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Manage Your Counterparty Risk
Feb 05, 2012
Whether it involves a heifer grower or a corn silage supplier, assessing and managing your risk with the party on the other end of a contract gives you a better chance of minimizing potential problems.
By Greg Steele, AgStar Financial Services
Dairy farming is a risky business. It always has been and quite likely always will be. Risk exposure levels are becoming larger, land values are increasing and the scope of financing is greater. As dairy producers, you work to manage production risks on a daily basis. Now you have one more risk to keep track of—counterparty risk.
Here is a list of common questions that can be useful to manage counterparty risk.
What is it?
Simply put, counterparty risk is the risk that the party on the other end of your contract will not perform as was agreed upon, which results in a default on that contract. This can be broken down further into risk of:
• - payment default or delivery default;
• - the contract will have no value;
• - deferred payments will not get paid.
A recent example of counterparty risk was that MF Global, the world’s leading commodity trading company, filed bankruptcy because of its trades in European debt instruments. This event caused immediate liquidation of farmers’ futures and options positions, which lead to significant turmoil in the U.S. commodity markets.
How does counterparty risk happen?
There are two main reasons for contract default (other than fraud):
- The other party is unable to meet the terms of the agreement (either financially or otherwise).
- The other party’s perception or understanding of the agreement terms differs greatly from your perception.
“I am a dairy producer. Counterparty risk only affects grain farmers.”
Not true. Examples of counterparty risk for dairy operations:
- You contract with a farmer to raise your replacement heifers and suddenly that farmer is short on cash and sells your animals to pay his expenses.
- You contract for corn silage from a local farmer who fails to harvest the crops at the appropriate time or isn’t able to harvest the crops at all.
How do I assess my counterparty risk?
It is important to understand this process. What are the chances that I will suffer a loss? If one occurs, how I can manage the loss? A recommendation of how to determine what your risk is would include:
- Identify the five to 10 largest third-party relationships you have, as these are your key business partners.
- Put together a plan to review these partners and do your due diligence.
What kind of due diligence should I complete?
As a producer, you may feel like the shoes have switched feet and you’re now playing an unsecured creditor to most of your suppliers. This is especially true as the need to prepay for the largest discounts is becoming the standard and contract dates are moving further from the actual delivery date. Price volatility, length of time between contract date and shipment or time between payment and delivery are all factors that can increase the risk to you.
Here are key elements in managing your counterparty risk.
- Pre-plan. Do your due diligence. Understand your risk and operate within your risk tolerance.
- Always have written documentation of the transaction. Signed contracts are a common business tool.
- Calculate the true cost of carry. Consider the interest cost on the early purchase.
- Look for ways to narrow the time between performance and payment or possibly eliminate deferred income all together. Are you better off to take the income now versus the risk of recognizing zero if something happens to the other party in the future?
- Deal directly with the source when possible. If there is a party in the middle, there is the additional risk of default.
- Consider diversification. Don’t have all your eggs in one basket. Consider spreading your purchases and sales out over different purchasers or suppliers.
- Identify other parties who might impact the outcome of the agreement. These might include business partners, parent companies, suppliers, banks or even landlords. Consider these parties’ interests when you review the agreement.
- Look for additional tools to manage risk. Take immediate delivery, obtain a lien or find a way to guarantee payments.
Reducing counterparty risk is different for every dairy operation and not every example of counterparty risk has been identified. While intended to help you understand and navigate counterparty risk, these comments should not be taken as legal advice. Rather, they are provided as a framework to help you start planning for, assessing and managing your way through the uncertainties of the marketplace. As with any risk, the more you assess and manage it, the better chance you have of reducing it.
Greg Steele is vice president of agribusiness capital with AgStar Financial Services, ACA. His focus is working with commercial dairy operations that have grown and expanded their business. He provides expertise in the area of finance, business planning, and accounting. Contact Steele at (612) 963-7941 or firstname.lastname@example.org.