The Evolution of Trade Finance: A Financial Institution’s Perspective

Protracted global economic uncertainty and ongoing regulatory change make this a challenging time for financial institutions engaged in trade finance. In addition to these external headwinds, banks face an uphill task maintaining profitability amidst a volatile operating environment and rising operating costs. In spite of this, growth opportunities exist.

Q: The past five years has been a period of significant change for global trade and trade finance. What are the key changes and how are they impacting the industry?

Although the fragile global economic environment continues to impact banks and their trade finance activities, regulation is probably the single biggest driver of change.

Trade loans – being short-term and self-liquidating in nature – were traditionally seen as low credit risk instruments. However, Basel III does not reflect this view and will require banks to allocate more capital to support trade transactions. Banks also have to intensify their Know Your Customer (KYC) and Anti-Money Laundering (AML) screening processes to cover risks in this new landscape. On the whole, these regulatory requirements are driving up capital related costs, which could result in a drop in liquidity in the market and higher pricing for clients, as well as increasing the cost and complexity of day-to-day operations, which may cause some market participants to rethink their commitment to certain geographies, or to the business as a whole.

Another key area of change is the rise of South-South trade, which according to a report by the United Nations exceeded growth in North-South trade for the first time in 2008. By 2010, 23% of trade flows were conducted between 'South-South economies' compared to 13% 10 years ago.

Corresponding to this shift is an escalating number of banks aiming to expand their market reach to provide support for their corporate clients in these new markets - either by partnering with a complimentary player in the market or by building their own networks.

Q: What are the emerging trends in trade finance?

Technology is transforming the way trade banking is being conducted. Traditionally a paper-intensive process, trade finance is evolving with the emergence of technology-based solutions that enable higher levels of process automation and standardization across the entire banking network.

One such product is the Bank Payment Obligation (BPO), which is an irrevocable undertaking by one bank to pay another bank upon successful matching of a mutually agreed set of data within SWIFT's Trade Services Utility (TSU). Not only does BPO reduce manual processes typically associated with a traditional letter of credit (LC), it also provides an effective risk mitigation and working capital optimization tool. This is not to say that BPO will replace a LC, which will continue to be used in high-value transactions, between new trading partners and in trading with non-conventional and high-risk markets. However, with the launch of the Uniform Rules for BPO (URBPO) in May 2013, we expect that the BPO will act as a substitute for Letters of Credit in some instances where risk is within manageable limits but counterparties still require some risk mitigation or financing.

Besides BPO, web-based trade portals that provide users with the ability to initiate trade transactions and manage flows have been in standard use for some time. However, the next generation of trade portals holds the potential to revolutionize usage, making these portals not just a tool for execution of specific transactions, but key hubs providing data-driven insights to drive management decision making. For example, J.P. Morgan's next generation Trade Channel platform provides corporate treasurers with the ability to perform business analytics on their trade transactions and ascertain value metrics across geographies and products.

Last but not least, I believe that mobile trade applications are as yet in the early stages of their true potential, but even so are already gaining momentum as users leverage the benefits for greater visibility and control over their day-to-day trade transactions.

Technology aside, there is also a gradual change in banks' approach to clients' requirements. Specifically, they are progressively moving away from a product-centric operating model to one that is more client-centric, by providing customized solutions and services, forming their own niches and strengthening their relationship with selected segments in a market. Similarly, corporations are also consolidating their banking relationships and establishing stronger ties with their key banking partners with the aim of safeguarding financing to be better protected from any future liquidity crunch.

Q: What are the key trade finance opportunities and challenges for banks in Asia Pacific?

Amongst the biggest challenges for banks is understanding the compliance requirements of each set of applicable rules and how it affects the others, and the related cost of understanding and administering all of these regulations. While the final impact of Basel III is yet to be determined, it is clear that the cost of trade financing will increase. In fact, the more stringent requirements under Basel III have already resulted in a pullback of activities from the region by some banks and it is likely to continue as they consolidate their capital for supporting growth in strategic markets.

This has turned out to be a market diversification opportunity for banks in Asia Pacific. That being said, this expansion is not without its challenges. More often than not, the first question they face is whether they should build their own network or partner with another market participant with the complimentary capabilities, network and client base they would need to support their own clients. Building a proprietary network is likely to require higher capital expenditure and a longer time to market, as well as higher operational risk for the bank. The partnership path generally provides significant cost benefits, but offers its own challenges, given the need to integrate their existing platforms and processing systems with those of the partner bank.

Key factors behind a successful partnership include selecting a bank with strong local market expertise, common objectives and operational standards, and establishing an arrangement that is flexible and can accommodate changes as the partnership grows. The right partner can help reduce time to market and achieve economies of scale, processing and efficiency gains. In some instances, these partnership arrangements also enable credit and risk sharing. Additionally, the partnership model is consistent with the best practice of establishing centralized processing hubs and centres of excellence for business continuity, consistency and quicker time to market.

In terms of technology, banks in Asia Pacific have been generally slower than their Western counterparts largely due to the region's lower operating costs and a preference for status quo. However, as they scale up their capabilities and market reach, it is vital that they develop their middle- and back-end processing systems simultaneously to prevent an infrastructure gap. This is changing with recent events that make deploying an electronic solution more palatable, amidst the rising operating cost in the region and the related pressure to reduce overhead.

Q: It is almost five years since the launch of the RMB Internationalization scheme. How has the market responded?

There has been a steady increase in the volume of RMB trade settlement over the past five years, with cross-border merchandise trade up by 41% to RMB 2.94 trillion in 2012, according to data from CEIC – a financial and economic database specialist. Similarly, according to the Hong Kong Monetary Authority, the number of Hong Kong-based banks offering RMB services also grew from 65 in 2010 to 177 in 2013.

This underscores the gradual change in mindset of some non-Chinese corporations, who were previously concerned over foreign exchange risks, convertibility issues and repatriation of RMB funds. With more corporations looking at conducting trade in RMB, banks are either developing their own RMB capabilities to meet their clients' needs, or providing them through their correspondent bank. Either way, it is certain that FIs cannot afford to ignore the RMB trend. What's more, they will need a concise RMB strategy – whether it is to build or partner – in order to continue to support their clients and stay competitive.

And with the Chinese regulators taking pro-active steps towards full convertibility, the trend looks set to continue. As a case in point, the State Council of China announced in May 2013 that it has developed a roadmap to liberalize its capital account, an initiative which will make it easier to move RMB in and out of China. Liquidity to support RMB transactions in offshore markets will also be increased as The People's Bank of China expands bi-lateral currency swaps with central banks.


Pravin Advani
Global Trade Executive, Asia Pacific
J.P. Morgan Treasury Services

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