Warehouse Receipt: As an Instrument for Financing
- Dr. Devajit Mahanta, Financial Columnist

One of the important aspects of the Indian commodity derivative market is the introduction of warehouse receipts (WRS) as an alternative solution for market participants to access short-term finance. The concepts of the WRS system is based on warehouse receipts which can be used as collateral for accessing finance. The system is made more sophisticated by adopting measures such as grading of commodities according to their quality, rating warehouses according to their size, reputation and integrity etc. In India receipts issued by Central / State Warehouses are accepted as collateral by banks however those issued by private warehouses are not. Since farmers/traders will not deposit their goods with a warehouse whose receipts are not financed by banks viability of the private warehouse is at stake. Hence there is scope for expanding the warehousing infrastructure and also WRS system by making it mandatory for the banks to endorse private WRS.

Warehouse Receipts (WRS) are documents issued by warehouses to depositors against the commodities deposited in the warehouses, for which the warehouse is the deposit bailee . These are negotiable instruments that can be traded, sold, exchanged, used as collateral to support borrowing, or accepted for delivery against a derivative instrument such as a futures contract. Warehouse Receipts are always backed by underlying commodities and constitutes an integral part of the marketing and financial systems of most industrial countries. The overall efficiency of these markets, particularly in the agri-business sector, is greatly enhanced when producers and commercial entities can convert inventories of agricultural raw materials or intermediary or finished products into a readily tradable device.

The basic features of warehouse receipt finance are relatively simple and straightforward, as illustrated in Figure 1, the client deposits a certain amount of goods into a warehouse in exchange for a WRS. The WRS conveys the right to withdraw a specified amount and quality of the commodity at any time from the warehouse. The warehouse manager is liable for guaranteeing the safety and quality of the stored commodity. The WRS can then be transferred to a bank, which provides a loan equivalent to a certain percentage of the value of the stored commodity. At maturity, the client (e.g., a farmer) sells the commodity to a buyer who then either pays the bank directly, or pays the borrower who then repays the bank. On receipt of the funds or an acceptable payment instrument (e.g., a confirmed Letter of Credit), the bank surrenders the warehouse receipt to either the buyer or the seller (depending on the specifics of the transaction), who then submits the warehouse receipt to the warehouse, which releases the commodity. In case of default on the loan, the bank can use the warehouse receipts in its possession to take delivery of and sell the commodity stored in the warehouse, to offset the amounts it is due.

VARIOUS WAREHOUSE APPROACHES TO COMMODITY FINANCING AND STORAGE
There are three major categories to commodity financing and storage.
1. Public Warehousing
2. Private Warehousing, and
3. Farmer focused approaches

Approach 1: Public Warehousing
Public warehousing, this term does not imply public ownership, but refers to a company storing goods for public in general on behalf of whosoever wishes to deposit in the warehouse and issues to the respective depositors warehouse receipts that can be used for trading purposes or as collateral for raising finance.

This in turn divided into:

A: Unregulated Independent Warehouses: An unregulated independent warehouse set up by the company concerned sets up business, invests in grain handling and storage plant, and uses it to trade and provide a variety of other services, including storage and warehouse receipting. In principle these are purely private initiatives, where the company believes it can best serve its business interests by offering farmers and smaller market intermediaries a choice of marketing arrangements allowing for immediate or later sale. Export Trading Company is already offering the service to farmers in Tanzania. The main limitation to this approach is the small number of companies currently able and willing to offer the service. Banks would not trust many commercial operators to hold third party stock as collateral managers, probably only the largest companies in the Region.

B: Warehouses regulated by the State: In this case, the regulatory service is a State-controlled technical service which licenses warehouse and ensures that they perform accordingly to a set of clearly understood rules. This may involve the suspension or revocation of licenses or taking over the management of failing warehouses. There are two major pre-requisites to the establishment of such a service: a) that it can be kept completely free of political influence, avoiding the sort of problems if this cannot be assured one should not try to establish such a service, and b) That there is sufficient demand to make the service self-financing on the basis of user fees. This approach, which builds mainly on the North American experience, is being implemented in Tanzania, Ethiopia and Uganda.

C: Warehouses Regulated by a Trade Body: In this case regulation may be carried out on a purely contractual basis, or under delegation of State powers. This approach has quite good prospects in Kenya, though some significant hurdles must be crossed. EAGC (trade body) is already certifying warehouses in Kenya, and can do likewise in other countries. Its survival depends on its establishing fruitful dialogues with Governments. With its membership base, EAGC is moreover well placed to promote exchange trading.

Approach 2: Private Warehousing
This approach would allow private players to issue warehouse receipts against their own stock for the purpose of raising bank financing, and also of transferring title to buyers. Potentially this could increase market efficiency, to the benefit of both farmers and consumers at either ends of the chain. It could help establish a more level playing field among trading companies, making it easier for local operators to access low cost capital. It is moreover a sort of self-propelling innovation, building on the motivations of the proposing company.

