3rd Party Risk on grain sales...

[TOM4CWB]

Dear Charlie,

Jerry Gulke DTN Columnist has an interesting colum this week...

..."Now comes the farmer wanting to deliver the higher-priced contracts. The middleman buyer will cry foul, as his buyer -- who is in bankruptcy -- wants to only pay market price. If the middleman buyer is large enough, with millions of bushels obligated to a defunct buyer, he may be seeing losses of $2 to $3 per bushel, if not more. The buyer soon realizes the only way out is to also file bankruptcy, and you (the producer) are left holding the bag. In some cases, that bag is worth a lot less than you thought. Worse yet, with the bankrupt entity continuing to file legal motions to require flow-through delivery, it leaves the fellow with the origin of the grain between a rock and a hard place.

VeraSun, for example, could force delivery by an elevator, and you would be obligated to delivery your contract knowing full well it may be a matter of time before your buyer is in the same shape, out of necessity, as VeraSun. ..."

This has not directly happened in Canada... YET...

[charliep]

Defaults have happened in the past that impact
businesses along the supply chain and this will not
change in the future. Pulse processing companies
have been and will continue to be impacted by
defaults.

Perhaps this is an extremely good argument for a
cash clearing house to look after transactional
risk. You have highlighted the cost of maintaining
margin the past but maybe a necessary evil to
ensure payment. I note current CGC bonding does
cover some of the risk around payment after
delivery but does not deal with the root
causes/risk of someone walking on a contract prior
to delivery.

[padron]

More to the point gents, in this case with prices dropping, Verasun would have been required to post margins all the way down and this mess could have been avoided or largely mitigated before it got out of hand. The farmers who sold at high prices would not have posted margin at all - not one cent.

Failure in Verasun's part to post margins would have caused immediate liquidation and sellers would have been protected. Now farmers have but one choice which is to deliver the grain at market value in order to keep the plant running through the creditor and hope they receive some recovery of their losses. The Iowa grain fund is capped at $300,000 per claim and will fall well short of full recovery. I believe they will get some protection on delivered and unpaid grain receipts but I do not think they will receive anything for open contract losses.

This is a classic example of local farmers making good marketing decisions and then getting burned on the deal. It sucks! Our industry needs something better than "funds" to protect market participants from this kind of behaviour.

[padron]

The article Tom refers to speaks on the impact to the agent or trader who might be in the middle of this transaction. If he is a broker he will not face a loss but if he is a principal then he has a high priced purchase to honour and a failure on his sell side. The potential for a domino of failures is triggered by this event which could have been avoided. The ripple effect could extend well beyond the immediate creditors of Verasun.

This demonstrates the weakness of "entity based" protection mechanisms and is a further endorsement of "transactional based" protection mechanisms. It is vital that each contract is secured - not each counterparty. That just doesn't get the job done and it definitely won't get the job done in a honour based system like CGC bonding.

Clearing each trade is the answer.

[TOM4CWB]

PARDON,

Proper risk management was the answer in the VeraSun debacle.

If I must post margins... I am much further ahead to use the futures. This will be less expensive and more secure.

[padron]

I don't disagree with your first statement Tom. Proper risk management is the key. However, as you well know, the real value of grain - the cash price has more recently been quite different than the futures values. The absence of conversion has led to a challenging scenario for hedgers. I believe you need both mechanisms in play - futures and cash - and clearing instruments for both. In an ideal world the clearinghouse is the same for both allowing you to net your margin requirements thereby reducing your costs.

Using this approach, if Verasun was long (high priced ) cash and short futures they would not be in Chapter 11 and they would have incurred very little margining cost. If they were outright long cash as it would appear then they would have been required to margin that cash position all the way down and farmers risk would have been covered.

As a seller in the market you can't be sure the buyer is hedged and not at risk but with a clearinghouse you don't have to carry that risk at all. The clearinghouse manages it as the central counterparty guarantor and monitors the financial integrity of both parties for the cost of a clearance fee. Money well spent in my view. The margin fees are all returned to each counterparty when the deal is complete.

This is the essence of clearing - manage the risk of each transaction - not the risk of each counterparty.

[TOM4CWB]

Pardon,

In the world of risk management... there are risks that are economic to cover... and those that the management costs more than the benefit.

Those who survive... learn... which is expensive overhead we can't afford... and which is a needed tool that helps.

CGC Bonding is a low cost tool... that does help in the vast majority of cases in the grain industry today.

A voluntary clearinghouse alongside CGC Bonding... would be just great in my estimation... GET AT IT! THe Aussies are doing it... the model is there and now working!

[stubblejumper]

the CWB works for me

[padron]

I'm glad for you stubblejumper - it's just not for everyone.

[charliep]

Just curious how the CWB handles transactional risk? Noting the level of
transactional risk associated with processors/others who do business into India
and other parts of the world, is this a service a CWB 2 could offer
exporters/farmers?

I suspect the CWB handles transactional risk by only dealing with customers they
are familiar with. They (like all exporters) likely use the services of EDC (Export
Development Canada) to ensure sales against default. A final way is to deal with
accredited exporters/selling in-store or loaded vessel Canadian port (accredited
exporter takes the transactional risk).

I note the way the CWB deals with price risk is to never take it on in the first
place. You as a farmer are paid 60 % of a total payment forecast at delivery and
wait for the actual results of all sales during the pooling period. The only risk
management that seems to be exercised is the process of ensuring the CWB
pools reflect an average price (p. 43 of the 2006/07 CWB annual report)

[charliep]

TOM4CWB

Will be very interested in the results/recommendations of the study lead by the
pulse growers but participated in by other commodity groups of alternatives in
managing transaction risk.

[TOM4CWB]

Charlie,

The individual transactional risk the CWB encounters are covered by the pool accounts... and everyone is averaged out.

Flying blind and not knowing what you are paying for risk management is working fine for you?

How much do you think bad/defaulted contracts will cost the pool accounts this year?

Do you actually think the CWB will share the truth with us... on high value wheat contacts they have had to rip up because of problems completing them?

With customers knowing the pool covers us... why should they worry about backing out on high value contracts...

when they wouldn't dare do this to US Companies... could this in fact explain a portion of CWB problems competeing with US DNS prices?

[TOM4CWB]

Stubblejumper:

"Flying blind and not knowing what you are paying for risk management is working fine for you?"

Interesting perspective... if you can't tell... then it doesn't hurt!

[dave4441]

I would guess that most of the CWB sales are to governments, not companies, so would guess there risk is not as great in the big picture. Saying that, risk does come from government buying agencies but probaly less so then some of our special crop problems

[padron]

For clarification - In Australia there is no form of bonding or "fund" protection. Growers are completely on their own. The Australian Grain Exchange will form a key role in providing security through their clearing services. It is a good model for us to emulate in my view and the clearinghouse project is in regular contact with our "mates downunder".