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Digital Innovation

THE CASE FOR A MORE TRANSPARENT AND
LIQUID MARKET FOR TRADE FINANCE ASSETS


Highlights

  • Increased regulation and growth in world trade is sparking a need for trade financing, and there is growing interest in transferring risk from banks to non-traditional sources of capital, such as investment funds with substantial capital and liquidity.
  • Although trade assets are attractive, there are a number of challenges to increasing the market for this asset class, and banks should work together to address these.
  • Populating an ICC Trade Finance Register, improving settlement and liquidity definitions and creating a series of Trade Finance Market indices (see callout box) are steps banks can take.

In recent years, regulatory capital requirements have motivated banks to securitize portfolios of trade loans for investors to free up capital for additional lending. A small number of investors—pension, insurance and hedge funds—have invested in trade finance assets, but more investors could become interested if the attributes align with institutional market needs.

During the 2008 financial crisis, international trade declined about 12%, as Germany’s exports fell 20% and Japan’s by 46% amid scarce financing opportunities. Since then, financing has become more accessible—in 2012, the Society for Worldwide Interbank Financial Telecommunication (SWIFT) estimated that its network processed about $2.5 trillion in letters of credit. The World Trade Organization estimates that 80% to 90% of the $17.3 trillion global trade market relies on trade finance.

 

 

Investor interest could rise as trade finance assets attributes align with institutional market needs
80-90% of the $17.3 trillion trade market relies on trade finance.

For institutional investors, trade finance falls into four main categories—supply chain finance, working capital loans, letters of credit and loans guaranteed by export credit agencies.

Greater investment in trade finance assets supports lending, which helps bolster global trade. By making the distribution of assets to the secondary market more viable, banks will be better positioned to handle capital requirements and associated costs.
 

Why trade finance assets are attractive

Minimizing cash flow volatility is an important concern for investors, such as insurance companies, with a low risk tolerance that can’t risk the loss of income or delays in collecting income from investment activities, particularly during periods of net cash outflows. Non-life insurance companies use investment income to reduce premiums and ultimately offer more competitive pricing.1 Trade finance’s low default rates meet the need for relatively reliable investment income to support business priorities.

Out of every 50,000 transactions usng trade finance, 52% of it are fully recovered.

According to the 2013 Global Risks Trade Finance Report from the ICC Trade Register, only 0.0021% of 8.1 million transactions using short-term trade finance products defaulted between 2008 and 2011. The recovery rate was 52%, reflecting the comparatively low risk of trade finance instruments.2

 

Trade finance loans, which have very short duration, help borrowers improve working capital. And during a sovereign restructuring, trade finance assets have historically received preferential treatment since they are critical to a nation’s ability to continue providing basic services to citizens. Banks need to convey the attributes of trade finance to investors, particularly as the regulatory landscape evolves in respect to liquidity, as these short-term loans can be quickly liquidated in a stress scenario.

Disadvantages include re-investment risk as market fluctuations can lower the interest rate the investor agreed to accept when making the investment. Also, while the rate of default is quite low, it still exists and could affect credit ratings.

Next steps for banks

Next steps for banks:

  1. Populate and circulate the ICC Trade Finance Register to provide access to institutional investors and ratings agencies
  2. Create a series of Trade Finance Market indices for the Trade Finance asset class by using data from SWIFT and the ICC Trade Finance Register
  3. Identify whether accelerated settlement between market counterparties when purchasing, selling or trading trade finance transactions can be attained

 

Why is the market not stronger?

One reason is that investors aren’t aware of the benefits. In addition, data is in short supply and documentation needs to be standardized.

The availability of relevant market information is critical since access to data on the underlying assets is essential for investors to make decisions. For evaluative purposes, investors require benchmarks that are reliably quantitative, not purely anecdotal, to estimate how much they may make or lose on investments and the favorability of pricing. Standardization of documentation will allow information to be aggregated more easily and encourage investors to view trade finance assets as easily understandable.

Developing an appropriate awareness of trade finance assets will help create the necessary market attention to drive industry bodies to collaborate with banks. So far, traction in promoting investment in trade finance assets has led the U.S. National Association of Insurance Commissioners to evaluate working capital finance investments as an investment opportunity for the insurance industry.3

Various banks have worked together to contribute to the ICC Trade Finance Register, a project to advance understanding of trade finance products and their risk characteristics, but work remains. As the Trade Finance Register provides more transparency into the trade finance risk profile, investors may be more willing to invest in trade finance assets. But banks must also be willing to share data at a more granular level for the register to play a meaningful role for institutional investors.

Information is especially important for certain types of investors, such as pensions. Defined benefit plans in the U.S. are required by the Employee Retirement Income Security Act (ERISA) to exercise appropriate due diligence when making investment decisions. Not all plans have the resources to appropriately investigate potential investments that are not well understood, so the dissemination of this information would only support the asset class.

 

1. Kahane, Yehuda. “The Theory of Insurance Risk Premiums—A Re-Examination in the Light of Recent Developments in Capital Market Theory.” ASTIN Bulletin 10, 223–239. 1979.
3. “Working Capital Finance Investments: A New Asset Class for Insurance Companies.” The Center for Insurance Policy and Research Newsletter. 2014.