Abstract

Banks and institutional investors are grappling with financial asset quality challenges.

The pandemic-induced macro-financial shock has further aggravated the problem. Banks will have to assess the non-performing assets (NPAs) and their influence on the overall balance sheet given the impact from the pandemic on the economy at large.

Banks and institutional investors are looking at safer avenues like trade finance assets for asset allocation. Although avoided by investors in the past, trade finance assets are gaining interest because of their short-to-medium tenor, low risk, and high-return possibilities. Trade finance assets also offer diversification as the transactions are spread across banks, geographies, trade product types, and different tenors with underlying goods involved catering to various industries and multiple commodities.

Recently, there has been an increase in default in repayment of other asset classes, and the risk has increased exponentially. This paper aims to demystify the trade finance asset class and its importance as a relatively safe investment bet.

Trade finance assets

A host of trade finance arrangements are available in the entire lifecycle of a trade, generating opportunities for trade assets.

Trade finance assets can be classified under various trade products like letter of credit (LC) – import or export, loans for import and export – guarantees, standby LC, supply chain finance, and commodity finance.

Letter of Credit (LC): LC is a payment undertaking issued by a bank or financial institution on a buyer’s behalf, guaranteeing on-time payment to a seller for the specified credit amount. While issuing an LC, the importer’s bank (issuing bank) blocks the credit limits of the importer so that the bank can own the liability on behalf of the importer. For exports, on the exporter’s request, the exporter’s bank (confirming bank) can take on the liability by blocking the funds of the issuing bank in exchange for a fee. Similarly, credit limits would be blocked during loans for import and export, depending on the bank’s role. The assets created by blocking these credit limits can subsequently be traded in the market as trade finance assets.

Guarantees or standby LC: While the LC is issued for performance (for example, supply of goods), the guarantees or standby LC is issued for non-performance. It guarantees the bank’s payment to a seller if the buyer defaults on the agreement, like not completing constructions on time. The assets created by blocking the credit limits can subsequently be traded in the market as trade finance assets.

Supply chain finance (SCF) or trade receivables: SCF optimizes working capital stuck in global supply chains and provides liquidity to both buyers and sellers. This SCF-generated financing asset can be traded in the market.

Commodity finance: Banks offer financing for commodities including but not limited to metals, mining, energy, and agricultural products. The bank blocks the borrower’s credit limits for financing these commodity transactions, which can subsequently be traded in the market as trade finance assets. The financing can be short-term or medium-term, depending on the contract. 

Limitations of assets

In the past decade, trade finance products have maintained favorable risk profiles compared with non-trade asset classes.

Supply chain finance represents similar or lower risk than other trade products. Although the default rates and expected losses remain low for trade finance products, they have not been able to attract investors in a big way due to the entry barriers.

Trade finance is a complex, heavily regulated, and paper-based business that relies on laborious manual processes and various guidelines. Although work on digitizing, automating the frontend, and processing is underway, the relative focus on trade asset automation is low. Similarly, as banks undertake most of the trade finance, other institutional investors like hedge funds, pension, and insurance are not aware of the lifecycle of a trade finance product. Moreover, trade assets lack transparency as the data is not freely available in any public domain for the investors to analyze and invest. Besides, compliance demands such as Know Your Customer (KYC), Anti-Money Laundering (AML), and sanctions make it more challenging for non-banking investors to comprehend the regulatory risks of the products. 

Safe investment class

Global markets are flush with investment opportunities for asset classes like stocks, bonds, commodities, currencies, and real estate.

Institutional investors like banks, hedge funds, mutual funds, pensions, wealth managers, and insurance companies are always interested in making high yields on their investments while maintaining minimum risk.

Lately, there has been some interest around trade finance asset quality for traditional products and supply chain finance, and rightly so. It is a safe bet for investors as trade finance has a proven track record of overall low default rates for ages, and the products typically have short-to-medium term tenure. Overall, the default rates and expected losses have remained low for trade finance products.

Committing to the future

Trade finance asset class can attract investors due to a host of factors.

These include low default rates, high recovery rates, reasonable yield on investment, non-speculative nature, portfolio diversification, long-term stability, and overall contribution to the critical economic sector. Investors can participate in these trade assets at scale if the banking industry is willing to invest in the following themes and commit to building the future of this coveted asset market:

• Simplified regulations: KYC, AML, sanctions, and local regulations must be simplified with all partnering banks for uniform KYC; adopting regulatory technology solutions can help simplify and automate regulations. Banks, governments, and trade governing bodies must collaborate for standardizing KYC norms and setting up the new global standards for trade finance asset transactions.
• Branding and quality education: Investments in branding and marketing, awareness sessions, workshops, seminars, and quality education content are required for demystifying the entire trade ecosystem and its functions to institutional investors.
• Building marketplace: Trade finance assets are closely preserved and safeguarded by commercial banks. This must gradually open up to institutional investors who can participate in this type of asset class investment. Cloud-based e-marketplaces with convenient market access must also be created for investors.
• Transparency and ease of transaction: Investors must have transparent and real-time access to trade asset data for analytics and decision-making. Easy access to data will allow them to buy or sell with connected payment interfaces.
• Adoption of disruptive technologies: The trade finance industry should adopt disruptive technologies like blockchain to eliminate manual paper usage and build trust, reliability, data confidentially, and transparency for effective record management.

The way ahead

Trade finance provides an opportunity for investors and banks to contribute to economic development.

They can do so by serving the underfinanced SME or MSME segment, as there is a high global trade finance gap. According to Asian Development Bank, the estimated global trade finance gap is at USD 1.7 trillion. To bridge this gap and scale trade financing, we require close collaboration among stakeholders, automation, simplified regulations, and investor participation in the secondary trade assets market