It is however quite a risky approach, where the regulator has little direct control over the actions of the licensee, who may move stocks around without the knowledge of a regulator who is not on site. Moreover, if such a warehouse operator goes bankrupt, it may also be difficult for the bank to prevent priority being given to other creditors.

Approach 3: Farmer Focused Approaches
These are approaches involving the storage and financing of commodities deposited (more or less exclusively) by farmers with the objective of supplying local food needs in rural areas or bulking product prior to marketing. There is a general need to increase farmers’ role in crop storage. If more is stored locally in villages, rural people will be more food secure in the lean season, notably households who produce insufficient to cover their needs, or who sell early for financial reasons. Occasionally rural storage initiatives have resulted in large increases in seasonal storage, lessening the need for States to establish price stabilization mechanisms. This is sometimes undertaken through marketing cooperatives. Large and multi-tiered cooperative marketing structures sometimes do not have a very good record, but there is some evidence that primary societies or groups can work effectively in bulking goods for marketing through public warehouses. An alternative approach involves rural storage financed by a local micro-finance institution (MFI). A highly successful experience in Madagascar suggests that this can work well where the local MFI is integrated into a structured microfinance (MF) network that can provide necessary management and financial support.

FINANCING AGAINST WAREHOUSE RECEIPTS IN INDIA
Financial accommodation against WRS is still not very popular in India although it is exhibiting an upward trend. This is indicated in Table-1 which exhibits data of a large Private Sector Bank and three large public sector banks with respect to extension of finance against Warehouse Receipts.

Some of the difficulties faced by banks in popularizing financing against Warehouse Receipts and their solutions as envisaged by them, are given below:
  • WRS to be made transferable through endorsement under Sale of Goods Act. This will enable the WRS holders to take delivery of the underlying goods on the same terms and conditions as would have been to the person who had originally deposited the goods.
  • Making WRS fully negotiable instrument, under Negotiable Instruments Act 1881, will enhance liquidity of the product and help in mitigating counter-party default risk.
  • Electronic maintenance of records of such WRS in a dematerialized form resolves the problem of inadequate speed of transaction, splitting of Warehouse Receipts, forgery and loss of receipts etc.
  • For all types of lending to agriculture sector in general and financing against WRS in particular the risk weight for the purpose of capital adequacy may initially be reduced to the level of 75 percent from the current level of 100 percent.
  • Difficulty in disposing of a security in case of default would be removed by creating a screen based spot market along with uninterrupted clearing and settlement facilities.
  • Receipts issued by Central / State Warehouses are financed by banks but those of Private Warehouses are not freely financed by banks. Since farmers / traders will not deposit their goods with a warehouse whose receipts are not financed by banks viability of the private warehouse is at stake. Hence it is necessary that private WRS should be endorsed by the banking system.
  • High margins, up to 40 percent stipulated by banks create liquidity problem for the farmers who are therefore not very keen on obtaining finance by means of WRS. The margins could be reduced to 10-20 percent if the issues regarding quality and grade and ease of disposing the stocks in case of default as mentioned above are solved.
  • Some state governments have introduced stamp duty on pledge / hypothecation which have an adverse impact on the nascent WRS in India. Hence at this early stage of development, WRS needs all the concessions from the state until it can bear the burden of state duties.
BENEFITS OF WAREHOUSE RECEIPTS
WRS are part of a framework of modern market institutions that countries adopt in different forms, to develop agriculture and to render markets more efficient and effective for both consumers and producers. This instrument can play a central role in developing the framework of modern market institutions in the following areas. WRS can provide surplus-producing farmers (including smallholders) with a market window which can help them secure the best possible deal, allowing them to deal directly with downstream buyers and financiers, and overcome asymmetric power relationships within the market chain. Smallholder farmers are typically isolated from markets with limited selling alternatives as lack of contact with downstream buyer’s results in their inability to enter into favourable contractual relationship. Farmers (or groups of farmers) can overcome these constraints by depositing their crops in a warehouse that dries, cleans and grades them according to established standards, and holds them until they wish to sell. The warehouse may be linked to a commodity exchange through which the farmer can sell the goods. Alternatively, the farmer may sell privately or make use of a simple settlement mechanism to ensure that he (along with the bank and warehouse operator) gets paid before the goods are removed from the warehouse.

WRS provides a platform for the introduction of other institutional innovations, notably grading, contracting and exchange trading. It is difficult to introduce grading systems into markets where most grain is traded informally and not graded. Buyers don’t look for graded produce because it is unavailable, while farmers don’t grade because of the lack of a price premium. By grading commodities on arrival at warehouses, it is possible to overcome this problem. A well developed WRS can provide a focus for development of the entire commodity chain, providing incentives for a range of different parties, including farmers, financiers, traders, processors, public sector buyers, food aid managers and investors in storage capacity. This is illustrated in flow-chart in Figure 2. WRS can help farmers retain more food for their local consumption requirements.

