What Is a Grading Certificate?
In the commodity futures market, a grading certificate is an important document that establishes the quality and authenticity of the commodities underlying the futures contracts.
Grading certificates are required in order to establish a given commodity as being exchange-grade and deliverable for purposes of honoring futures contracts. To obtain them, traders must rely on the expertise of specialized inspectors or testing firms.
- A grading certificate is a document used by participants in the commodities futures market.
- It is used to establish the quality of the commodities being delivered and is judged by an expert sampler who inspects the goods.
- Futures markets use standardized contract specifications, known as the basis grade, that must be met.
- Market participants are required to adhere to the quality standards set out by the commodity futures exchange.
- Failure to do so can result in the seller of the futures contract defaulting on their agreement and being penalized by the exchange.
How Grading Certificates Work
Only certain authorized persons or organizations can issue grading certificates. To provide them, these inspectors rely on various methods, including personal observation and formal materials testing procedures such as photographic and chemical analysis. Depending on the commodity involved, different types of expertise might be required. For instance, an inspector might use X-rays to test the grade of precious metals such as gold and silver. In the case of oil, they use chemical testing methods such as crude oil assays.
These commodity grading certificates serve valuable purposes which are helpful to both the buyer and seller of a commodity in the futures market. The document provides an official, objective determination of the product's value, quality, and condition. It not only establishes the status for a sale or exchange but can also serve as valuable documentation necessary to obtain loans or submit claims in case of a loss. If the product in question is of exceptionally high quality, then its grading certificate may be used to justify a higher price. Conversely, they may support a lower price if the product is deemed sub-par.
Commodities exchanges such as the Chicago Mercantile Exchange (CME) establish defined quality standards for each of the commodities they trade, so that market participants know the quality grade that is expected of them. The party delivering the commodities is required to meet those standards or risk being found in default of their contracts.
What's in a Grading Certificate?
Generally speaking, the level of complexity involved in producing a particular grading certificate would be roughly in line with the market value of the commodity in question. Precious metals would have relatively elaborate and precise testing standards compared to relatively inexpensive commodities such as cocoa or soybeans.
In the case of cocoa, for instance, a typical grading certificate would indicate the beans’ country of origin, a general description of the product, and its condition—such as whether it is smoky or dry. It would also include commentary on its quality, such as what percentage of the beans were defective, and the approximate number of beans per kilogram.
If a commodity is evaluated at lesser than the required basis grade, the seller (deliverer) may appeal that decision to the exchange.
As an example of a futures contract standard and grading certificate, we can consider the coffee futures contracts listed on the Intercontinental Exchange (ICE).
A coffee futures contract specifies the delivery of 37,500 pounds of:
"Washed arabica coffee of the growths of Brazil, Burundi, Colombia, Costa Rica, Dominican Republic, Ecuador, Guatemala, Honduras, India, Kenya, Mexico, Papua New Guinea, Nicaragua, Panama, Peru, Rwanda, Salvador, Tanzania, Uganda, or Venezuela."
Furthermore, the ICE specifies:
"Coffee 'C' shall consist of one (1) growth, in sound condition, free from all unwashed and aged flavors in the cup, of good roasting quality, and of bean size and color in accordance with criteria established by the Exchange. No delivery shall be permitted of coffee containing more than fifteen (15) full imperfections below the basis for the respective growth, except that in the case of Colombian coffee no delivery shall be permitted of coffee containing more than ten (10) full imperfections below the basis for the respective growth. Imperfections shall be established on the basis of a grading schedule established by the Exchange."
Upon delivery, the futures contract owner can request of the exchange that the coffee be graded. Then a master sampler (who is randomly selected from among a list of eligible and unbiased graders) will inspect the deliverable coffee from a 5x8" aluminum tray with 1.2" sidewalls. Inspecting now fewer than six cups sampled from the batch, the grader will evaluate its cleanliness, bean size, aroma, flavor, roastability, and imperfections (such as off-color, off-odor, broken shells, etc.). The master sampler will then write up a grading report and a corresponding certificate will be issued by the exchange.
The fee for grading a commodity is paid by the one requesting the grading certificate. In the case of grading coffee contracts, the ICE charges $1.25 per bag of coffee with a minimum fee of $40.
What Is the Basis Grade?
The basis grade, or par grade, is the minimum standard for a commodity deliverable under a futures contract.
What Is the Difference Between Futures and Commodities?
Futures contracts are an agreement to deliver some underlying asset at a future date, but for a price established today. That underlying asset can be anything from an equity index, bonds, or currencies to commodities. Commodities are the physical items that would have to be delivered, and which a commodities futures contract's price is based upon. Examples include oil, gold, wheat, and livestock.
How Is the Quality of a Futures Commodity Determined?
The standard quality of goods is defined by the futures contract as its basis grade. The actual quality of delivered goods is established via a grading process judged by an unbiased expert and according to pre-established criteria set out by the exchange and the contract itself. Upon inspection, a grading certificate is issued.