NOTES AGRICULTURAL & RURAL DEVELOPMENT 37033 EXPANDING POST-HARVEST FINANCE THROUGH WAREHOUSE RECEIPTS AND RELATED INSTRUMENTS ISSUE 8 BY: THE COMMODITY RISK MANAGEMENT GROUP MARCH 2006 International trade in agricultural goods is constantly WHAT IS WAREHOUSE growing, and to help finance this increase in trade RECEIPT FINANCING? flows, innovative collateral securitization mechanisms1 Warehouse receipt financing is a collateralized com- continue to evolve and develop. Emerging markets, modity transaction where the goods themselves pro- however, do not benefit as much as developed coun- vide security for the loan. This type of financing allows tries from the increased trade flows and alternative lenders to immediately sell off a very liquid asset, name- methods of finance. Warehouse receipt financing and ly the commodities they grow, if a farmer defaults on similar types of collateralized lending provide an alter- the loan. The underlying collateral is usually a soft native to traditional lending requirements of banks commodity like grain, cotton, coffee, or cocoa. and other financiers and could provide opportunities to expand this lending in emerging economies for Warehouse receipts and other collateralized lending agricultural trade. are means of accessing post-harvest finance for work- ing capital needs. As a result, the financing cycle The concept of warehouse receipt financing is not begins after harvesting the commodities (or goods). new, but what is new is the innovative applications of The commodities are stored in a licensed warehouse collateralized lending to extend financing in markets that issues a receipt proving that the commodities are where other attempts have failed. The creative use of physically in the warehouse. This receipt forms the the basic principle behind warehouse receipts--collat- basis of the financing. eralized lending--in order to design new financing instruments is making new waves in rural finance. The warehouse receipt consists of two parts: a certificate of pledge and a certificate of title Certificate of pledge. The certificate of pledge is pro- vided to the lender in order to take out a loan, allowing the farmer who has deposited goods in the warehouse to borrow against those goods (e.g., the grain) to cover his working capital needs. Once the certificate of pledge has been issued, the lender usually advances funds as a specified percentage of the value of the commodity. The lender does not give the borrower the full value of the goods in the warehouse to provision for the costs the lender will incur when selling the com- modity in case of a loan default, as well as the poten- tial decrease in value of the stored good caused by price volatility in the respective commodity market. Certificate of title. The farmer then sells the commodi- ties that are stored in the warehouse, either to a trader or primary processor, validating the sale with a certificate of title which is given to the buyer. The buyer pays back the loan plus interest directly to the lender, receiving the certificate of pledge in exchange. Once the buyer has both, the certificate of pledge and the certificate of title, he can release the commodities from the warehouse.2 WHAT IS THE VALUE OF WAREHOUSE RECEIPT or shipped, actually buys the goods and simultaneously FINANCING? signs a contract for resale at a certain point in time, either at a fixed price or at an agreed reference price. A transaction backed by a warehouse receipt allows a Export receivables financing: funds paid out to an financier to shift its risk from the borrower to the asset. exporter against assigned off-take (import) contracts of Since the lender can sell the liquid collateral asset in case commodities from an importer. The financier, based on of default, this type of lending lowers risk and reduces the off-take contracts, finances the exporter for working typical costs of commodity transactions--e.g., high loan capital needs. The off-taker (or importer) pays the finan- servicing costs due to limited volumes, high information cier first, who then pays down the loan and passes any additional proceeds to the exporter. Factoring: a supplier assigns receivables (payments due) from sales contracts to a factor (i.e., a broker such as a bank). The factor can provide finance for the supplier through loans, advance payments, and other additional services. This shifts the risk for the factor from the rela- tively riskier supplier to the typically lower risk buyer. Islamic trade finance: a banking system in which the lender must share in the profits and losses arising out of the enterprise for which the money was lent. For exam- ple, an Islamic bank would purchase the commodities in its own name and then sell them on to the end buyer at an agreed mark-up. Two specific examples of the successful implementation of collateral lending mechanisms are outlined below. costs, and high supervision costs. In addition, borrowers do not need a strong balance sheet or long credit histo- ry because the lender is not relying on the individual or TRADABLE RECEIPT company, but on the value of the commodity. Since the FINANCING: THE EXAMPLE lending costs for the financier are reduced, the interest OF CEDULA DE PRODUTO rate for borrowers could also be reduced. RURAL IN BRAZIL In the late 1970s the Brazilian agricultural sector was Warehouse receipts are a good mechanism for accessing characterized by abundant subsidized credit and mini- short-term