Grain Bonding/Security

[TOM4CWB]

Charlie,

I see this on DTN... here is conventional wisdom... and for very good reasons.

DTN is running a whole series on Elevator security... and Weber's Web site give access;

Here is part of the second article:

"BONDING LAWS

Regardless of the market condition, most states offer some level of protection through the bonding of either warehouses and/or merchandisers, with requirements varying from state to state and according to the size of the operation. But the recent runup in grain prices has diminished the amount of protection provided by the bonds.

John Fecht, director of grain warehouses at the Nebraska Public Service Commission, said it would not be easy to convince bonding companies to increase bonds.

"Increasing bonds is not the answer," he said. "The bonding companies will not write the bonds at levels that would make some sense -- and that’s understandable. You would need to increase the bonds by millions of dollars to have some real protection and the bonding companies are not going to be exposed to that kind of risk."

Fecht said that perhaps the only way to establish "real security" is to create a state-managed account funded by proceeds from grain sales.

"In the event of a failure, money is in place to pay out with some rules needed to ensure good management practices by the farmer," Fecht said.

Klenklen said Missouri lawmakers have started looking at bonding laws."

http://www.webercommodities.com/index.cfm?show=4&id=0702BF52

It SHOULD be more than obvious that a combination of security 'tools' is in the best interests of grain growers... INCLUDING bonding!

[charliep]

Tom4cwb

Hopefully nothing I have said indicates eliminating CGC bonding without having another product or for that matter a private sector approach to bonding.

What is good is to have people recognize transaction risk (potential for someone to walk away from a contract or default on a payment after delivery) and have an open discussion about risk mitigation strategies/alternatives. All will have some cost. All will have to apply to both buyers and sellers equally and fairly.

[padron]

While I'll agree CGC bonding has offered some level of settlement protection I think it has done more to encourage farmers to avoid risk rather than mitigate it. In that process farmers have foregone premiums and enhanced revenue opportunities. Bonding warehouses is very different than bonding entities against both payment and contractual risks - especially in highly volatile pricing situations. As this article indicates bonding is failing its users under these conditions.

The suggestion by this article to create a fund - presumably by a producer check-off - does not reward the well managed, prudent businessman. It rewards the poor decision making and excessive risk taking individual who gets caught in a failure situation. The well managed business ends up paying for the poorly managed operation. It sounds too CWBish for my liking.

It is also a very poor use of capital. Having $5, $10 or even $100 million sitting in a fund waiting for something to go wrong just seems impractical to me.

I know I'm beginning to sound like a broken record on this topic but it seems to me that the best route is to introduce measures that prevent failures from happening (clearinghouse). Then you don't needs funds, bonding or insurance.

[TOM4CWB]

Pardon,

A grain dealer or co. can go just as broke... just as quick (perhaps faster if they can't maintain margin accounts)... under a Ag Clearing House...as any other system.

So what happens then?

No Partner to dance with... leaves the grower out in the cold...

And what small dealer doing back to back sales... is going to offer Ag Clearing House coverage in any event? Further... If these folks are 'complaining' about the CGC bond... and restrictions on Capital... the Ag Clearinghouse further compounds this problem for them... adds huge cash-flow risk for the grower on margins that never existed under the present system...

There is no question the AG Clearinghouse model is many times more expensive... ESPECIALLY for the grower...

Name one working example of an Ag Clearing House... (FOR GRAIN) any where on the globe... that is operating on a voluntary basis... and is economically viable/operational!?

Isn't there just a small possibility... that this might just tell a wee story... why it won't work on a voluntary basis in Canada... and leave grain growers high and dry with NO PROTECTION AT A L L!?

[padron]

It's Padron - not Pardon, Tom - or are you just doing that to bug me? Padron as in one of my favourite cigars.

http://www.padron.com/cigars/cigars.php

As to your questions.....

Yes, a grain dealer can go broke under these volatile circumstances - that's the point. You have to be very careful who you are dealing with. The bond offers no protection against fraud or outright deceit. And that's where we get into trouble. Buyers aren't honest or forthright when things are going sideways. You find out after its too late. But in a clearinghouse scenario the counterparties post security against their specific contracts that incur liability. Once they perform the posted security is returned. Banks are more receptive to loan additional financing as required in a securitized agreement. It actually acts to prevent failures thereby avoiding the scenario you pose where there are "No partner to dance with".

