Why has Trade finance become an area of focus for banks, fintechs and institutional investors? What is driving this change?
Trade finance is one of the oldest banking products and must have been around ever since banking started. However until recently, the Trade finance business continued with its age-old paper based manual processes, couriering document from one bank to another. As rules, regulations, documentation and compliance increased, processing became more complex and time consuming.
Here was a business that banks viewed as stable, annuity, short tenor and low risk thus operated at low margin. This however meant higher break-even volumes and growing manual operational costs and pressure on margins, with increasing compliance requirements.
Rationalisation of the business was an absolute need to improve profits and return on capital invested.
Technology companies and Fintech’s found this to be a great opportunity to digitise and apply modern technology, automate and streamline the process to reduce costs significantly while improving efficiency. This made Trade finance improve margins, reduce errors and operational risk and regain returns.
As technology improved, Fintech’s also saw the opportunity to finance these transactions and disrupt the banking business. Some Fintechs raised their own capital and started financing trades, while others approached Non-Bank Investors to invest in trade assets originated from corporates. These companies provided a streamlined single point platform to invest and access trade assets, along with an eco-system providing insurance capabilities and other risk defeasance tools.
In the current low/ negative interest rate environment even low margin trade assets became attractive to several investors, especially to park their short-term surplus, as banks offered no returns.
Traditionally trade transactions were mostly documentary transactions for collections through banks or supported with Letters of credit. With growing demand for open accounts, three asset classes were created. Supplier finance programs, Account Receivable discounting programs and Letter of credit based documentary credit transactions.
Whenever sellers wanted funds before the due date, banks stepped in to financed and created a paper based financial asset. The big change today is to create a digital financial trade asset with automated end-to-end straight through processing. Banks, technology companies as well as Investors are now up to grab a share of this $18Tr Global Trade business.
As a fintech expert you must have seen a multitude of technologies enter the market, what would advise financial institutions to look for in a partner for trade finance transactions?
In the first wave, technology helped banks to automate booking of transactions and accounting. Then came the wave of disruptive fintechs, directly approached corporates for their supplier finance and accounts receivable programs. The technology improved accuracy, speed, on boarding and portfolio analytics, in addition to automated accounting. However this wasn’t enough to differentiate and create an USP, the market started getting crowded.
The new age technology is focusing on developing data mining, data architecture developing data lakes key to manage speed of information, applying Machine learning to improve accuracy and analytics, use of Cloud technology to help global information access, Artificial/ Augmented Intelligence to improve data quality and validation reducing human functions and manual errors, Block chain and Distributed ledger technology to trace and track transactions real-time and reduce/ eliminate reconciliations and possibility of frauds, Natural language processing to translate multiple languages and standardise data definitions globally. There are several tools/applications covering risk, liquidity management, compliance etc., creating a Trade finance Eco system
Large tech companies are gearing up for end-to-end infrastructure that can monitor transaction life cycle and provide client analytics to improve client experience, reduce costs, enabling banks to grow their business.
While these technologies benefited businesses, it has at the same time exposed them to financial crime and cyber risk. Costs of Cyber risk protection has increased for banks in general. There is also a constant need to improve data security to shield from changing tactics of cybercriminals.
These technologies are indeed game changing, but not all stakeholders are equally tech savvy. This creates systemic loopholes for cyber criminals. It is therefore critical that FI tech teams conduct a through technical due diligence and stress tests covering all eventualities as well as the operating environment.
Obsolescence has been another key factor to check in a fast changing world of technology. While technology can create a competitive edge, obsolete technology can be liability and very expensive to replace.
It’s also critical to understand whether the business model of the techs is disruptive or collaborative for FIs. To maintain competitive edge tech firms often sign up on white-label solutions. Patents are critical to protect against growing competition. Start-ups are often financially fragile and their survival on private funding remains critical.
It’s critical that Regulated FI’s evaluate risk and governance process of these tech companies. Excessive dependence on 3rd party tech vendors can lead to weakness in contingency planning and operational resilience.
