Banks play an integral part in the international commodity trade business. They fulfill a number of essential roles upon which the commodity market depends. These activities range from actually trading the commodities, to serving as a counterparty for derivatives, to providing trading companies with necessary instruments to be able to trade on the commodity market. Furthermore banks play a major role in the supply of foreign exchange contracts, which companies use to ensure themselves of an acceptable exchange rate.
Many banks are entering the commodity market nowadays. With their extensive financial capacity and their experience with risk management, they present capable players on the commodity market. Banks will have to adjust to the specific need of a risk management system for commodity trading. Such a system is usually hard to integrate in to existing systems for a bank and therefore large investments are required for a bank to enter commodity trading.
Banks are however not limited to trading commodities nowadays, but are also becoming increasingly involved in the production and logistics of commodities. Hereby controlling the commodity chain and thus will try to influence prices in their favor.
For the international commodity market the exchange rate of different currencies can play an important role. When companies have a lot of international trading activities, the exchange rate of different currencies can account for large costs or cost-reductions. Banks offer futures on currency exchange, to provide companies with the insight of future exchange rates and the means to cover themselves against adverse exchange rates. Companies can plan investments and secure themselves of an acceptable exchange rate, by using exchange futures.
Banks will often fulfil a function as counterparty for traders and companies using derivatives. Especially swaps are very depended on banks for successful usage of this derivative. Banks perform the essential role of counterparty in the effective use of swaps. When using swaps, a bank or other type of financial institution will usually be the party agreeing to pay the market price of a commodity against a fixed payment form the other party. This position generates great profits for banks and also gives them significant control over certain commodities, that rely heavily on swaps.
Banks can supply (trading) companies with the necessary documents to engage in commodity contracts. These documents can serve as a warranty for both the buying and selling party, engaged in a contract.
Performance and bid bonds
A performance or bid bond serve as a token of the ability of a company to fulfil its obligations conform the signed contract. First a bid bond will be requested form a bank to ensure a party will effectively sign a contract when negotiations have commenced and not back out of the negotiations or is unable to supply the product which is the object of the negotiations. After the parties have signed a contract, the buying party will request a performance bond form the bank of the selling party. This performance bond guarantees the buying party of the supply recorded in the contract. The bank offering the performance bond hereby vouches for the supplying party. When this party is unable to supply the product, the bank will pay the value of the bond, which ranges from 5 to 25 percent of the contract value.
Letter of Credit
A letter of credit is a financial instrument which protects a selling party against the inability of the buying party to fulfil his payment obligations. In such a situation the bank will vouch for the buying party in a contract. Should this party be unable to fulfil his payments, the bank will pay the amount agreed on in the contract. A bank will perform a check for creditworthiness of its clients, to determine whether their clients are still able to fulfill their payment obligations.