Commodity Paper: What It Is, How It Works

Commodity Paper: What It Is, How It Works

What exactly is commodity paper? Commodity paper serves as a loan or advance where the borrower's owned raw materials act as collateral. The term "paper" here refers to the contract, usually a promissory note. In some cases, collateral for commodities may include grading certificates, warehouse receipts, or bills of lading.

Understanding Commodity Paper

Exploring Commodity-Backed Loans

Commodity paper resembles a mortgage agreement or a car loan but deals specifically with commodities. In a secured debt scenario, the collateral provides assurance to the lender, offering recourse if the borrower defaults or fails to meet contract terms. While real estate secures a mortgage, commodities serve as collateral in commodity paper loans.

Commodities encompass raw materials or production goods, ranging from oil, grain, and gold to copper, coffee, and natural gas. Due to the nature of these products, commodities may not always be readily available at a specific location, making it challenging, if not impossible, to produce them as collateral.

Providing Proof for Commodity Paper

Ensuring the Integrity of Collateral

The presence of goods serving as collateral is generally not necessary, as long as their situation can be verified when needed. The lender only takes possession if the borrower defaults. Verification of assets securing the loan may be required, and depending on the commodity, proof can take various formats. Grains and oil might use a grading certificate, while live cattle or hogs may require a delivery order or bill of lading. Precious metals like gold may need a vault or warehouse receipt.

Risks arise when the lender cannot physically take possession of collateral or visually inspect it, introducing an element of risk, especially if the borrower is deceptive. An example of such risk is evident in the Salad Oil Scandal of 1963, where fraudulent documents inflated inventory levels, costing banks an estimated $200 million in 1960s dollars.