How do you see the role of NBFIs in these uncertain times, do you think that they can provide alternative pools of trade finance liquidity that corporates so badly need?
NBFI’s can be a great alternate source of funds although unlikely to replace Banks. Trade finance is an $18Tr industry and expected to grow to 25tr by 2030. Trade finance is seen as a relationship business by Corporates, which serves as an entry barrier and protects banks
The growing interest in this asset class by NBFC’s is mainly to invest short term mismatch in liquidity; Better yield vs. banks with nil/ negative returns; Short tenor/ low risk asset class; Different risk-return hurdles compared to banks, bringing additional pools of liquidity.
In the current pandemic, while financial markets are flushed with liquidity driving down pricing, the increased default rates have reduced risk appetite. Sectorial risks have increased; with higher investor demand focused on acceptable risks e.g. Pharma, Technology etc. Some NBFI’s may have higher risk appetite based on their investment mandate. This opens up pools liquidity for high yield trade assets.
NBFC fund availability is driven by investment criteria set by asset managers and investors. While they like short-term yield pick up, they too remain cautious on asset quality.
What role does Risk play in the trade finance business? Can technology help to manage Risk?
Risk can be a key differentiator. Trade finance is exposed to Credit, Operational, Sovereign Risks as well as FX risk. A comprehensive risk management module tailored for trade finance can be a critical edge for a tech company.
No technology company is prepared to guarantee or mitigate risks for a FI, but they can create very efficient systems and tools for Banks and Investors to determine and manage their risks.
Banks traditionally managed risk with a rear view mirror using historical financials. Today, it is changing to predictive and forward looking risk management with the help of data analytics, use of AI to model stress test scenarios, merging market and fundamental data to develop early warnings and portfolio management tools.
If risk can be managed well, the risk reward can be improved well above loss norms of a Trade asset portfolio. We need to remember that a single large loss can wipe out profits and returns.
Trade finance is also subject to operational losses and financial crime. There have been multiple cases of duplicate invoice frauds recently in Asia. A tech initiative has been launched across APAC to stop duplicate invoicing
In addition there are AML/KYC and Sanctioned goods/counterparty risks. A number of Big data initiates have been developed to provide on line real time information on Clients, counterparties and logistics.
Risk pricing and reducing Risk weighted assets/capital is critical to meet returns hurdles. A systematic churning of the portfolio’s to reduce assets and make a profit of the margin, improves portfolio returns. Thus originate to distribute can be a game changer.
EM Risk management needs access to local intelligence, as information is often dated or scarce. Platforms specialising on EM assets/risk can create strong USP by developing their own EM risk information and network.
There is much talk of a digital revolution in the world of trade finance at present, but it is a complex universe. What do you perceive to be the main barriers to full digitalisation of trade processes?
Trade finance documents digitization technology is ready to go live. However, Legal and Regulatory acceptance of digital documents & signatures are yet to get approved in most countries. Disputes in a Court would need to be supported with paper based wet ink signed documents.
To accept digitised documents require simultaneous change in legislation and modification of Acts in multiple countries, a challenging task. There are a number of global initiatives by ICC, ITFA, GTR, UNICITRAL to bring about standardisation and digitalisation of documents. However the process is slow, requiring parliaments to agree to change the present Act, involve Law commission and Regulators to make the changes and finally get it passed by the parliament to amend the act.
The Covid crisis has set back political priority in some countries while in many it has reprioritised as such digital initiatives to overcome the lockdown restrictions and working from home situations.
Some technology platforms have developed OCR technology as interim solution. However maintaining interoperability to switch to digital documents to adopt block chain technology or SWIFT is essential.
Ideally a few large exchanges that can provide the capability trade this asset class digitally, with straight through processing and real-time reconciliation would be Nirvana. No doubt, we are directionally heading that way, although Regulators, Compliance & Governance folks are yet to feel reassured about the robustness of the new technology and guard us form of abuse in the new digital world.