Commodity papers are a special type of loan or advance that is made using commodities in the possession of the borrower as collateral for the transaction. In general, the lender does not take possession of the physical commodities as part of the loan agreement. Often, documents such as bills of lading, verified inventory lists, and warehouse receipts are used to establish the status of the commodities and allow the lender to prepare a commodity paper.
The nature of commodities is different from many other investments, in that the commodity is a physical substance that has to be produced before it can be sold on an exchange. For example, food products and grains are raised by farmers and then stored, all in the hope that the products will sell at a good price when the time comes. The commodity paper is one of the ways that the owner of produced commodities can benefit from the stored goods prior to the point of sale.
Loans and advances that are transacted with the use of a commodity paper are otherwise very similar to any other type of loan. There is normally a fixed or variable rate of interest applied by the lender. Repayment of the loan balance plus interest can be structured into monthly installments of a series of balloon payments. In the event that the borrower defaults on the loan, the lender has the right to assume control of the commodities as a means of settling the remaining debt on the commodity paper.
Generally, the lender and borrower will work together in structuring the terms so that the borrower can obtain permission to sell the pledged commodities when the sale price is attractive. The terms will often involve a commitment on the part of the borrower to use a portion of the sale to settle a part of the outstanding balance on the commodity paper. This type of arrangement makes selling the commodities at the highest market price possible a goal for both the lender and the borrower.