The importance of short-term financing of international trade, known as trade finance, is explicitly recognized in the Addis Agenda as an important means of implementation of the SDGs. Estimates show that if trade financing to small and medium-sized enterprises (SMEs) increases by ten per cent, global trade would grow by one per cent.However, the gap in trade finance remains large, particularly in developing countries, with global unmet demand estimated at about $1.5 trillion.The gap is especially pronounced for SMEs, including many women entrepreneurs. While SMEs comprise 44 per cent of proposed trade finance applications, they comprise 58 per cent of all the declined trade finance proposals in 2016. This figure has increased since 2014, when 53 per cent of all declined requests were from SMEs.
Existing data shows that default rates on trade finance have historically been very low, with typically lower default rates and expected losses than other asset classes. Nonetheless, in some areas, trade financing data is incomplete. Data for Africa, the Middle East, and Central and South America remains limited, although existing data indicates that default rates remain low. Strengthening data collection on default and recovery rates is thus important.
Trade financing can be furthered with digitization and automation of transactions and due diligence. Electronic transactions can infuse efficiency, promote transparency—including through providing a trail of ownership to the transaction—and enhance efforts to build security around data and its accessibility. Digital platforms and fintech can lower barriers to enter the financial markets and increase productivity, and can also reduce costs of due diligence and KYC processes, thus helping to reverse the decline in correspondent banking.
The Basel Committee on Banking Supervision sets standards for the capital that commercial banks must hold against liabilities, including liabilities related to trade finance. The December 2017 Basel III reforms adjusted capital charges for banks’ exposures to other banks, which are relevant for trade finance exposures. The reforms incorporated the removal of the Basel II sovereign floor rule which the Basel Committee on Banking Supervision announced in October 2011. Under the sovereign floor rule, the counterparty risk weight applied to a claim on a bank could not be lower than that of the risk weight applied to the Government of the country in which the bank was incorporated, resulting in higher risk weights for banks in countries that are poorly rated or do not have credit ratings. Improving regulatory alignment across countries, encouraging greater collaboration between financial institutions, and promoting standardization of trade finance instruments can help combat the decline in correspondent banking and enhance the provision of trade finance.
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Correspondent banking is an arrangement under which one bank (the correspondent) holds deposits owned by other banks (the respondents) and provides payment and other services to those respondent banks.The Wolfsberg Principles on Anti-Money Laundering (AML) consider correspondent banking as the provision of a liability to another financial institution, for the execution of third party payments and trade finance, as well as cash clearing, liquidity management and short-term borrowing or investment needs in a particular currency. AML, CFT, KYC and other rules have led to ‘de-risking,’ meaning that many global banks have exited markets, closed relationships with clients, including respondent banks, especially in smaller developing countries, partly because of the increasing cost of additional staff and infrastructure to comply with the requirements, and also because cross-border banking relationships involving the execution of third party payments have been associated with higher risk.The Financial Stability Board (FSB) drafted an action plan to assess and address the decline in correspondent banking. The action plan has four pillars.
a) Data-driven cause analysis based on SWIFT data and the FSB’s Correspondent Banking Coordination Group Survey of 345 banks;
b) Regulation clarification, including through guidance by the FATF and the revised Basel Committee on Banking Supervision to apply KYC but not know your customers’ customer (KYCC);
c) Domestic capacity-building in jurisdictions with affected respondent banks via, inter alia, industry or due diligence questionnaires for correspondent banks, such as the one launched by the Wolfsberg Group in October 2017; and
d) Due diligence tools, such as KYC utilities, information sharing initiatives, use of the Legal Entity Identifier (LEI).
Trade finance supports the settlement of a transaction between an importer and an exporter. The objective of the importer is to receive the right goods in the right quantity in a timely manner. The objective of the exporter is to ensure that payment is received once the shipment is made in a timely manner. Four elements of a trade financing transaction are particularly relevant:
- Payment, which should be secure, timely, global, low-cost and in all leading currencies.
- Financing, which should be available to the importer and the exporter;
- Risk mitigation, which is handled by the banks of the importer and the exporter;
- Information on the financial flows, shipment status, quality of shipment, letter of credit systems, and others.
Trade financing instruments include the long-established traditional trade finance (TTF) and the fast-growing and more innovative supply chain finance (SCF). MSMEs trade using TTF in the amount of $2.4 trillion. The ratio of TTF to SCF financing is 15/85. In TTF, banks provide letters of credit (L/Cs) to importers and exporters to ensure that the settlement of trade takes place. L/Cs guarantee the payment to a seller on time and for the correct amount, provided the exporter demonstrates through agreed documents that all agreed terms and conditions have been met.
