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.

Key Takeaways

  • 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.
  • 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 are required to meet those standards or risk being found in default of their contracts.

Real World Example of 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.