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Nevertheless, the grim caution from the chief executive of the world’s largest retailer reflects a growing unease that while global trade is not grinding to a halt, it is slowing. The point was made forcefully by Natalie Blyth, HSBC’s global head of trade and receivables finance, in an address to the ICC UK Trade Finance Conference in November.
“For the first time ever, we have seen a dislocation of trade, as values collapse compared to volumes, and trade growing below the rate of GDP,” she said.
The numbers may not quite be suggestive of a collapse, but they are disconcerting. According to the World Trade Organization (WTO), in value terms, merchandise exports fell by 3.3%, to $15.46 trillion, in 2016. Volumes rose, but at a disappointingly subdued pace.
“In 2016, world merchandise trade recorded its lowest growth rate in volume terms since the financial crisis of 2008,” the WTO reports, “with an increase of just 1.3%, as measured by the average of exports and imports. This low level of expansion was half as strong as the 2.6% recorded in 2015 and well below the 4.7% average annual rate since 1980.”
More worrying than the headline statistics is that it is not just weaker global growth and sagging commodity prices that are to blame for the slowdown. Protectionism is emerging as an equally destabilizing influence in global trade.
|Natalie Blyth, HSBC|
According to a report published in November by the UK-based law firm, Gowling WLG, since 2009 the world has implemented more than 7,000 measures believed to be injurious to global trade. The US alone has passed almost 1,300 of these, many of them long before Donald Trump entered the White House, blowing his ‘America First’ trumpet.
But it is Argentina and India that the Gowling report names as having been the “biggest proponents” of protectionism in recent years. Brazil, Saudi Arabia and Tunisia, meanwhile, are singled out for having bucked the trend by loosening their borders since 2009.
“In some ways, the numbers between GDP and trade are disconnected,” says John Ahearn, global head of trade in Citi’s New York-based Treasury and Trade Solutions business.
Banks can hardly be held accountable for any of these drivers of weaker global trade growth. But they have a role to play in addressing another reason why trade is failing to maximize its potential as a propellant of economic growth and job creation.
This is the so-called ‘trade finance gap’ that attempts to quantify the amount of world trade that cannot access traditional trade finance products, especially among small and medium-sized enterprises (SMEs) in emerging markets. While estimates on the size of this gap vary, the most eye-catching is the figure based on annual surveys of banks and companies published by the Asian Development Bank (ADB).
The most recent of these, released in September 2017, reports a gap of $1.5 trillion. That is down slightly from $1.6 trillion the previous year, but it remains a huge figure. According to the ADB, 40% of this deficit originates in the Asia-Pacific region, with 74% accounted for by SMEs and mid-cap companies.
How much of this void could realistically be filled on a commercial basis is open to question.
“We should all be looking for ways to fill these gaps because trade creates jobs,” says Rüdiger Geis, head of product management, trade, at Commerzbank and member of the ICC Banking Commission’s executive committee. “But as much as two thirds of the unmet demand is accounted for by SMEs in remote regions of emerging markets without the creditworthiness or collateral to make them bankable.”
Bankers also caution against assuming that the trade finance gap is anywhere near as applicable to developed markets as it is to emerging ones. There is, for example, no evidence of a trade finance gap in Europe, even in support of emerging market trade, says Luca Corsini, global co-head of global transaction banking at UniCredit.
“Banks are happy to buy trade finance debt on the Continent and aren’t that interested in selling it,” he says. “This is reflected in the margin pressure that continues to push down the price of trade finance. If a trade finance gap were creating serious bottlenecks, banks would be able to command higher fees.”
|John Ahearn, Citi|
But emerging markets account for between 360 million and 440 million of the world’s 420 million to 510 million micro, small and medium enterprises, according to an IFC/McKinsey study. That means it is in everybody’s interest to explore financing solutions for smaller companies.
Part of the deficit in the SME sector in emerging markets may reflect the innate conservatism of the leading banks in trade finance, which has given rise to a concentration of lending. A recent African Development Bank (AfDB) analysis on the trade finance gap in Africa, for example, notes that on average, the 10 largest trade finance customers in the region account for 58% of a bank’s total trade finance assets.
Duarte Pedreira, head of trade finance at Crown Agents Bank and board member of the International Trade and Forfaiting Association, says that a disproportionate share of this lending is accounted for by large trading companies.
“The real issue underlying the trade finance gap in Africa is that banks are moving more and more towards financing the same counterparties, which is creating considerable concentration risk,” he warns. “Whilst banks don’t want to lend to African commodity producers or importers, they happily lend to large commodity traders, who then undertake the lending to these entities themselves.”
