From the October 2014 Special Report issue of Treasury & Risk magazine

Trade Finance Moves Ahead

A new instrument, bank payment obligations, may mark the start of a shift to paperless processes.

As global trade expands, trade finance is growing and evolving along with it. Most notably, the traditionally paper-based processes around trade finance are being pushed into the electronic age. Trade finance units are also dealing with new Basel III capital requirements, along with the rest of the banking industry. And trade finance methods are increasingly being used as part of companies’ supply chain finance efforts.

A recent survey by Aite Group showed that while relatively few banks provide electronic interfaces for trade finance processes, more than three-quarters said they are seeing demand for electronic trade finance from their corporate clients.

One step in this direction is a relatively new instrument, the bank payment obligation (BPO), which replaces the paper documents that are the basis for letters of credit with data that moves between the buyer’s and seller’s banks.

“The bank payment obligation, an alternative means of international trade settlement, combines the risk-mitigating attributes of letters of credit with the speed and efficiency of open account trade,” said Jim Volkwein, Head of Trade Finance and Cash Management Corporates Americas, Global Transaction Banking, Deutsche Bank. “While still early days, we believe that bank payment obligations are likely to play a bigger role in facilitating international trade going forward.”

To date, though, the pace of adoption has been slow. In the first half of this year, there were 340 transactions using BPOs, up from 249 in the first half of 2013, according to SWIFT.

Paul Johnson, Bank of America Merrill LynchPaul Johnson, director and senior product manager in Global Trade and Supply Chain Finance at Bank of America Merrill Lynch, said that while adoption of BPOs has been slow, “that’s the case with any new development that involves a fundamental shift in the way business is done.”

BPOs seek “to automate the provision of finance, as opposed to its being triggered by the presentation of paper documents,” said Johnson, pictured at left. “It’s all triggered by electronic data flows. As a result, you have to change a lot of long-held business practices.”

Enrico Camerinelli, a senior analyst at Aite Group, cited the costs that are entailed in starting to use BPOs. “You need to have dedicated software,” he said. “Installing, implementing, and running the processes does have a cost, and it’s very difficult, especially for companies, to understand what is the return for doing this.

“You have to show corporates what is in it for them,” Camerinelli added.

Johnson said he is seeing “increasing interest” from companies in BPOs, adding that the early adopters of BPOs tend to be companies that do business globally, are technology savvy, and are shipping big-ticket items. “If you can reduce [days sales outstanding] on a $50 million iron ore shipment or a grain shipment, that obviously has far more impact than reducing the DSO of a $50,000 shipment of garments or T-shirts,” he said. “We’re seeing the take-up primarily in metals, mining, energy, [agriculture].”

While the early adopters are large corporates, Johnson predicted BPOs will eventually expand to mid-market companies and to a broader range of industries.

 

Financing Trade Finance

While the growth in global trade fuels an expanding appetite for trade finance, banks are facing new reserve requirements that crimp their ability to provide any kind of financing.

Johnson said that in the trade finance area, banks are dealing with capacity problems by moving from an originate-and-hold model to originate-and-sell. “Banks are having to tap outside of their normal secondary market channels and look to investors that are maybe not subject to the Basel III regulations—pension funds, insurance companies, hedge funds, sovereign wealth funds,” he said.

The originate-and-distribute concept isn’t new, but it has grown in recent years, said Sebastien Delasnerie, Citi’s trade head for North America. “It used to be applied on a more episodic basis,” he said. “Then over the past couple of years—call it the past five years—it has become more of a core aspect of certain banks’ offerings.”

Trade assets are generally short-term, and Johnson noted that investors are hunting for yield at the short end these days.

“There are a lot of investors that are interested in 60-, 90-, 180-day paper and are willing to buy 75% of a trade asset on a bilateral basis, even if it’s only for 90 days,” he said. Another way to monetize a bank’s trade loans is to securitize them, offering investors one-year notes that are backed with a pool of shorter-term trade assets.

The volume of trade assets that banks are selling off is “probably in the billions [of dollars], and it’s growing,” Johnson said. “And it’s all driven by this hunt for yield, and people waking up and seeing that the trade asset class is now a liquid instrument.”

Camerinelli suggested that corporates may eventually start providing trade financing for one another, in what he calls “inter-firm trade credit.”

“Companies tend to be clients and suppliers of each other; they tend to have these complex inter-relationships,” he said. “Instead of relying on a financial institution, companies between themselves could start lending money or providing that kind of financial support.”

 

Financing the Supply Chain

The area that’s experiencing the greatest growth in the trade finance area is supply chain finance, Delasnerie said.

“That’s a product that is being more and more embedded in the supply chain to facilitate the trade flows and strengthen the supply chain from a financial standpoint, ensuring that suppliers have access to attractively priced financing in order to continue to provide the goods to their buyers under the prevailing commercial terms,” he said.

Johnson cited companies’ interest in supporting suppliers that are strategic to their business. “By using various kinds of supply chain finance solutions, you can provide financing, leveraging the risk rating of the buyer down the supply chain,” he said. “That is the big trend.”

He noted the gap between the supply of trade finance in developed nations and in emerging markets. “For the larger companies operating in the developed markets, where you’ve got access to the capital markets and you’ve got many banks, there is trade credit available at relatively attractive pricing,” Johnson said. “But going back to where we started in terms of the emerging markets, if you happen to be an small or midsize enterprise, let’s say, in a developed country with a low country rating, a weak banking system, you’re going to find that the availability of trade credit is limited, certainly limited at an attractive price.

“If you take a step back and say, ‘How can we use tools of trade finance to grow our business?’—if you’re dealing with buyers or distributors in an emerging market that may have limited access to capital, providing them with financing to enable them to grow or increase sales or enable to them to grow a new market is extremely useful,” he said.

“We see the continuing exceptional growth and take-up of financial supply chain offerings as they become mainstream across a range of industry segments and company sizes,” Volkwein said.

Meanwhile, Johnson noted that more and more transactions are being conducted in local currencies. “When I started in this business 20 years ago, 80% or 85% of trade was conducted in U.S. dollars,” even if neither party to the trade was based in the U.S., he said. “Obviously that created foreign exchange exposure and risk for both parties.”

Regardless of whether trade transactions are financed via open account or letters of credit, “we’re seeing an increasing diversification in terms of currencies and suppliers with leverage insisting on the trade being done in their currency,” he said.

 

 

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