This enables the farmers to avoid repurchase grains in the market price when they experience unanticipated shortages for consumption. In fact, in Africa there are numerable instances of farmers ‘overselling’ crops, which are shipped out to urban centers, only to be shipped back as either grain or meal, and at much higher prices in the lean season. Under the circumstances better storage facilities and localized warehouse receipting can help farmers hold back more crops, avoid circuitous transport and better assure their local food security. The availability of secure WRS may also allow owners of inventories to borrow abroad in currencies for which real interest rates are lower, particularly if loans are made against inventories of an export commodity, thereby hedging against the foreign exchange risk of foreign borrowing. This practice is followed in Kenya and Uganda, where coffee stocks are often financed in pounds sterling. Also, since high real interest rates are often linked to perceived risks, particularly when it concerns agriculture, secure WRS may reduce risk and lead to lower lending rates. Correctly structured WRS provide secure collateral for banks by assuring holders of the existence and condition of agricultural inventories “sight unseen”. Warehouse Receipts can be used by farmers to finance their production and by processors to finance their inventories. If there is a default on any obligation guaranteed with the Warehouse Receipt for instance, a bank loan, the holder has first call on the underlying goods or their monetary equivalent. Collateralizing agricultural inventories will lead to an increase in the availability of credit, reduce its cost, and mobilize external financial resources for the sector. WRS contribute to the creation of cash and future markets and thus enhance competition. They can form the basis for trading commodities, since they provide all the essential information needed to complete a transaction between a seller and a buyer. Their availability will thus both increase the volume of trade and reduce transaction costs. Since buyers need not see the goods, transactions need not take place at either the storage or the inspection location. A transaction can take place informally or on an organized market or exchange. In either case, the Warehouse Receipt forms the basis for the creation of a spot, or cash market. If transactions involve the delivery of goods on a future date, Warehouse Receipts can form the basis for the delivery system in a commodity futures exchange.

LIMITATIONS ON USE OF WAREHOUSE RECEIPTS
The use of Warehouse Receipts is limited in India because of institutional and structural shortcomings, among which the most significant are the following:
  • State intervention usually in the form of procurement at minimum support price acts as a disincentive for the private storage industry as it ignores price variations over time or in different regions to allow for profitable storage.
  • Lack of an appropriate legal, regulatory, and institutional environment to support a system of Warehouse Receipts; and
  • Limited familiarity of the country’s commercial and the financial community with Warehouse Receipts.
PRECONDITIONS FOR VIABILITY OF WAREHOUSE RECEIPT SYSTEM
In order for a Warehouse Receipt system to be viable, the economy within which it operates must meet certain conditions. The legal system must support pledge instruments, such as Warehouse Receipts, as secure collateral. The pertinent legislation must meet several conditions (Ministry of Agriculture, 2005):
  • Warehouse Receipts must be functionally equivalent to stored commodities;
  • The rights, liabilities, and duties of each party to a Warehouse Receipt (for example a farmer, a bank, or a warehouseman) must be clearly defined;
  • Warehouse Receipts must be freely transferable by delivery and endorsement;
  • The holder of a Warehouse Receipt must be first in line to receive the stored goods or their fungible equivalent on liquidation or default of the warehouse; and
  • The prospective recipient of a Warehouse Receipt should be able to determine, before acceptance, if there is a competing claim on the collateral underlying the receipt. The lack of an appropriate legal environment is probably the single most important constraint on the creation and acceptance of Warehouse Receipts in many developing countries.
CONCLUSION
One of the important aspects of the Indian commodity derivative market is the introduction of warehouse receipts (WRS) as an alternative solution for market participants to access short-term finance. The concepts of the WRS system is based on warehouse receipts which can be used as collateral for accessing finance. The system is made more sophisticated by adopting measures such as grading of commodities according to their quality, rating warehouses according to their size, reputation and integrity etc. In India receipts issued by Central / State Warehouses are accepted as collateral by banks however those issued by private warehouses are not. Since farmers/traders will not deposit their goods with a warehouse whose receipts are not financed by banks viability of the private warehouse is at stake. Hence there is scope for expanding the warehousing infrastructure and also WRS system by making it mandatory for the banks to endorse private WRS.

References:
  1. Coulter, J.P. and Martines M. (1998) ‘Brazilian Experience with Grain Warehousing Services and Associated Marketing Tools’, Report for the DFID Crop Post-Harvest Research Programme.
  2. Department of Banking Operations and Development (2005) ‘Report of the working group on warehouse receipt and commodity futures’, Reserve Bank of India, Mumbai.
  3. Department of Banking Operations and Development (2006-07) ‘Report of the working group on warehouse receipts and commodity futures’, Government of India.
  4. Ministry of Law, Justice and Company Affairs (1962) ‘Central Warehousing Corporations Act’, Government of India
  5. Ministry of Agriculture (2005) ‘Agricultural Produce Marketing Committee Act’, Government of India.
  6. UNCTAD (2009) ‘Review of Warehouse Receipt System and Inventory Credit Initiatives in Eastern & Southern Africa’.