If grain dealers do back to back sales, their liability to the clearinghouse would be the net of the positions - assuming they clear both their purchase and sale. That's the incentive to get more players involved in clearing. The actual cost would be negligible but the protection is bulletproof. It also forces companies to trade within their means preventing high exposure positions that you as a farmer would not be aware of in a bonding situation. Neither would the CGC as a matter of fact.

Clearing is more expensive than bonding. The WBGA project has never stated otherwise. But the benefits of additional margin capture through capturing carrying charges, price discovery, arbitration & dispute resolution, prompt payment, expanded marketing opportunities, more balanced contracts and broader coverage than bonding far outweigh the additional costs. If they don't, then the use of clearing is optional and voluntary.

As for working agricultural examples you can look to every commodity futures exchange on the planet from Sydney to London to Chicago to Winnipeg. Every one of them uses clearing to manage performance and settlement risk. Grain buyers and farmers are very familiar with the process and use the margining system daily.

On the physical side there are two new examples of market innovators introducing clearing for cash transactions. The first is the Australian Grain Exchange who see deregulation as a catalyst event to open a phsical exchange and clearinghouse.

http://www.grainexchange.com.au/index/index.shtml

The second example is happening in Ethiopia where they are experiencing a wholesale revision of their commodity marketing infrastructure - including clearing. This is led by an impressive woman named Eleni Gabre-Madhin who left the World Bank after many years to return to her homeland and build a better marketplace for their agricultural producers.

http://www.ifpri.org/pressrel/2008/20080414.asp

http://www.unctad.org/sections/wcmu/docs/c1em33p10_en.pdf

In Ethiopia they opened their exchange and clearinghouse last month. They don't distinguish between the two entities but see value in the whole business process - trading and clearing. It should be noted the government is integral in launching this new system and carries a lot of the financial risk initially. Over time they may be able to let this business operate on its own as the marketplace accepts the process and enjoys the success they hope to achieve.

Clearing will work for physical ag trade in Canada. It may need some support to get it started and acceptable to the market participants but based on the enormous success of the concept in other industries there is no reason why it won't work for agriculture. In comparison, bonding is woefully inadequate. In my view this approach is worth the effort to implement.

[charliep]

Will leave your questions to padron.

For clarification, your assumption is that CGC bonding and the AgClearinghouse cannot survive together? No farm group (including the WBGA) has suggested 100 % replacement of CGC bonding.

There are a lot of other issues including covering transaction risk on forward sales and the large volume of grain not handled in primary elevators/processors (i.e. not covered by current CGC bonding).

What are the other options for handling these risks: Agricorp model in Ontario, Export Development Canada style recievable insurance, etc. What are the costs of these? Having the farmers accept the risk of non performance and/or non payment on a contract themselves/being prepared to bare the consequences?

[just_wondering]

Padron- Don't you know smoking is bad 4 U

In your example of clearing what happens ,if buyers are unwilling to come up with continuing margin calls?
I'm thinking specifically of Cargill and Canola contracts that they are unwilling to go out more than three months out with. I guess even the big C , could have cashflow problems on margin accounts.
(above example does not include the first 10 bu. on CSCO Canola)

[padron]

I don't inhale


To your question........

This is exactly the point. Because grain companies like Cargill have to carry large short futures positions as a hedge against their forward purchase contracts they are faced with large margin calls in rising markets. Under the right set of circumstances the cash contract would act as an offset to the futures hedge and all the grain company would need to carry margin against would be their net position. By securitizing both (cash and futures)you reduce the financial risk to the net. Companies like Cargill would actually benefit greatly if the physical markets were cleared as well as their futures positions. They wouldn't be put in such a position of having to restrict the volume of business they commit to as per your example. This would be true for smaller companies who reach a financial threshold and have to withdraw from the market.

The "right set of circumstances" means the entity offering the clearinghouse service has an offset agreement with ICE Futures Canada (who offers the canola futures contract) or ICE becomes the clearinghouse. These cross exchange agreements exist now - for example - between ICE and TSX's Natural Gas Exchange. It makes sense and helps both parties attract business to their exchanges and clearinghouses. This is getting into the mechanics but it demonstrates the feature of clearing financial managers like the most - reduced risk.

