Trade Finance TV: Managing trade finance risk

Clarissa Dann: The ICC Trade Register 2022 highlighted yet again the low default rate of trade finance. Export letters of credit showed exposure weighted default rates as low as 0.02%. Trade’s record for safety has shaped prudential regulation and has been attracting investors.

Our experts in the studio today have spent their careers managing trade finance risk.

James Binns: The thing that I think differentiates trade finance from everything else is that everything we do is related to an underlying movement of goods or services, which means the additional information and data that we have on counterparties, on the goods types and so on gives us so much more information on which to make risk based decisions. Obviously that also means that associated with that underlying movement of goods and services, you have cash flows and therefore you have sources of liquidation for any funding or risk mitigation that you provide.

Sean Edwards: Trade is about the real world. It’s about people eating, running their cars, having fuel for their generators. So, you know, this famous mantra, trade gets paid, which isn’t strictly true in the legal sense, but in practice it is what happens because the importers, the people who have to pay and governments will usually prioritize their trade receivables.

James Binns: People need the underlying goods and services that we’re financing and they don’t just need them once, they need them on an ongoing basis. So payment histories, track history and so on is massively important to the types of people that we deal with and companies.

Boris Jaquet: Given the track record and the density of it, that’s also something which can be explained and sold to other banks. So that’s the kind of assets that you can actually syndicate. You can explain your track record of very low default rates. When you have default, you have a lot of recovery. So that class of assets has been there for years and will stay for years. So in that sense, this is something which is super important for the banks and of course for the wider community as well.

Sean Edwards: Commodity prices over the last years, they’ve increased massively. So no bank wants to have all that risk. There’s a number of ways of distributing risk. There’s the classic way of syndicating it. They arrange the deal. Typically that will happen with a very large customer and you make sure that upfront you get your risk participants in. But there’s other ways of doing it. And I think it’s worth mentioning the huge growth in trade credit insurance.

James Binns: Over many, many years there’s a very fundamental and core set of rules and process and regulation which has been established and become market practice worldwide. Uniform code of Practice 600, UCP 600 is an example of that. A, that makes trade a safer environment to do business because everyone is operating off the same playing field. But B, it actually makes it easier to syndicate and to risk participate out because it’s more defined and people know what they’re actually investing in.

Clarissa Dann: Boris, what is your perspective, the characteristics of a deal everybody wants to be in?

Boris Jaquet: I think that’s a deal which is well structured for a client that potentially has a long track record, well priced because that’s quite important and a deal which is understood by a wider number of participants. And when you have all those four elements, you will naturally tend to see quite a lot of demand. And that leads indeed to usually another subscription. So much of a solution is maybe not a great thing because people are getting allocated lower than what they committed for. But it’s a good thing because that shows the strengths of the product, the understanding of the market, what is being sold. And actually that’s good for the market overall because that’s another good news in the global trade environment, which means that another deal will actually get also attention and maybe banks will be able to commit a bit more or to look at how to structure it the right way.

Clarissa Dann: Do you think in times of volatility like this that there is a sort of flight to trade almost? That volumes are going up and people turn to that form of financing because they feel safe with it?

James Binns: Certainly that’s what we’re seeing at the moment. And I’ve seen this in the past as well, where you have volatile market conditions, there’s a flight of liquidity towards high quality, short term assets. Those tend to be trade assets. It tends to be the FI, risk associated or financial institution risk associated with trade instruments. And what I tend to see in those instances is pricing widening over else in the market, but infuriatingly compressing at the short dated, sort of high quality end of trade assets.

Sean Edwards: Pricing compressing is not something I’ve seen, but the upward movement is much slower in trade finance. If there is going to be one, there’s always a delayed reaction and that’s because there are a number of layers in trade finance. You mentioned the banks, but there’s also people like ECAs, credit insurers, and there’s, you know, implicit or explicit, sometimes government support. So all those layers give you a much safer product. It is a quality product as long as it’s well structured. Against that, in times of big market stress, when banks pull back all of their lending, trade sometimes does fall over first because it’s the easiest to liquidate because it short term, so you just don’t renew it. I don’t think we’re seeing any real signs of that yet. There’s always going to be a core level of trade that everyone will have to do.

Boris Jaquet: I think when you have time where it’s a bit more choppy, people tend to go back to what they know, where they’ve experimented, where they understand, where they can liquidate and what has delivered a very strong track record. And I think irrespective of what participants you look into, everybody will come back to those products and know best because this is what you do when you have choppy times.

Clarissa Dann: Boris, from the credit insurance fund. You do a lot of credit insurance. What are you hearing?

Boris Jaquet: I think the track record, the low default and the fact that when you have issues, there’s a quite high level of recovery, it is exactly what people are looking for in times like today. So from that standpoint, this is a very stable and very deep market which can go through volatile time, but nevertheless the test of times and I think it’s what we’re seeing today.

James Binns: I agree with everything that we’re saying. And I do think trade is a lower risk asset class, but at the same time, it’s not no risk. And, you know, if you have fraud, if you have bankruptcies, there’s not a lot that can protect you, whether it’s trade or not.

Sean Edwards: That all goes to the trust that you have in the arranging bank in your clients. And sometimes that trust can be misplaced. There’s been some cases, but actually it’s pretty rare.

Clarissa Dann: I think part of the problem is that some of the high profile frauds…

Sean Edwards: Get a lot of publicity.

Clarissa Dann: …Get a lot of publicity, unfair publicity, but then deter investors and cause contagion.

Sean Edwards: Are there going to be new investors or potential investors were put off or new investors who don’t come in. That’s not my sense of it. Two weeks ago, we did a trade and investment forum precisely to attract those new investors into trade finance. And there’s a lot of interest. It’s 50-50 banks and non-banks and the non-banks are all sorts of people, including local authorities and family offices, sovereign wealth funds, dedicated trade funds, a lot of different people. That’s part of the problem. Very broad range of understanding. The problem is not actually the fraud. The problem is understanding the product. For the non banks, you know, because a difference between a letter of credit and a payable, a receivable, a collection and so on. We know all this stuff, but they don’t. That’s really what puts them off, its perceived complexity, which often actually is not justified. But if you don’t know it, you don’t know it.

James Binns: And I think at the same time, it’s important to note as well that the industry as a whole is doing a lot. The regulators are driving a lot of this as well for the right reasons around how we manage fraud, how we manage financial crime and so on. And we are continuing to do the right things and move in the right direction, in my view.

Boris Jaquet: The more you have syndicated deals, the more you have deals with a lot of participants, even if they scale back, that goes in the right direction, because that bring the level of knowledge of the market participant to a slightly higher level. And coupled with what we just said around the regulatory framework, the understanding, the due diligence, the track record. To me, I just see a very bright future for that product and for the markets in general.

James Binns: I think now regulators are starting to understand our business better and understand how it can be used effectively to risk mitigate. And equally, you’ve got governments starting to understand our business better. The rise of ECAs and so on. And then you combine all of that with digitization, which then gives you even more granularity of data and access to those underlying shipments and movements of goods and services. I think we have an amazing opportunity in the trade finance world to really grow our business over the next years and decades.

Clarissa Dann: For our other episodes do visit TRADEFINANCETV.NET. All our episodes are available on Spotify as well.

Published on April 13, 2023