working capital loans because they do not mum price guarantees. But through gradual liberaliza- tie-up fixed assets, which are more appropriate collater- tion in the 1990s the agriculture sector improved by al for accessing long-term financing for capital expendi- securing outstanding rural debts; repositioning the tures. In addition, warehouse receipts offer the opportu- state, which began to act in a more localized and trans- nity for borrowers who lack fixed assets altogether to parent manner; and privatizing agricultural finance and access finance. marketing. Despite these advancements, there were no OTHER COLLATERAL formal and secure mechanisms and guarantees to secu- LENDING MECHANISMS ritize agricultural lending. In response to this situation, in 1994 the Cedulo de Produto Rural (CPR) was created through Law 8,929. While warehouse receipts are the basis for collateralized lending, the basic concept behind warehouse receipts The CPR is a bond issued by rural producers, farmers' (leveraging physical production to access finance) can be associations, and cooperatives in order to obtain financ- applied in innovative ways to deepen financial services in ing for production. There are three types of CPRs: the agricultural sector. 1. Physical CPR: The producer receives cash or inputs Repurchase agreements (more commonly known as when the bond is issued and must deliver an agreed "repos"): simple forms of commodity finance. The bank, amount of production at an agreed location and rather than taking a pledge over the goods being stored future date. 2 2. Financial CPR: The producer receives cash or inputs In response to this lack of financing in the formal sector, when the bond is issued, but settles the debt with NAFIN developed an electronic platform for reverse fac- cash instead of products. toring through a program called Cadenas Productivas, (or Productive Chains), which provides greater opportu- 3. CPR indexed to futures: The producer receives cash or nity for small suppliers to access working capital. While inputs when the bond is issued, but the settlement is currently a small percentage of NAFIN's factored portfo- based on the amount of production established on lio is in the agricultural sector, its success with small and the bond, multiplied by the agreed upon reference medium enterprises (SMEs) shows a potential path for price at the time of settlement. extending lending to agricultural clients. The main benefit of the CPR is that it brings new finan- The aim of Cadenas Productivas is to create linkages ciers into the agricultural finance markets by reducing between small suppliers and "big buyers." The big buy- their risk. The CPR bond guarantees payment in case of ers are large, creditworthy firms that have low credit nonperformance or breach of contract on the part of the risk. The suppliers are small, risky firms that generally bond issuer through an out-of-court dispute settlement cannot access any financing from the formal banking mechanism. This reduces risk of moral hazard and sector. The NAFIN reverse factoring program allows speeds the recovery of loans when needed.3 small suppliers to use their receivables--or balance due--from big buyers to receive working capital financ- The evolution of the CPR has also been one of its keys ing. This transfers the credit risk of small suppliers to to success. Initially the physical CPR saw a limited num- their high-quality customers, which allows them to ber of investors because many financiers did not want to access a larger amount of less-expensive financing. risk receiving physical goods. In response, the financial CPR was created, which attracted a greater number of In order to understand reverse factoring, it is important investors because it was cash settled. The further refine- to understand the mechanics of ordinary factoring (see ment of the CPR contract, the indexed CPR, allows not Box 1). In factoring, the underlying assets (the products) only for cash settlement but also transfers the price risk are the seller's accounts receivable--that which is owed from the seller to the buyer of the CPR. to a seller after he/she sold and shipped the product to a buyer. The accounts receivable are purchased by the In addition, CPRs are negotiated in an environment that "factor," usually a bank or other lender, at a discount. guarantees visibility, transparency, and security of opera- The factor deducts the amount that is owed once the tion. The Brazilian Futures Market and seven regional accounts receivable are paid. The remaining balance is commodity exchanges established The Brazilian paid to the seller, less interest and service fees. Commodity Exchange (BBM) to create an electronic reg- istration environment and clearinghouse for transactions with agricultural contracts, including CPR operations. Box 1. The Mechanics of Factoring This system permits electronic access to information and business opportunities to nearly 400 traders throughout tomatoes to its customer Big Buyer, B, a large Step 1: Small Supplier,S,sells 1 million dollars in Brazil. Traders can offer and buy contracts, register the operations, and guarantee the custody of bonds. The multinational exporter. S, in a competitive gesture, BBM system even permits potential investors to see the offers B 30-days trade credit. S records the sale as bonds guaranteeing their operations.4 US$1 million in accounts receivable and B records the purchase as US$1 million in accounts