although Leasing financing method is in nascent stage in India, there is a huge scope for this considering the fact that most of the agricultural cooperatives still follow traditional or semi-mechanized modes of production. The two important types of lease financing are: Short-term and Long-term Direct Financial Lease A short-term direct financial lease provides asset control with generally no ownership rights, except for the opportunity to acquire the asset at lease termination through a purchase option. This financing technique has been used by cooperatives for the last many years or so and is typically used to finance relatively small, short-term asset requirements. The long-term direct financial lease is generally non cancellable financial arrangement and the terms remain unchanged for several years. It differs from an annual operating lease as the financing terms of an operating lease may be adjusted on an annual basis in contrast with financial lease. Leveraged Lease

This financing arrangement provides an alternative to the direct financial lease when large capital outlays are required on depreciable real and personal property. A leveraged lease operates the same for the lessee as would a direct lease. The lessee contracts to make the periodic lease payments and is entitled to the use of the asset. The lessor acquires the asset, financing a minor part of it as an equity investment, and borrowing to finance the remaining amount. The loan is usually secured by a mortgage, as well as by an assignment of the lease and lease payments. Since the lessor is a borrower, the lease rate must be set at a level that will cover the interest expenses incurred under the loan and provide the lessor with an acceptable after-tax rate of return. The lessor is entitled to all tax benefits of depreciation and investment credits that apply.

Approach needed for Agri-commodity Finance: Investment Finance or Lifecycle Finance- what to focus upon? The separation between medium- and long-term (investment) finance and short-term finance (working capital finance), with some institutions only providing one form, is counterproductive. Ironically, in many cases that long-term finance was available to develop a plantation or a processing plant, the operators lacked the working capital finance to operate properly. Working capital finance is needed because production or procurement generally requires pre-finance, while buyers generally make payment only a certain time after shipment. Among other things, inputs and processing need to be financed, and the goods require financing while awaiting shipment. The seller may also need post-shipment finance. For example, European buyer of vegetables would normally expect to pay at the earliest on arrival of the vegetables in his premises, or even 15-30 days after that; for commodities with a slower commercial cycle this can go up to 120 days. The costs of the finance have to be built into the final price, because if an Indian supplier wishes to be competitive, he should be able to offer similar credit terms to his competitors. This can be difficult if his interest costs are much higher than those of competitors. Insufficient working capital finance will reduce the ability of the producer, or processor, to use his productive capacity, making investments less profitable and endangering the reimbursement of investment credits. Instead of separating investment finance and working capital finance, financiers should consider the two as part of life-cycle finance. The investment will generate revenue in the years to come, but only if certain activities are undertaken. For example, farmers need to be provided with seeds and other inputs, buyers need to be given postshipment credits. By keeping track or even controlling the sources of revenue, the financier can not only secure his initial investment finance, but will also be in a position to provide working capital finance. Financial engineering techniques can help in this regard by shifting the risk of lending from the farmer (a credit risk) to the crop (a performance risk).

Conclusion The landscape of commodity finance has witnessed radical changes over the last few decades. Companies involved in commodity trade are mainly private, operating under an evolving trade regime shaped by liberalization policies. Borders between banks, investment funds and insurance companies have opened up, and the consolidation of commodity markets, coupled with the introduction of new information technologies, has created new challenges and opportunities for commodity producers and exporters, particularly small and medium-sized ones in developing countries. However, increased opportunities entail increased risks. STCF is a tool for realizing opportunities while controlling risks. However, the success of STCF depends on the extent to which involved parties (international banks, local banks, importers, exporters, Governments, etc.) are capable of pooling their efforts and knowledge in a coordinated manner. Governments can play a major role in

facilitating the use of STCF by providing an enabling environment, particularly in relation to appropriate legal and regulatory reforms for enhancing transparency and reducing uncertainty. As mentioned above, the establishment of STCF entails several risks that cannot be appreciated by traditional banks. Banks should stretch their activities to include commodity trade financing and to appreciate the particularities of the commodity trade. However, local banks in developing countries with economies in transition are risk-averse and often lack the required knowledge of STCF. Capacity-building programmes and pilot projects are needed to help local banks to successfully engage in STCF. The possibilities for STCF can also be greatly enhanced if there are strong support institutions, such as warehouse companies, collateral managers and other entities enabling the mitigation of commodity price risks. Strengthening such local support institutions deserves a prominent place in any programme to develop a national trade finance infrastructure.

