Commodity trading can be a risky business, especially when it comes to counterparty risk. In this article, the author shares his experience and expertise in identifying red flags when dealing with new counterparties. He emphasizes the importance of recognizing these red flags to avoid being scammed or wasting time and money on deals that are unlikely to materialize.
The author identifies seven red flags that he looks out for when dealing with new counterparties. These include requests for proof of funds, defensive counterparties and lack of transparency, language barriers and communication issues, and requests for letter of intent for small deals. By being aware of these red flags and cutting off communication with counterparties who exhibit them, traders can minimize their counterparty risk and protect their investments.
Key Takeaways
- Recognizing red flags is crucial in commodity trading to avoid being scammed or wasting time and money on deals that are unlikely to materialize.
- Seven red flags to look out for include requests for proof of funds, defensive counterparties and lack of transparency, language barriers and communication issues, and requests for letter of intent for small deals.
- By cutting off communication with counterparties who exhibit these red flags, traders can minimize their counterparty risk and protect their investments.
The Importance of Recognizing Red Flags
In physical commodity trading, recognizing red flags is crucial to avoid being scammed and losing everything. A seasoned trader with over a decade of experience shares seven red flags that he uses to determine whether a new counterparty is trustworthy or not.
The first red flag is when the counterparty asks for proof of funds (POF). POF is a document or bank statement verifying that an individual or entity has the financial ability to complete a transaction. However, in dynamic cash positions such as in import-export or trading companies, having a stack of cash waiting for a deal is unlikely. Therefore, asking for POF is a waste of time and a red flag.
The second red flag is when the counterparty is defensive and doesn’t give clear information about their business, such as where they buy their product, their current supplier’s specifications, target price, lead times, and payment terms. If someone is very defensive and doesn’t provide any information, it’s best to cut ties and move on.
The third red flag is when the counterparty doesn’t speak the same language, making communication difficult and increasing the risk of misunderstandings and conflicts. In such cases, it’s best to avoid dealing with the counterparty altogether.
The fourth red flag is when the counterparty asks for a letter of intent (LOI), which is an initial step towards formalizing a transaction and facilitating due diligence. However, LOIs should only be used for significant assets and not for small transactions. If the counterparty asks for an LOI for a small deal, it’s a red flag.
Ignoring red flags can lead to being scammed and losing everything. Therefore, it’s crucial to have high standards for the counterparty that you deal with and to recognize and act on red flags promptly.
Red Flag 1: Requests for Proof of Funds
According to an experienced commodity trader, one of the first red flags to look out for when dealing with a new counterparty is a request for proof of funds (POF). POF is a document or bank statement that verifies an individual or entity’s financial ability to complete a transaction. However, the trader argues that POF requests are often unnecessary, as cash positions in import-export and trading companies are extremely dynamic, with money coming in and going out regularly.
The trader advises that POF requests should be immediately met with suspicion and that communication with the counterparty should be cut off. This is because scammers can use POF to scam other people, and wasting time and resources on such requests can be detrimental to the business.
The trader also shares a personal experience with a partner who received a contact for a lady who claimed to have a producer offering a good product below market price. The trader was immediately skeptical of the deal, but the partner pushed for it, leading to a request for POF. The trader ultimately discovered that the whole thing was a scam, and the partner had wasted time and resources chasing a non-existent deal.
In summary, requests for POF should be viewed as a red flag and dealt with accordingly to avoid falling victim to scammers.
Red Flag 2: Defensive Counterparties and Lack of Transparency
When initiating a conversation with a new counterparty, it is standard practice to ask questions about their suppliers, product specifications, target prices, lead times, and payment terms. However, if the counterparty is defensive and hesitant to provide clear information, it may be a red flag.
According to a seasoned physical commodities trader, a lack of transparency from a counterparty is a warning sign that should not be ignored. If a counterparty refuses to disclose key information about their business, it indicates that they may be hiding something or are not a trustworthy partner.
In addition, defensive behavior from a counterparty can also be a red flag. If a counterparty is unwilling to answer standard questions or becomes defensive when asked, it may be an indication that they are not interested in building a collaborative relationship.
In physical commodity trading, counterparty risk is the biggest risk that traders face. Therefore, it is crucial to have high standards for the counterparties with whom one chooses to do business. If a counterparty is not forthcoming with information or is defensive, it may be best to cut ties and move on to a more transparent and cooperative partner.
Another red flag to watch out for is when a new counterparty asks for a Proof of Funds (POF). A POF is a document or bank statement that verifies an individual or entity’s financial ability to complete a transaction. However, in physical commodity trading, cash positions are dynamic, and it is not practical for companies to have a stack of cash waiting for a deal. Therefore, it is not necessary for a counterparty to provide a POF, and if they insist on it, it may be a sign of a scam.
Overall, when dealing with new counterparties, it is essential to be vigilant and look out for any red flags. Defensive behavior, lack of transparency, and requests for POFs are all warning signs that should not be ignored. By being cautious and selective with counterparties, traders can mitigate their counterparty risk and protect their investments.