There are plenty of other explanations for the deceleration in de-risking among trade finance lenders in recent years. Foremost among these are know-your-customer (KYC) and anti-money laundering (AML) requirements, which were identified by 90% of respondents to the latest ICC survey as “significant” or “very significant” impediments to underwriting trade finance business.
This is appreciably higher than the 76% that cited Basel III regulatory requirements as a stumbling block.
An alarming by-product of de-risking across the global banking system has been a conspicuous decline in correspondent banking relationships (CBRs), which have traditionally played a key role in greasing the wheels of international commerce.
“Either because of their size or because they’ve had issues with KYC and AML, a number of banks in emerging markets are having a hard time finding correspondents,” says Ahearn at Citi. “That is adding to the trade finance gap, because if banks can’t access international networks, then neither can their clients.”
According to a survey published by the IFC in September, 27% of respondent banks indicated that they saw reductions in CBRs in 2016. With 78% of banks reporting that they expected their compliance costs to increase “substantially” in 2017, it is probable that there will be more pressure on these relationships for the foreseeable future.
This unsettles policymakers and multilateral development banks (MDBs), because as the IFC warns: “In many cases, trade in emerging markets would not occur without trade finance.”
|Nicolas Langlois, |
The outlook for trade is far from being uniformly bleak. Pedreira says that in emerging markets, niche players are stepping into the void created by de-risking among large banks by supporting due diligence-led trade financing in countries ranging – in the case of Crown Agents Bank – from Sierra Leone and the Gambia to Malawi and Mozambique. In developed regions, meanwhile, bankers insist that demand among lenders for viable assets outstrips supply, even at the smaller end of the market.
There are other reasons to be positive about the prospects for global trade, most of them emanating from Asia.
Another driver of rising demand for trade finance in Asia is China’s Belt and Road Initiative, which Blyth says is forecast to lift annual trade between countries impacted by the project to $2.5 trillion.
A further reason for lenders to be more positive about the outlook for the market is that technological innovation and digitization are helping to enhance efficiencies and reduce the costs of banks’ trade finance operations.
“If anything, trade finance is getting simpler,” says Corsini at UniCredit. “New blockchain solutions such as we.trade, for example, drastically simplify the process for all involved – using smart contracts and transparent tracking to ensure processes are fast, clear and efficient. Common concerns such as KYC are also being allayed by technology. All parties on we.trade, for instance, are KYC-approved, saving participants huge amounts of time and resources.”
There is still plenty of scope to make further savings by tackling the administrative burden associated with trade-related lending. Perhaps the most striking insight into the magnitude of this challenge was given by HSBC’s Blyth in her recent speech to the ICC. To facilitate half a trillion dollars of trade annually, she said, a team of 4,000 people is still required to review a jaw-dropping 100 million pieces of paper manually.
“Having that number of people working with so much unstructured paper is clearly unsustainable,” says Blyth. “It is one part of the trade finance architecture that has to change through automation and digitization.”
She adds that HSBC has already jump-started the process, developing a cognitive intelligence solution in cooperation with IBM aimed at making global trade safer and more efficient by combining optical character recognition with advanced robotics.
“Trade is like water,” says Commerzbank’s Geis. “It will always find a way around obstacles.” Perhaps. But there is plenty that can and should be done by the global financial services industry to encourage trade to flow more freely, especially among smaller companies.
Blyth says: “SMEs are the backbone of economic growth, but as things stand, I don’t believe regulators or banks are providing them with all the tools they need to access finance.”
“The trade finance gap is a concern because it is having a very real impact on the real economy,” says Nicolas Langlois, managing director and global head of trade distribution at Standard Chartered in Singapore.
He points to two important ways in which the banking industry is responding to this challenge: “One of these is the work that banks are doing around regulatory advocacy, aimed at ensuring that as the regulatory environment continues to evolve with Basel III, trade finance is allocated with appropriate capital and liquidity requirements that reflect its low risk profile.
“Another area where banks may be able to exercise more direct control over the trade finance market is by focusing on the entirety of the supplier and distributor chain,” Langlois adds. “At Standard Chartered, we have adopted a strategy of banking the ecosystem of our clients by digging much deeper into the distribution chain. Leveraging our relationships with large companies to develop our understanding of their suppliers is a game-changer for smaller players, which might not otherwise have access to funding.”
At HSBC, Blyth also points to several initiatives that could – and should – be explored, such as closing the gaps in the chain between SME borrowers, banks and non-bank investors. The first of these, she says, would be the cultivation of closer relationships between local lenders and international development and commercial banks.
Blyth’s second suggestion is that other markets follow the precedent established by Mexico and India, both of which have set up platforms allowing banks and non-banks to bid for invoices uploaded by sellers and buyers.