In the case where no futures contract exists - which is most grains in Canada - the practice of offsetting cash purchases and sales would be where the value comes into play. This also has the potential to generate more interest in developing futures contracts for these commodities because there is now a strong financial reason to dedicate the volume to the futures contract. I have always felt the evolution of a physical clearinghouse would stimulate futures trade. It's a big education project but the end game offers enough value to justify the effort.

[TOM4CWB]

Dear Charlie,

If the CGC bonding were to be operational at least to some extent... I would be quite satisfied with the additional tools such as a Ag ClearingHouse and Producer Security Fund system being added to fill in weaknesses present today.

Where do you get the impression that the CGC bonding will NOT be dismantled?

The other option... if the feds keep going forward with deregulation... is for the provinces to re regulate with a license and security systems on grain dealers/co's individually... kind of like the securities commissions operate.

The grain trade had better think twice about what they are asking for... they could end up with a whole lot more restrictive system... after a failure that causes big disruption in the Ag community... caused by overzealous deregulation that breaks growers.

I beg your pardon... padron... it does however bug me more than just a little... about the massive federal money going into your project... and what are we to do fighting against our own taxpayers money... that does not fund alternative options and give them a fair opportunity to become options?


Prove me wrong... propose a cooperative project... with the recommendation for CGC bonding to continue along side new options... that would create a much better atmosphere to develop risk management alternatives that best serve grain growers!

[padron]

Certainly Tom, anyone person or group are free to approach the APF with a sound argument to investigate a potentially viable alternative. I am not aware of such an alternative or a group who supports anything other than maintaining the status quo. The WBGA was very thorough in determining that clearing offered the grain producer more protection and an opportunity to capture more revenue on existing production. Don't forget this project started well before the Conservatives announced their intentions around changes to the CGC including producer security. It started during the CGC review and received endorsement from the Compas Review. I share the government's perspective on bonding as such, that it is expensive coverage for the value it produces. It would be substantially cheaper for the federal government to just repay anyone who lost money on a bad settlement - but of course that would just encourage this type of bad behaviour.

I can't speak about where the clearinghouse project will go from here as that is in the hands of the program directors but I can say that in the last phase we spoke to many producer groups, from associations to policy groups in an effort to create awareness and garner collective support to approach the government with a unified voice. This might address the co-operative approach you are referring to.

I can't say whether or not this will take the shape of something working in conjunction with bonding but I do note in the article you quoted to start this thread that the author quotes many people who are less than enthralled with bonding:

"Increasing bonds is not the answer," he said. "The bonding companies will not write the bonds at levels that would make some sense -- and that’s understandable. You would need to increase the bonds by millions of dollars to have some real protection and the bonding companies are not going to be exposed to that kind of risk."

"When you have a failure, you wish the bonds were a lot more than what they were," Klenklen said.

"But the recent runup in grain prices has diminished the amount of protection provided by the bonds."



There's more than one way to skin a cat Tom and I suggest governments will need to play a larger role in transitioning out of bonding into an alternative approach. Make your own conclusions as to what that might entail.

[TOM4CWB]

Padron,

The CGC and pulse/special crops industry has had CGC legislation in place... since 1999... to set up and run a producer security system... and we spent mega bucks of our own grower time and money organising and putting this system in place.

It was decided at the time the CGC bonding system was less expensive and provided better coverage... the primary reason a producer funded security system is not in place right now. All Goodale or Alcock had to do... was proclaim the CGC legislation for our pulse/special crops sector.

Now, for the past few years the Ag Clearing House APF funded proposal has had the mega bucks of federal funding... since our system is/was all set up... why did we need to reinvent the wheel? Now our system is to be dismantled by the amendments (Special Crops Security removed) from the Canada Grain Act... WITHOUT proper consultation... or alternatives... or fair comment from our organisations before this legislation was brought forward.

Of Course the Grain DEALERS/Co's approve of deregulation! WHY wouldn't they?

We don't need drivers licenses, manditory liability insurance... speed laws... financial lending regulations... securities act regulations on companies... CDIC bank account coverage... Pesticide Regulations... or environmental regulations, either... RIGHT?