The dark arts of commodities trading: assessing risks and claims in trade credit insurance

By Baldev Bhinder

The business of credit insurance does not always sit neatly with the business of commodities financing or trading. Underwriters tasked to provide cover do not have a full understanding over the lifecycle of the trade that may involve commodities being sold forwards, backwards and in circles. A claims manager needs to analyse the nature of the trade against the policy wording. If physical interest in the goods is necessary for cover, then an investigation into the evidence associated with such a trade, including the movement of relevant shipping documents between parties needs to be seen. Fictitious, mirror trades and forged documents are not unheard of in the commodities space even before we dive into synthetic trade structures designed for financial arbitrage.. In that regard, a trade credit policy is not just a non-payment cover – it is predicated on trades involving a physical interest in goods.

Why the obsession with original BLs?

Selling and buying goods typically involves payment in return for goods (e.g., think of your daily purchases in a shop). But international trade involves moving goods on a ship to different destinations. Unlike a shop purchase, the ship as the custodian of the cargo, issues a document known as the bill of lading (“BL”) which has multiple functions including as a receipt of the cargo as well as acting as a document of title. The BLs will list the shipper who loads the goods on the ship (e.g., the exporter) as well as the notify party who needs to be notified when the goods arrive at the destination (e.g., the receiver of the goods). But between the shipper and the receiver, numerous parties may “trade” the goods without physically taking possession of the goods while it moves on the water from one country to another. Only an original BL gives the right of possession to its holder – for negotiable

BLs, the ship is obliged to deliver the cargo to whomever presents the BLs to them, irrespective of whether they are named on the BLs or not. However, since couriering original documents might take days, some parties might agree to buy and sell using photocopy BLs. This is where the danger lies.

For example, it would not be unusual for an underwriter or claims person to be presented with a trade of commodities involving Singapore company A, Hong Kong Buyer B, and Dubai Sub-buyer C involving palm oil that moves from Indonesia to Netherlands. In a claims situation, traders A, B, C are not listed on the BLs but claim to be part of the trade and as proof of that, the insured Trader B, produces a copy of the BL to substantiate their involvement in the trade.

The use of copy BLs are more the exception than norm in trade chains. This is because counterparts need to be confident that their sellers do in fact have good title (typically manifested by the transmission of the original BLs) before paying several millions of dollars for the trade. Copy BLs however carry the danger of giving rise to mirror trades, where a photocopy of a BL can be used to create the appearance of a trade that mirrors the actual trade but involves completely different parties. Unlike an original BL, a copy BL has no real value. Often when we are approached by claims teams to analyse a trade, our primary concern is to connect these trio of parties to the actual physical trade, hence the obsession with who had the actual BL as two parties can’t trade the same goods at the same time. In our investigations focussed on the actual BL, we then discover the actual movement of goods between the actual trading parties.

In this case, Traders A, B and C have created a fiction of a trade using a photocopy BL. This may primarily be for the purpose of obtaining liquidity by creating the appearance of commodities trading and applying it elsewhere. Traders do this because the risk versus reward might appear in their favour. A single cargo of grain, metals or oil in one BL, could be worth anywhere between $5m to $50m. With a photocopying machine, the “trade” could be reproduced 100 times with 100 photocopies of the BL. This may explain how some traders can grow their revenue from $100m to 1 billion in just a few years.

Financial structures dressed up as trade

Multiple financing and mirror trades aren’t particularly sophisticated fraud. But the fact that it happens so often and even slips past experienced trade finance bankers, goes to demonstrate the human fallacy of being seduced by compelling narratives and glitzy balance sheets.

But the dark arts of commodities financing gets more troubling when we look at circular or synthetic trades, loosely described as structured trades. In these structures, parties are no longer concerned with the physical goods and are creating structures to leverage on financial positions –something a trade credit insurance policy might simply not be designed to respond to.

Using the example of copper trades, a voyage between Chile and China could take more than a month. During this period, a trader might seek to “monetize” goods on the water by selling them in a circle back to itself before the ship arrives in China and the goods delivered to the buyer.

Circular trades often raise eyebrows – why would a trader sell goods in a circle and buy it back later in 30 days for a higher price? There are many reasons for creating circular trades but one common denominator is that by putting together a circle, Trader B, Trader C and Trader D have all raised financing on a trade that each never had any physical interest in. More importantly, it becomes a shortcut to increasing their balance sheet without actually doing very much. Circular trades can also sometimes be used as a disguise for a loan between parties, where a trader prepays its “supplier” $100 today through the circle and gets paid $110 in 30 days’ time. The clear risk with circular, synthetic or structured trades is that the parties involved have no interest in the physical trade, and there can be little incentive to verify their actual involvement in the trade, the documents related to the trade such as the original BL or for that matter, even if the trade existed. All that is concerned is that invoices are submitted to each for a fleeting “involvement” in the trade.

Once again, such financial structures wrapped up in the appearance of a trade, does not sit well or at all within a vanilla trade credit policy coverage.

What should underwriters and claims handlers look out for?

It is notoriously difficult to spot dubious trade patterns but a good deal of comfort can be obtained if insureds can legitimately connect their trade directly to the shipper or receiver of the cargo. Ultimately, the familiarity of a trader with the physical operations of trading a particular product and how trade structures are originated will give an insight as to whether such trades might in essence just be financial structures. Most importantly, given the manner in which balance sheets can be inflated in commodities trading, a healthy dose of scepticism might serve underwriters when analysing remarkable growth stories.

For claims handlers, a pro-active approach is critical. Understanding and investigating how the alleged trade fits into the actual physical trade will invariably require insight into the full lifecycle of the BL as well as product knowledge on how that commodity is traded. An inability by an insured to provide prompt responses to requests relating to trade origination, transmission of shipping documents including BLs, proof of payment to suppliers and contemporaneous cover correspondence would, from experience raise serious concerns on the legitimacy of the trade and would warrant closer scrutiny of the transaction.

Baldev Bhinder is the Managing Director of Blackstone & Gold, a specialist commodities and trade law firm based in Singapore. He specializes in trade fraud investigation, asset recovery and litigation. He has helped various insurers in investigating dubious trade claims and has represented insurers in litigation cases. He can be reached at baldevbhinder@blackstonegold. com