Blyth says that regulations on bank capital also need to be reviewed: “The regulatory capital treatment of trade finance should be appropriate and proportionate to its low risk profile. Why can’t other countries cut and paste the EU’s explicit capital requirements deduction factor for the calculation of capital set aside for SME lending?”
Given that two thirds of bank respondents to the latest ICC survey said that the implementation of Basel III regulations had affected their cost of funds and trade finance liquidity, it is a good question.
“It should not be beyond the wit of man to create some kind of credit information bureau allowing lenders to monitor payment behaviour,” she says.
Costs could also be cut and efficiencies enhanced through the broader adoption of legal entity identifiers (LEIs), which would automate identity verification and allow for the digitization of a number of the steps involved in trade finance transactions.
According to a paper published recently by McKinsey and the Global Legal Entity Identifier Foundation (GLEIF), banks could make collective annual savings of between $250 million and $500 million if LEIs were used to identify international entities and support the automation of the issuance of letters of credit.
To put these savings into perspective, the McKinsey/GLEIF paper reckons that at their maximum potential, they would represent 4% of the current global trade operations cost base.
“At the ICC, we have encouraged the UN to support us in lobbying to make LEIs mandatory across the world,” he says. “We believe this would be a game-changer in reducing the operational costs of KYC compliance.”
Small wonder that trade finance bankers are wholehearted supporters of the wider use of LEIs. So is the ICC’s Banking Commission, which is chaired by Daniel Schmand, head of trade finance at Deutsche Bank.
|Luca Corsini, UniCredit|
The impact of making LEIs an industry standard, says Schmand, would be at least twofold. Cost reductions would support banks’ return on equity goals, while the enhanced economics of trade-related SME lending would help to make more inroads into the trade finance gap by minimizing on-boarding costs.
One of the more intriguing potential solutions for plugging the trade finance gap is the promotion of its credentials as an asset class and the encouragement of more participation in the market by institutional investors.
As Standard Chartered’s Langlois explains, non-bank investors could play a critical role in the trade finance market by unlocking an added layer of demand for assets with a different risk-return profile to the loans that are the focus of bank lenders.
UniCredit’s Corsini agrees that institutional demand for trade-related assets would be an ideal complement to traditional bank lending.
On paper at least, the argument for institutions to play a more prominent role in the trade finance market is compelling.
“Trade finance has a much lower risk profile than traditional assets, yet the Basel III and Basel IV capital requirements do not fully recognize this in their risk-weighting specifications, meaning banks cannot extract their full value,” he says. “Institutional investors, on the other hand, can take advantage – either by using trade finance assets as low-risk ballast to offset riskier investments as part of a balanced portfolio, or by simply extracting the inherent value of such a low-risk profile.”
“There are 101 reasons why trade finance should be an attractive asset class to institutional investors,” says HSBC’s Blyth. Many of these are easy enough to identify. There is a plentiful and consistent supply of trade finance loans across a variety of structures, largely in floating-rate format, which offers the appeal of diversification, modest volatility and relatively low correlations to mainstream asset classes.
Trade finance also boasts a track record of very low defaults. According to the latest data published by the ICC Trade Register, which covers 17 million transactions worth over $9 trillion of exposures, default rates for short-dated import and export letters of credit are close to negligible, at 0.08% and 0.04% respectively, rising to 0.21% for export/import loans and 0.19% for performance guarantees.
In the case of medium and long-term transactions covered by OECD-backed export credit agencies (ECAs), the average default rate is a modest 0.44%, with a loss-given default (LGD) of 5.3%, driving an expected loss of 0.024%.
SMEs are the backbone of economic growth, but as things stand, I don’t believe regulators or banks are providing them with all the tools they need to access finance- Natalie Blyth
Bankers say that there are sound reasons why trade finance loans are intrinsically more secure than many other assets.
“Countries and companies tend to prioritize repaying trade loans,” says Deutsche’s Schmand. “Borrowers recognize that if they don’t settle their trade liabilities promptly, they will be out of business very soon. Lenders also derive a huge level of comfort from the underlying trade in a default scenario.”
Against this backdrop, it is easy to grasp why a recent Greenwich survey finds that: “Trade finance over time will emerge as an important asset class in the portfolios of many European institutions.”
For now, the survey emphasizes, a trade finance asset class remains in its infancy in Europe, with only 5% of the institutions polled by Greenwich having invested in commodity trade finance. Another 14% are yet to invest but have looked into the credentials of the asset class, which according to Greenwich did not post a single month of negative returns, even at the height of the financial crisis.
In Africa, for example, specialists such as Barak Fund Management and Scipion Capital have been able to capitalize on the trade finance gap by rolling up their sleeves and doing intensive due diligence on opportunities unlikely to interest local or international banks.
