Bankers have known the appeal of trade finance for decades – offering, as it does, a good return for a low-risk asset class. Yet this has been less obvious to institutional investors, mainly because of a simple lack of awareness regarding both the asset itself and its low risk profile.
Fortunately, this is now changing – meaning that there is significant opportunity to increase uptake from outside of the banking environment; for instance, among insurance companies, pension funds, endowments, sovereign wealth funds, hedge funds, foundations, mutual funds and private wealth management. Estimates suggest that over US$110 trillion of investible assets exist worldwide in these groups, so there is definitely room for new investors in this asset class.
A low-risk asset
The benefits to investors, as well as the trade finance industry, are manifold. First and foremost is its legendary low-risk status – as demonstrated empirically by the International Chamber of Commerce’s (ICC) Trade Register.
In particular, short-term trade finance products from 2008-15 experienced low default rates across all products and regions. The default rate (weighted by transaction) is just 0.09% for import letters of credit (L/Cs), 0.01% for export L/Cs, 0.19% for loans for import/export and 0.24% for performance guarantees, as per Figure 1 below.
Figure 1: Default rates by class
With short contractual maturities, short-term trade finance products are often issued on a transaction basis – allowing banks to review the risk on a regular basis. Furthermore, even in the event of a default, the time to recovery is consistently lower for trade finance products, at 0.2 to 0.5 years, compared to over one year for other asset classes – with the exception of commodities finance.
Yet medium- to long-term products are also low-risk. Again, the Trade Register shows that default rates here are exceptionally good – not least because this is an asset class mostly backed by Export Credit Agency (ECA) guarantees, which limits losses unless the ECA itself defaults, which is historically very rare due to the support of the governments in the ECAs’ respective countries. In fact, even in the event of a default, with the ECA cover there is 97.1% total recovery for medium to long-term products.
Given this, trade finance provides an opportunity for investors to produce yield without taking on excessive rate and credit risk. In fact, project and trade finance provide a particularly powerful diversification tool for any mix of floating rate assets.
To take one example, the international fixed income team at Federated Investors, Inc. – a US-based asset management firm- has long made use of trade finance assets as a source of alpha for their international bonds and strategies. Trade finance products have provided a short-term floating-rate asset while producing impressive returns.
Last, but by no means least, by engaging in trade finance, investors can help bridge the sizeable trade finance gap – estimated at US$1.6 trillion by the Asian Development Bank (ADB). This strengthens the wider business environment and cross-border trade flows – supporting the day-to-day operations of businesses worldwide.
Barriers to investors
There are, however, barriers to overcome in order to make project and trade finance assets more accessible and visible to investors.
As stated, a primary concern is the lack of knowledge of the asset class among institutional investors. Trade finance has traditionally been targeted as a bank product – not least because its complex structures and process, as well as the somewhat esoteric nature of the deals and counterparties.
Raising awareness with institutional investors is therefore a key need for increasing trade finance appetite, as is an educational programme regarding the nature of the structures and counterparties. Here, the fact that there is currently no material on the Bloomberg terminals needs addressing, considering that this is the primary source of information for most investors.
In addition, trade finance deals require specific knowledge and skills. Few are equipped to settle or safe-keep the deals, and there are often limited administrative personnel equipped to handle the necessary documents and accounting requirements. In addition, the major originators of deals have limited experience of working with institutional investors. In addition, it can be difficult to access the consistent volume of the flow of deals needed to maintain a diversified portfolio.
Lastly, even global banks can find it challenging to comply with anti-money laundering (AML) and know-your-customer (KYC) requirements – now acknowledged as a necessary and intrinsic part of the financial system. A majority (62%) of respondents to ICC Banking Commission’s 2016 Global Survey suggested they had declined trade finance transactions due to AML/KYC issues, as per Figure 2 below. What’s more, compliance is aimed towards banks rather than investors; further complicating an already challenging task.
Figure 2: Have you declined trade finance transactions because of AML/KYC concerns?
Drawing investors in
Increased and continued advocacy work from the trade finance industry will help communicate the positive attributes of trade finance. In addition, collaboration with international organisations – the United Nations (UN) along with its subsidiary bodies, specialised agencies, and affiliated organisations, multilateral development banks, and the World Trade Organisation (WTO), for instance – will help engage senior bank executives seeking investment opportunities.
Yet investors also need to understand the basics of trade finance. The difference between trade finance and leveraged loans, for instance, should be made clear; a trade finance loan is a transaction with specific assets pledged, as opposed to a loan for general corporate enterprise value. In addition, trade finance stakeholders need to present trade finance products and measures in the language appropriate to investment banking, considering that many will be unfamiliar with trade finance terminology. Here, initiatives such as ICC Academy offer a wide range of specialised e-learning courses and online certifications to meet the educational needs of banks, corporates and other organisations at the forefront of international trade – providing investors with a sure-fire way of improving their knowledge of trade finance.
Ultimately though, efforts from the trade finance community will not be enough alone. Investment managers themselves must be open to engaging in dialogue and be willing to learn about different investment options. Here, objective, reliable data, such as that in the Trade Register, can provide a basis for constructive discussions among investors, trade financiers, and regulatory authorities.
In line with this, while the Trade Register already provides an insight into the credit-related features of trade finance, it could also provide informative commentary specifically for investors in future reports. Yet other resources will also prove important in making the case for trade finance as an asset class – including informative groups, web resources providing information on upcoming deals and conferences specifically for investors on trade finance as a financial asset class.
There is no doubt that investors should consider the compelling benefits of engaging in trade finance, but in order to do so they will need greater clarity and information on the basic issues. Much work remains to be done.