Red Flag 3: Language Barriers and Communication Issues
In physical commodity trading, the biggest risk is the counterparty risk. Therefore, it is crucial to have high standards for the counterparty that one deals with. When starting a new conversation with a new counterparty, it is standard to ask questions about their suppliers, product specifications, target prices, lead times, and payment terms. If the counterparty is defensive or does not give clear information about what they do or who they buy from, it is a red flag and the communication should be cut off immediately.
Language barriers and communication issues are also major red flags. If the counterparty does not speak the same language or is difficult to understand, it is not worth pursuing the deal. Using Google Translate or other translation tools is not a reliable solution and can lead to miscommunication and potential losses. If the counterparty asks for a proof of funds (POF) or a letter of intent (LOI), it is also a red flag and the communication should be cut off immediately.
POF is a document or bank statement verifying that an individual or entity has the financial ability to complete a transaction. However, in the dynamic cash position of import-export or trading companies, showing a bank statement is not a reliable indicator of financial ability. LOI serves as an initial step towards formalizing a transaction and facilitating due diligence. It signals the party’s commitment to proceed under the agreed terms while laying the groundwork for a more detailed and legally binding contract. However, using LOI for small transactions is unnecessary and can lead to potential scams.
In conclusion, language barriers and communication issues can be major red flags in physical commodity trading. It is important to have clear communication and understanding with the counterparty to avoid potential losses.
Understanding Counterparty Risk in Commodity Trading
Counterparty risk is the biggest risk in niche commodity trading. It is the risk of losing everything in a trade due to a default or insolvency of the counterparty. In this section, we will discuss seven red flags that can help traders identify potential counterparty risks.
Red Flag #1: Proof of Funds (POF)
If a counterparty asks for a POF, it is a red flag. A POF is a document or bank statement verifying that an individual or entity has the financial ability to complete a transaction. In physical commodity trading, cash position is dynamic, and nobody has a stack of cash waiting for a deal. Therefore, asking for a POF makes no sense. It is best to cut communication with a counterparty that asks for a POF.
Red Flag #2: Lack of Information
When starting a conversation with a new counterparty, traders usually ask standard questions, such as where they are buying from, the specifications of the product, target price, lead times, and payment terms. If a counterparty is defensive and does not provide clear information, it is a red flag. Traders should cut communication with such a counterparty.
Red Flag #3: Language Barrier
If a counterparty speaks a different language and cannot communicate effectively, it is a red flag. Traders must ensure that they can understand the counterparty to avoid misunderstandings and potential disputes.
Red Flag #4: Letter of Intent (LOI)
If a counterparty asks for a LOI, it is a red flag. A LOI serves as an initial step towards formalizing a transaction and facilitating due diligence. It signals the party’s commitment to proceed under the agreed terms while laying the groundwork for a more detailed and legally binding contract. However, in most cases, a LOI is unnecessary and can be a sign of a potential scam.
Red Flag #5: Unusual Payment Terms
If a counterparty offers unusual payment terms, such as upfront payments or payment through a third party, it is a red flag. Traders must ensure that the payment terms are reasonable and in line with industry standards.
Red Flag #6: Lack of References
If a counterparty cannot provide references or has a bad reputation in the industry, it is a red flag. Traders must ensure that they are dealing with a reputable and trustworthy counterparty to avoid potential losses.
Red Flag #7: Unreasonable Demands
If a counterparty makes unreasonable demands, such as unrealistic delivery times or prices, it is a red flag. Traders must ensure that the demands are reasonable and in line with industry standards.
In conclusion, traders must have extremely high standards for the counterparty that they deal with in physical commodity trading. They must be vigilant and identify potential counterparty risks by looking out for the seven red flags discussed in this section. By doing so, traders can avoid potential losses and ensure the success of their trades.
Red Flag 4: Requests for Letter of Intent (LOI) for Small Deals
According to the speaker, counterparty risk is the biggest risk in niche commodity trading. Therefore, it is important to have extremely high standards for the counterparty that one deals with. One of the red flags that the speaker identifies is when the counterparty requests a Letter of Intent (LOI) for small deals.
An LOI is a document that serves as an initial step towards formalizing a transaction and facilitating due diligence. It signals the party’s commitment to proceed under the agreed terms while laying the groundwork for a more detailed and legally binding contract. However, the speaker advises against using LOIs for small deals as they are unnecessary and can be a red flag.
The only time the speaker used an LOI was for the purchase of a mine for multi-millions of US dollars. In that case, it made sense to formalize the LOI as a 30-page document so that all parties agreed before the due diligence on what would be the terms of the engagement. However, for small deals, the speaker advises against using LOIs as they can be a waste of time and a red flag.
If a counterparty asks for an LOI for a small deal, the speaker advises immediately cutting communication and moving on. This is because small deals do not require an LOI and the counterparty’s request for one may indicate that they are not trustworthy. Therefore, it is important to be cautious and have high standards when dealing with counterparty risk in niche commodity trading.