ROLE OF THE EXCHANGE IN AGRICOMMODITY FINANCING:

Agri-commodity financing at various levels of supply chain provide the exchange the tremendous opportunity to increase the volume of various commodities being traded on it. A few innovative financial instruments which a commodity exchange can leverage upon to increase contract volumes on its trading platform are:

Facilitating finance to traders, millers, exporters, etc. through warehouse receipt (WHR) mode:
This mode of financing is being used by commodity exchanges throughout the world and is quite popular. In India, NCDEX facilitates this medium through collaboration with credit institutions and warehouse management Company. The trader deposits the commodity with a professional warehouse operator or collateral manager, such as Origo Commodities Ltd. or NBHC . Warehouse accreditation and quality certification are ensured by the Warehouse Company or collateral manager. A WHR is issued against the stored quantity by the warehouse operator. With the physical commodity in the warehouse, the trader then takes a contract on a future exchange, such as Indian Commodity Exchange (ICEX), for sale with delivery at a future date when the prices are favourable. He receives a contract note or a sales receivable note. The financing institution takes the WHR and the contract note or sales receivable from the trader and gets the confirmation from the exchange to check the authenticity of the receipt. The bank or lending institution then advances a specific percentage of the value of the commodity as represented by futures contract sales note. The loan advanced by the lending institution depends upon the acceptability and ease of control of collateral. The exchange agrees to pass on the sales receivable at the expiry of the contract against the submission of sale note and WHR to the bank. After adjusting the payment received against the loan advanced, the bank will pass on surplus fund to the borrower. Since the exchange guarantees a previously agreed and full price of contracts sold by the trader, the credit risk of the bank is mitigated. The bank, in turn, is ready to give loans at lower rates. The borrower also benefits from lower applicable bank interest rates against the loan amount.

Beneficiaries: Supply Operative Seller Warehouse operator/ Collateral manager Exchange Chain Role in Supply chain Sells the produce on the exchange Facilitates storage and provides collateral management Provides a platform for trading in futures Risk Mitigation Mitigates price risk by selling on the exchange Mitigates quantity and quality loss during storage Mitigates credit risk of banks Mitigates price risk for the seller and guarantees revenue Mitigates risk of default- payment default for the seller or banker and delivery default for the buyer Mitigates credit inadequacy risk by making available sufficient loan to cover working capital requirements Mitigates price fluctuations and demand risk by buying on the exchange

Banks Buyer

Provide loan against WHR End user

As the warehouse receipt system of ICEX uses physical mode, it should take some extra precautions while approving financing for traders or producers on the warehouse receipt. However, it makes business sense to shift to dematerialized warehouse receipt system as its competitors like NCDEX and MCX already have electronic record maintenance system in place. Maintenance of WHR in demat form would solve many problems concerning speed of transaction, splitting of warehouse receipts, forgery and loss of receipts etc.

Sell futures through broker Farmer Coop. Exchang Issue sales contract e

Exchange facilitating finance for traders and producers through Forward Contracts:
The farmer at the beginning of the planting season will sign a forward contract to sell a fixed volume of a commodity (e.g. 50 tonnes of mustard) to a trader after harvest at a fixed price. Most farmers using the system will sell between 30% and 50% of their expected output under the forward contracts. The fixed volume reflects past production and marketing record as well as expected output based on acreage planted and forecast

Qty Certification & Issue of WHR

e

Bank

Deposit of Commodity

WHR & Futures sales Note

Pay Margin & MTM

Reimburse

Financing

Warehous

Bank

production factors such as the weather. The price will be negotiated on the basis of market trends and projections. Both the farmer and the trader will use futures and options contracts traded on ICEX to hedge adverse price movements (and can potentially benefit from favourable price movements). The farmer projects farm income based on assured price and on the basis of this secures production finance. The bank in turn hedges price risk using futures and options contracts traded on ICEX as a means of reducing default risk. After harvesting, the farmer deposits the 50 tonnes of mustard (committed under the forward contract) to a ICEX-designated Arathiya and is issued with a receipt confirming the deposit at a named location. The farmer then transfers the receipt to the trader for delivery of the underlying commodity. The trader pays the farmer at the fixed price, thereby becoming bona fide holder of the receipt i.e., have the right to transfer the Certificate to other trade or financing parties. Where the trader requires inventory financing, the receipt can be pledged to a bank as collateral for a loan in this case the bank will take physical possession of the receipt until the loan is repaid. Payment to farmers will be usually into their accounts held at the lending bank, which can directly recover the loan. Farmers can deposit the remaining output (50% to 70%) with the same Arathiya and obtain receipt, which they can take to banks for inventory finance under terms/conditions similar to what is offered to the traders. Holders can also use receipt for delivery against futures and options contracts. The delivery is usually to an end-user e.g. processors. The volume of commodities actually delivered against futures and options contracts represents a very small proportion of the total volume traded as these instruments are used more for managing price risks than for trading the physical commodities.

