What is 'Commodity Paper'

Commodity paper is a loan or advance for which raw materials owned by the borrower serve as collateral. The  term paper refers to the contract, which is essentially a promissory note.

BREAKING DOWN 'Commodity Paper'

A commodity paper might be viewed as being similar to a mortgage agreement or a car loan, in that it is a secured loan, with collateral being pledged in order to give the lender assurances that the loan will be repaid, or that they will have some recourse should the borrower default or fail to satisfy the terms of the contract. Whereas a mortgage is secured by a home or other real estate, in the case of a loan involving a commodity paper, the collateral is in the form of commodities.

Commodities are raw materials (production goods) such as oil, grain, gold, copper, coffee, cocoa, lumber, cotton, wheat, corn, sugar, and natural gas. Different tools are available for investing in commodities, such as futures, options, stocks, ETFs and ETNs.

Commodity paper and risk of offsite collateral

By the nature of the products and materials involved, commodities may not be readily available at a certain location and therefore it may sometimes be difficult, if not impossible, to produce them to provide as collateral. In these situations, there are several alternative options that can serve as proof of collateral. These include bills of lading, if the commodities are in transit, or warehouse receipts in cases where the commodities are in storage.

It is generally not necessary for the goods that will serve as collateral to be present at that particular location, as long as their location is verified and they can be accessed should the need arise. This is because the lender does not actually take possession of the commodities unless the borrower defaults on the loan. 

Still, this inability to physically take possession of the collateral or at least visually inspect it and confirm its existence can present some element of risk to the lender, especially if the borrower is unethical or intends to deceive the lender.

Commodity paper was at the center of a notable incident known as the Salad Oil Scandal. In the early 1960s, the owner of Allied Crude Vegetable Oil used fraud to make inventory appear many times what it was, and then borrowed against the erroneous inventory receipts. It was estimated that he used fraudulent tactics to make it look like his company had $175 million worth of inventory that did not actually exist, and then used this fake inventory to secure massive loans.

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