Posted in Finance Articles, Total Reads: 4720
, Published on 21 November 2013
Trade finance, one of the oldest services offered by banks, has never managed to take off as an investment despite its numerous advantages for investors. The traditional source of trade finance has been banks but with the recapitalization of banks, and trade finance not being a highly profitable source of revenue, there have been attempts to enhance investor interest in trade finance. Banks have tried to market trade finance deals through securitization and a new primary market has also been constituted especially for trade finance with the help of Deutsche Bank.
image: renjith krishnan, freedigitalphotos.net
Trade finance involves financing of goods being shipped from one place to another. The importer avails the service from a domestic bank which in turn pays the exporter of goods and seeks the reimbursement from the importer. This is beneficial to the importer as he does not have to bear the financial risk of the exported goods. The short term loan of trade finance has been structured in different forms depending on the type of transaction. Letters of credit, factoring, direct lending and supply chain finance are some of the different mechanisms through which banks provide trade finance services. The large bulge bracket banks have focused on financing large military sales or massive commodity shipments. On the other hand, the smaller regional banks have funded local manufacturers & dealers.
Since the recapitalization of commercial banks post the financial crisis of 2008, there has been limited issuance in trade finance. This is because of the extensive due diligence and resulting low profitability of the deals. Although trade finance is highly secure for banks as it is backed by real assets, the banks have refrained from doing too much business on this end due to the constrained lending ability. Banks have been serious about implementing Basel III reforms which has constrained their ability to finance the movement of goods across borders. This has forced Trade finance bankers to look at alternate avenues of investment to keep the movement of goods running or risk being forced out of the business due to decreased lending capacity.
The constrained ability to lend has made different types of bank loans, including trade finance, costlier. There exists a possibility that banks might stop financing trade finance transactions altogether. But with companies still needing a source to finance the enormous trade of goods globally, which rose in value from $16 trillion in 2010 to $19 trillion in 2011, makes it easier for other financial institutions to enter into trade finance. Many banks have been rigorously trying to offload their entire trade finance portfolios as they aim to become Basel III compliant by the beginning of 2014 and none wants to lag behind in the race to adopt the new regulations because of their perceived benefits to public image and increased cost of capital.
The opportunity of entering into trade finance is much greater in the US as many researchers and economists have been pointing out the need of US to export more goods in order to recover from the impending economic slowdown. President Obama recently announced his intention of working on doubling exports in five years’ time. With the constrained ability of banks to finance the trade movement, there is expected to be a rising gap in the trade finance space. This is expected to enhance the yields in such transactions due to the limited supply of funds, hence providing the investors with the required incentive to enter into financing these cross-border transactions.
Though lower on the profitability front, trade finance offers the lender numerous advantages:
There are very few defaults by borrowers in trade finance and in the case of a default, like a buyer refusing payment for shipped goods, the lender can simply look elsewhere to sell those goods. But trade transactions have rarely got to the point of a default in the past as there are a number of safeguards put in place to protect the lender. This is proved by the fact that only 1,089 trade finance transactions out of 5.2m transactions from nine leading international lenders defaulted between 2005 and 2009 (according to a study conducted by the International Chamber of Commerce and the Asian Development Bank). This accounts for a default rate of just about 0.02%. Such a low default rate can be compared to the average default rate of long-term obligations for companies rated AA by S&P (according to a report by UK-based Equity Development).
Despite the general presumption that Trade Finance has very low yields, several funds have managed to construct Trade Finance portfolios with returns comparable to assets like leveraged loans but with far less risk/volatility. Several Trade Finance portfolios have succeeded in outperforming S&P 500 year after year. GML Capital and Federated Investors are two of such examples.
Trade Finance provides excellent diversification benefits due to the low or negative correlation with other assets. A comparison of the correlation of the returns of Fibonacci Master Fund, a Trade Finance portfolio managed by GML Capital, with returns of other assets including Floating Rate, TIPS and Leveraged Loan showed a negative correlation which exhibits the possible benefits of adding Trade Finance to one’s portfolio.
Trade finance loans are not only collateralized but also self-liquidating. Trade finance is predominantly related to a specific transaction between an importer and an exporter unlike corporate debt, where there have been occasions of funding speculative transactions which were not the actual purpose of the loan.
Insurance of the goods is paid for by the parties involved in the transaction and not the lender. The parties avail to insurance against the damage of goods while being shipped. Although the lender hires collateral monitoring agents to escort the goods while they are warehoused. Lenders also look for back-up off takers in advance as the original buyer might refuse to pay up.
Being shorter tenor transactions, trade finance involves very low duration risk. An average payment period would range anywhere between 90 to 120 days while the longer transactions span to maximum of 18 months.
Although there are several advantages of an exposure to trade finance, there are a few underlying disadvantages as well:
Being safer investments compared to other services, trade finance has narrower yields than even secured loans or high-rated bonds.
The process involves large amount of paperwork to document these transactions and extensive due diligence needs to be done. The bank needs to maintain a specific set of employees to keep track of that paper, which they call as the “back office”.
Trade finance is not easily scalable. Most of the transactions are small and to enhance investment capabilities banks need to hire additional employees which is one of the limitations.
The return on the investment (in the form of time and work) in these transactions remains insufficient even if the bank is able to build a sizable and high-yielding portfolio. This is one of the reasons for large money managers to stay away from trade finance.
The mechanism used to finance these deals vary widely – from direct lending to letters of credit – and each of these has further subclasses depending on whether it is used to fund an export or import transaction. This makes it difficult for banks to bundle it into homogenous financial products.
TRADE FINANCE AS AN ASSET
The simplest way to market trade finance deals to investors is through securitization – that is, amassing several individual import or export transactions into one large portfolio that a firm can invest in. There have been several developments in the field of trade finance in the last few years leading to an increased interest of institutional investors in trade finance.
Federated Investors, managing around $ 350 billion in assets, started pitching its trade finance strategy to investors in 2011. The Pittsburgh head-quartered financial services company had been running the strategy internally since 2005 but moved on to institutional investors looking at the current opportunities in the field. The company boasts of a vast experience in trade finance which is primarily the reason for expanding their base. The company realizes the negative impact of the Basel III reforms on the banks’ ability to fund these transactions and indicate the widening yield spreads to be a justification for the increasing attractiveness of trade finance. Federated has had an excellent record with its diversified portfolio of trade finance, registering annual returns of 5.9% from 2005 to 2011 with a meager monthly volatility of 1.3%.
The recently launched Internet Trade Finance Exchange (ITF) is a closed online marketplace with an aim to create a digital warehouse for the custody of trade finance assets. Deutsche Bank will be the custodian for these assets which will be offered for sale through auctions or continuous offerings. The rationale behind the move is to create liquidity and transparency of pricing which will convince investors of trade finance being a viable asset. Banks are interested in associating with ITF as despite low returns banks do trade finance to provide other services to these clients. ITF would enable the banks to reduce overheads and stick to their share of trade finance portfolios. Banks and financial institutions would be given the flexibility to designate their assets for sale and also specify the investment period. The platform already has 180 registered members with 5 of the 10 biggest banks of the world already signed up. Several investors have already lined up and Argentine, Peruvian and Mexican pension funds are looking at buying into these instruments as they have plenty of cash.