Benefits of this approach for all the players involved: a) The system creates a means by which sellers and buyers are brought together to trade on the basis of reliable information on the quality, quantity and location of commodities to be traded. This reduces the cost of sourcing produce for traders and processors, while lowering the cost of accessing markets, especially for premium quality produce, for Arathiyas/farmers. b) The guarantee of delivery by the exchange, based on the guarantee by Arathiyas or traders, reduces the risk of non-performance of contracts. This makes it possible for farmers to obtain both production and inventory finance. c) Liquidity in the agricultural sector can be significantly enhanced as a result of improved access by farmers, traders and processors to finance based on instruments traded on the exchange as well as bilateral contracts linked to those instruments. d) The greater security in trade transactions provided, will lead to lower cost in enforcing contracts, especially where litigation is time consuming and expensive. e) Exchange trading improves collection and dissemination of market information to all players, making it possible for all players to negotiate trade and contracts on the basis of reliable information. f) The commodity exchange represents a transparent and often reliable means by which lenders can liquidate collateralized commodities in the event of default by the borrower. Therefore, it facilitates access to commodity finance. g) As the exchange matures from a spot to a futures market, lenders tend to use futures and options contract to hedge price risks, thereby reducing credit risk and therefore, the cost of borrowing. The formal market in commodities also becomes attractive to investors intending to profit from price movements. Their involvement often brings added liquidity to the market to the benefit of all players.

Collaborating with farmer cooperatives, NGOs and regional rural banks:

The proposition entails funding from a core development finance institution that can play a critical role with NGOs and ICEX to work in synergy. The objective would be to link farmers with relevant organizations for

spot marketing and simultaneously accessing the future market to hedge risks. As majority of the farmers in India belong to small or middle category, they are not in the position to trade on the exchange because of the requirement of lot size. For example, the lot size for mustard seeds on ICEX is 10MT and it is not possible for an individual farmer(small or middle category) to meet the criteria for lot size. Hence, it makes sense to form homogeneous farmer sub-groups of 5-7 farmers who can collectively pool in the required quantity. The exchange will be required to develop information structures on the ground which would help keep track of physical operation of farmer groups in order to manage their corresponding future positions and subsequently redistributing the benefits of price hedging proportionately among farmers. Farmers growing a particular crop can be divided into sub-groups of 5-7 for meeting the minimum lot criteria (say 10 MT for mustard seeds). Various sub-groups in the village will have one representative who will take decisions regarding the position on the exchange on behalf of his associated farmer members. Moreover, arrangements for public display of market information need to be made in villages to maintain transparency in prices. These farmer sub-groups will be associated to a Farmers federation or cooperative. The social organisation/NGO selected will be responsible for collecting the price and market scenario information from broker, web sources, etc., and subsequently pass it on to the Farmers federation for further dissemination. Subsequently, the information will be passed on to member farmers. The member farmers will convey opinions and decisions about their positions to their representatives, which will then be aggregated at the level of farmers federation. The farmers federation will subsequently communicate the necessary actions to the broker or the NGO representative dealing with the broker.

Key Constraint: Regulatory Constraints: The foremost regulatory constraint with respect to participation of farmers (particularly small and marginal farmers) on commodity exchange are the procedural hurdles (PAN card requirement, KYC norms compliance, burdensome paperwork etc) for opening a demat/trading/bank account. Institutional Constraints The procedural requirements and the technical complexities involved in commodity derivatives trading necessitate the presence of institutional entities which can act as technical support providers for farmer participation on commodity exchanges. Grassroots organisations like NGOs, cooperatives, agribusiness companies, farmer organisations do have the ability to serve as technical support providers to some extent. However, given their existing under-preparedness and limited capacities for managing price risk management initiatives, the fruits of promising initiatives for improving commodity markets in India may not reach the intended beneficiaries especially the disadvantaged farmers. Hedging the prices of the forthcoming harvest through futures trading requires the farmer to pay in the initial margin and Mark-to-Market (MTM) margin upfront. Such requirement is extremely constraining for farmers keen to hedge their price risks and calls for funding through institutional financing mechanisms.

Enabling Farmers to Leverage Commodity Exchanges The first step towards such farmer-participation initiatives needs to be linkage development with NGOs and organizations associated with farmers for regular price and market information dissemination. The information dissemination has to be complemented by intensive efforts in building the capacities of aggregator organisations and their associated farmer representatives. To ensure the proper understanding of theoretical concepts, it would be useful to conduct simulation and coaching exercises.

