What is a Commodity Paper
A commodity paper is a loan or advance for which raw materials owned by the borrower serve as collateral. The term paper refers to the contract, which is mostly a promissory note. For some commodities grading certificates, warehouse receipts, or bills of lading may comprise the collateral.
BREAKING DOWN Commodity Paper
A commodity paper is similar to a mortgage agreement or a car loan. With a secured loan, the collateral pledged gives the lender assurances they have some recourse should the borrower default or fail to live up to the terms of the contract. Whereas a home or other real estate secure a mortgage, in the case of a loan involving a commodity paper, the collateral is in the form of commodities.
Commodities are raw materials or production goods, such as oil, grain, gold, copper, coffee, cocoa, lumber, cotton, wheat, corn, sugar, and natural gas. By the nature of the products and materials involved, commodities may not be readily available at a specific location, and therefore it may sometimes be difficult, if not impossible, to produce them to provide as collateral.
Providing Proof for Commodity Papers
It is generally not necessary for the goods which serve as collateral be present, as long verification of their situation can be accessed should the need arise. The lender will not take possession of the commodities unless the borrower defaults on the loan.
Often the lender will want to confirm the assets which secure the loan exist in the quality and quantity required. Depending on the commodity which is ensuring the note, proof may be in several different formats. Products such as grains and oil may use a grading certificate. A grading certificate is a document issued by inspectors or an approved grading panel that formally signifies the quality of a commodity. Items such as live cattle or hogs may require proof of a delivery order or a bill of lading. Gold or other precious metals stored in a vault may need a vault or warehouse receipt.
An Example of Lender Risks
This inability to physically take possession of the collateral or at least visually inspect it and confirm its existence can present some element of risk to the lender, especially if the borrower is unethical or intends to deceive the lender.
Commodity paper was at the center of a notable incident known as the Salad Oil Scandal. In the early 1960s, the owner of Allied Crude Vegetable Oil used fraud to make inventory appear many times what it was and then borrowed against the erroneous inventory receipts. Estimations are that Allied used fraudulent tactics to make it look like the company had $175 million worth of inventory that did not exist, and then used this fake inventory to secure massive loans.
Trading in Commodities
The most common methods of trading commodities include:
- Futures are financial contracts obligating the buyer to purchase an asset, or the seller to sell an asset, at a predetermined future date and price.
- Options offer the buyer the right, not the obligation, to call or put the underlying asset at an agreed-upon price during a specific period.
- Exchange-traded funds are liquid marketable security that tracks a commodity or a commodity basket and trade like stocks on an exchange.