“Specialist managers in Africa are stepping in and taking risks on direct loans, mostly of between $500,000 and $5 million,” says Pedreira at Crown Agents. “The double-digit returns on these deals can be very attractive to investors prepared to do due diligence to the nth degree. But they don’t appeal to international banks because they are too small, while local lenders will generally require substantial land collateral, which borrowers don’t have.”
EFA Group is an example of an asset manager focusing on Asia. It was established in 2003 and reports that it now provides over $2 billion of loans annually to mid-market companies through a range of specialist funds. The most recently launched of these, announced in July, is a supply-chain finance fund providing 30- to 180-day loans to SMEs in Asia aimed at chipping away at the region’s $700 billion trade finance gap.
EFA has taken an especially close interest in the evolution of institutional demand for trade finance, commissioning the recent Greenwich white paper on the subject.
Gerry Afentakis, EFA’s head of strategic development, says that the reception that the group’s funds have had from institutions such as pension funds and insurance companies is principally a reflection of rising demand for the added yield offered by trade finance loans too small to command the attention of the banks.
“Our structured commodity-trade finance portfolios manage about $800 million of short-term transactional loans to commodities-trading companies with an average loan size of between $600,000 and $700,000,” Afentakis explains. “That means there is immense granularity within the portfolios, which differentiates us from bank lenders.”
“One of the reasons we have benefited from the emergence of direct lending as a bona fide asset class is that institutions have historically found it difficult to place trade finance within their asset allocation,” says Afentakis.
Even for credit specialists familiar with individual corporate credits, the structure of trade finance loans can make them difficult to assess. “While trade finance is a good asset, it is not always clean from a credit perspective,” says Citi’s Ahearn. “Normally as a lender, you are exposed to a subsidiary rather than the parent company, which can make understanding the risk more challenging.”
Equally challenging for investors new to trade finance is the fragmented and heterogeneous nature of the asset class.
“Part of what holds back investors at the moment is a lack of clarity as to exactly what they are purchasing when they buy trade finance debt,” says Corsini at UniCredit. “Common terminology, definitions and taxonomy are therefore needed to create this clarity. ICC initiatives such as the ‘Standard definitions for techniques of supply chain finance’ are an important step in this direction, but there is still work to be done.”
The difficulties associated with pigeon-holing trade finance has also complicated the process of benchmarking performance. Afentakis says that before the financial crisis, all EFA’s funds were benchmarked against three-month Libor. Today, he says, in the absence of a broadly recognized benchmark, the establishment of an index would represent another important milestone in the accelerated development of trade finance as an asset class.
With the fund route such a convenient way of accessing trade finance among institutions, it is unsurprising that the fund model has attracted a flood of newcomers.
The magnitude of the trade finance gap is such that it will be a long time before meaningful inroads are made into the deficit.
“If you were to add up the assets under management of all the non-bank trade finance fund managers, I’d be surprised if they were much more than about $5 billion or $6 billion,” Afentakis says.
“This is such a small market that any new entrants raise the profile of the industry as a whole, which is a positive dynamic,” he says.
While some of the new entrants are focusing on direct lending opportunities, others are looking to buy portfolios of assets from banks. That may be easier said than done because opinion is mixed over whether or not a sufficient high-quality supply of trade finance assets is likely to be made available to existing or new institutional investors by banks.
A number of banks are clearly committed to distributing their trade finance assets.
“The days of being able to originate and hold this debt are long gone,” says Blyth at HSBC. “We believe that an originate-and-distribute model is a much more efficient way of generating the balance-sheet velocity you need to free up new lending capacity and address concentration risk.”
Deutsche has a similar model.
“Smaller or regional banks without a global origination network may want to hold on to their assets, but it is in our DNA as a trade finance bank to originate to distribute,” says Schmand. “Demand is very strong; so far we have had absolutely no difficulty in finding investors and distributing assets at reasonable prices.”
Many of the largest and most multinational lenders, however, say that in the present market environment, the last thing they want to do is shed safe, reliable short-term assets.
The healthy appetite for trade finance assets reported by some of Europe’s leading lenders may not last indefinitely.
“At the moment, with commodity prices low, most banks aren’t under any pressure to sell trade finance assets,” says Geis at Commerzbank. “But if commodity prices were to double over the next couple of years all of a sudden banks might be looking again for opportunities to transfer trade finance exposures to non-bank investors. For banks that have to start from scratch by educating investors and getting the necessary approval, the process will take some time.”
“There was no immediate need to remove these assets from our balance sheet, but we wanted to ensure that we had all the necessary internal and external approvals in place,” Geis explains.
As Langlois at Standard Chartered points out, trade finance loans are generally short-dated assets. That, he says, suits investors that are comfortable with participating in trade finance portfolios as an alternative to money market products but not those that have higher yield expectations.