For future initiatives of similar nature, the creation of an apex level management team consisting of representatives from all key project stakeholder-entities is essential. This apex-level team would regularly assess the direction and progress of initiative and undertake necessary course correction measures. Survey of focus group and control group farmers needs to precede the development of the institutional framework on the ground. In addition, the specifications of the futures contract needs to be in conformity with the physical commodity and farmer for which price hedging is desired. Financial support sources for such projects can include loans from financial institution and development funding for envisaged developmental activities under the initiative. The loan part should include long term funding support from funding agencies and other institutions (like CCI, NABARD etc) for mark-to-market margin. This fund can be utilized for streamlining the cost & benefits over the duration of the initiative. To ensure proper compliance and improving the quality orientation of farmers, it is necessary to provide linkages to farmers for assessment of their quality specifications. This would enable the aggregatingorganization to link project benefits with the quality and avoid cross subsidization among participating farmers mills arising from proper distribution of costs and benefits. In addition, the linkages with industry and processing can ensure spot market interface, and standardization of production and market operations.

Exchange Traded Repos

In ve s to r/b a nk R e c o g n ize d w a re ho u s e
2. Is su a nce of w areho us e w arrants 5. O p en o u tcry b ids o n the in teres t rate for lo a ns s ec ured b y the w arran t

1. D ep osit of g o ods

6. C re dit (b y w inning b idd er

N a tio n a l A g ric u ltu ra l E x c h a ng e

4. W arrant is g iv en in cus to d y of E xc ha ng e

A g ric ultu ra l o r a g ro -ind u s tria l firm

B ro k e r
3. Tra nsfer of w arrant, w ith the ag re em en t to b u y it b ack after a c ertain p eriod

Conclusion:

Structured commodity finance, with the participation of the future exchange, provides a new and low risk way of commodity financing of traders, farmers, exporters and other participants in the supply chain. The key benefit of exchange participation lies in the mitigation of credit risk for lending institutions, thus making credit availability for supply chain participants quite easier. This is a win-win situation with potential for enhanced trade and investment in agriculture. With the launch of negotiable warehouse receipt system in India in May 2011, farmers would prefer using their crops in warehouse storage as collateral for bank loans and as backing for fully negotiable instruments of trade and finance backed by the national government. This provides immense opportunity to agri-commodity future exchanges to increase the volume being traded on their platform by facilitating credit to farmers through collaboration with scheduled commercial banks, regional rural banks and various other financial institutions. If we look at the opportunities available for Indian Commodity Exchange (ICEX) in agri-commodity financing, I think ICEX has got immense advantage because of the fact that farmers cooperative KRIBCHO being a stakeholder in it. However, one may argue that why should ICEX bother to facilitate easy credit for farmers who are members of KRIBCHO as they would anyway prefer hedging price fluctuations through futures on ICEX trading platform. But I believe this is a long- term strategy which ICEX should follow if it wants to compete effectively with other leading Indian agri-commodity exchanges like NCDEX. Adequate and easy availability of credit to farmers help them adopt modern agricultural practices leading to increased yield. Banks generally prefer lending only a fraction of the value of commodity stored in warehouse to farmers. However, the amount of finance available to farmers may not be sufficient to adopt better agricultural methods which cause decrease in yield. If ICEX can facilitate adequate credit to farmers at affordable rates through collaboration with banks, it will be win-win situation for everyone involved with the system. Farmers will have better yield which will increase their income, banks can expect timely repayment of loans because of improved economic status of farmers, and the exchanges volume in futures will go up.

In order that the volume of agri-commodity futures being traded on ICEX futures can take on the volumes being traded on NCDEX which is the market leader in agri-commodity trading, it should not limit itself just to KRIBCHO. If they can help farmers belonging to other cooperatives like NAFED by facilitating easy and adequate credit through collaborating credit institutions, ICEX can gain a decent trading volume. There is no doubt that NCDEX has an upper hand over ICEX in terms of reputation and volume. Moreover, NCDEX has already entered into collaboration with banks like ICICI, IndusInd and YES bank to facilitate availability of easy credit to farmers associated with various cooperatives. It becomes quite imperative for ICEX to explore this domain through various innovative methods like Leasing which till now has been out of radar of agri-commodity financing institutions. As the trading in agri-commodity futures by farmer cooperatives is only in nascent stage, currently volumes in future come mainly from traders, exporters and processors. So, the present strategy should be to develop a robust system to facilitate easy financing options for these players against warehouse receipts and simultaneously develop proper mechanism for financing cooperatives from where significant volumes in futures trading could come in the coming years.