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SCF, in particular finance, aims to leverage the highest credit rating along the supply chain to reduce the cost of financing for SMSEs, which might have difficulty accessing affordable finance on their own, thus minimizing risk across the supply chain. What makes this form of financing so efficient is that it is buyer-centric—since the buyer who will be making the ultimate payment, is often credit-worthy. This information is leveraged to the benefit of the MSME. Typical programmes average $50 million, although transactions as small as $100 exist. Technically, once it is set up, even one cent can be discounted. In an effort to standardize these types of transactions, the ICC Banking Commission and the Bank Association for Finance and Trade (BAFT), together with three other leading industry associations have developed standard definitions for techniques of Supply Chain Finance. In addition to TTF and SCF, there are other innovative trade financing instruments, such as reserve-based lending (RBL), Pre-Export and Pre-Payment Finance (PXF, PPF) and Borrowing Base Finance (BBF). RBL is designed to finance assets that are already in production or where production is expected to commence shortly. PXF and PPF involve repayment secured on self-liquidating cash flows generated from the supply of goods or commodities by the supplier to an acceptable off-taker. BBF, which is financing based on current assets, addresses working capital needs that are volatile, generally due to commodity price fluctuation.
Factoring is a finance instrument where sellers of goods and services sell their receivables (represented by outstanding invoices) at a discount to a finance provider (commonly known as the ‘factor’). Unique to factoring is that the credit provided by a lender is explicitly linked to the value of a supplier’s accounts receivable and not the supplier’s overall creditworthiness. Some variations of factoring allows high-risk suppliers to transfer their credit risk to their high-quality buyers. Factoring may be particularly useful in countries with weak capacity and collateral. In Africa, where most of the economically active population is engaged in the informal economy with no access to banking, such innovative instruments can also promote financial inclusion, under the right conditions.
In addition to commercial banks, export credit agencies (ECAs), and development finance institutions (DFIs), including the multilateral development banks (MDBs), are actors in trade finance. They act as intermediaries between national governments and exporters and provide financial advisory and loan syndication services, promote concessional funding arrangements, offer credit enhancement and risk bearing instruments, and promote alternative funding initiatives. ECAs are also active in capacity building, in particular relating to formalising Small and Medium Enterprises (SMEs) in developing countries. ECAs can be government-sponsored, private, or a combination of the two.
ECA financing can take the form of credits (financial support), credit insurance and guarantees, or both. ECAs also offer credit, insurance or guarantees on their own account. NEXIM, which is an ECA from Nigeria, for instance, provides short- and medium-term loans to Nigerian exporters. It also provides short-term guarantees for loans granted by Nigerian Banks to exporters as well as credit insurance against political and commercial risks in the event of non-payment by foreign buyers. The average cost of borrowing for an SME in Nigeria is 18-19 per cent, while Nexim’s rates can be as low as 7 per cent. The historical default rate among ECAs is close to zero.
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Most DFIs have trade finance programs that provide guarantees and loans to banks to support trade. MDBs act like wholesale banks, and undertake independent validation and risk check to decrease commercial banks’ counter-party risk in facilitating trade. Collectively, MDB programs close approximately $12 billion of market gaps in developing and emerging markets. The vast majority of their activities, 98%, is in guarantees to banks to reduce country-level risk. The Asian Development Bank’s trade finance portfolio has totalled $26 trillion over the past nine years, covering 160,000 transactions. This year, it reported $4 billion in trade finance activities, with Vietnam, Pakistan and Bangladesh being the largest markets. The International Finance Corporation (IFC) and Multilateral Investment Guarantee Agency (MIGA) financed and guaranteed approximately $7 billion of trade finance deals, other MDBs totalled approximately $ 1 billion. Similar to ECAs, the defaults on MDB trade finance portfolios is extremely low. For example, ADB, as an intermediary bank, has not had a single default in its trade financing over the last nine years. EBRD and other MDBs have similarly low default rates. MDBs can play an important catalytic role, if implemented and scaled, in concert with local, regional and international banks.
Understanding the flow of goods, ownership and transfer of that ownership at various points of a transaction is critical to the financing decision. The Boston Consulting Group and SWIFT provide estimates on the amount of time and energy and costs to generate paper documents which are conveyed via traditional shipping/ mailing routes. Their study indicates that more than $81 billion a day is tied up in the flow of paper documents supporting global trade.
Distributed ledger technology or blockchain is a shared ledger to which participants can provide data to represent their activities in the end to end supply chain and validation from the agreed upon parties leading to the consummation of the transaction. In simple terms, it is a large, decentralized spreadsheet in which transactions are securely recorded. Everyone in the network owns a replicated version of the ledger. Ownership and transactions are stored in data blocks, each of which is secured by a cryptographic algorithm. The blocks are then linked to each other, which is why the technology is called blockchain. Ownership and transactions are securely recorded in data blocks using cryptographic algorithms. With real time visibility of events along a supply chain and the ability of non-bank actors (shipping companies, customs agents, etc.) to update ledgers once a transaction is finalized, financing triggers can be identified sooner, which means that funds can be released faster both between a buyer and a seller as well as to a bank.
There are a number of ongoing activities in multilateral organisations and networks to address the trade finance gap. The IATF builds its work on these ongoing initiatives.