payable. THE USE OF REVERSE FACTORING: THE EXAMPLE inventory. A factor,F,purchases S's accounts receiv- Step 2: S needs working capital to produce more OF NAFIN IN MEXICO able (S "assigns" its accounts receivable from B to F). S receives today 70 percent of the face value of NAFIN is a state-owned development bank in Mexico the accounts receivable (US$700,000). B is notified that uses new technology to provide small and micro that S's receivables have been factored. enterprise loans and enhances its lending with training directly from B, and S receives the remaining 30 Step 3: In 30 days, F receives the full payment and technical assistance. In 2004, the typical small Mexican firm received less than 17 percent of its financ- percent, less interest (on the US$700,000) and ing from banks, relying instead upon family savings and service fees. other personal funds, while almost 80 percent of small Source: Klapper 2005. firms received no bank credit at all. 3 In emerging markets, factoring is uncommon due to lack CONCLUSION of sufficient credit information about the sellers and In traditional lending, the underlying collateral is only the frequency of fraud, such as bogus receivables and the second source of repayment that needs to be nonexistent customers. NAFIN uses reverse factoring to mobilized when something goes wrong. In collateral- overcome these obstacles. In reverse factoring, the lender ized commodity lending it is the first source of repay- purchases accounts receivable only from high-quality ment. Rather than relying on the willingness of the buyers. This way, the lender only needs to collect credit borrower to repay the loan, his balance sheet, or cred- information and determine the credit risk for large, very it history, the lender relies on the ability of the borrow- transparent, accredited firms. To reduce costs and speed er to conduct the underlying commodity transaction transactions, an electronic platform that provides online and has the possibility to sell off a very liquid asset, factoring services carries out NAFIN's factoring transac- namely the commodities, as soon as the loan is in tions. This electronic platform also facilitates competition default. In this way, collateralized commodity transac- among banks to factor a supplier's receivable. tions provide a structural risk change for the lender. Through innovative approaches in different emerging As an additional service, NAFIN provides contract financ- markets both warehouse receipts and innovative col- ing for up to 50 percent of confirmed contract orders lateralized lending mechanisms could provide opportu- from big buyers for NAFIN suppliers. Since NAFIN nities to expand the levels of post-harvest financing requires no collateral, charges no fees, and provides this being provided to producers, traders, processors, and finance at a fixed interest rate, this service provides SMEs other agribusinesses. access to sufficient working capital to fulfill the order. Factoring is an ideal source of financing in countries with REFERENCES small, risky suppliers and large, foreign buyers. One of the keys to success for the NAFIN factoring program was Klapper, Leora. 2005. "The Role of `Reverse Factoring' in Supplier Financing of Small and Medium Sized Enterprises." government support in setting up a legal and regulatory Background paper prepared by the Development Research environment that allows a secure and electronic sale of Group for "Rural Finance Innovations." Washington, DC: receivables. NAFIN has been used as a model in Mexico World Bank. for the automation of other government agencies and service providers. Additionally, the success of the NAFIN program depends on the legal and regulatory support SELECTED READING: offered in Electronic Signature and Security laws which World Bank, 2005. Rural Finance Innovations: Topics and could be a model for other developing countries. Case Studies. Washington, DC: World Bank. 1 A securitization is a financial transaction in which assets are pooled and securities representing interests in the pool are issued. An example would be a financing company that issued a large number of auto loans and wants to raise cash so it can issue more loans. 2 In jurisdictions where there are not two parts of a receipt (certificate of pledge and certificate of title), but only one, the lender receives the single-part warehouse receipt and releases it to the off-taker once reimbursed. The off-taker uses the receipt to release the commodities from the warehouse. 3 Moral hazard is defined as the possibility of loss to an insurance company arising from the character or circumstance of the insured. 4 At the end of October 2004, nearly 70,000 contracts had been registered with BBM, with a total financial volume of approximately US$900 million--in little less than one year of operation. This note is a product of the Commodity Risk Management Group. It was prepared by Marisa Baldwin, Erin Bryla, and Anja Langenbucher. It is based on the larger Economic Sector Work (ESW) entitled Rural Finance Innovations: Topics and Case Studies. The work describes how innovative techniques can be used to overcome traditional barriers of providing financial services to agriculture. A diverse group of case studies and thematic discussions provide key lessons. You can download a copy of the full report at www.worldbank.org/rural or email ard@worldbank.org. THE WORLD BANK 1818 H Street. NW Washington, DC 20433 www.worldbank.org/rural