Trade finance has been around for centuries – as long as there has been trade. You could say that trade finance is at the heart of global trade, as it reduces risks for both parties, whether it is the risk of non-payment, currency fluctuations or late payments.
Without trade finance, there would be much less global trade and economic growth. Global trade makes it easy to buy tea grown in China, avocados from Mexico, or the latest iPhone. According to the World Trade Organization (WTO), it is estimated that 80 to 90% of world trade is based on trade finance, or $ 15 trillion per year. Yet despite its enormous influence, trade finance does not receive much attention. Even fewer understand how it works.
How it works: reduce the risks
Trade finance encompasses several financial instruments and products that make doing business easier for both importers and exporters. For example, say an American importer agrees to buy avocados from Mexico for a fixed price. These avocados must be harvested, loaded onto trucks and shipped. The exporter is worried about not getting paid and may want upfront payment for a shipment. On the other hand, the importer may fear that he will not receive his lawyers after having paid the exporter in full. Tracking overdue or missed payments is complicated and time consuming when dealing with multiple jurisdictions.
The solution to this problem? Put a third in the middle to facilitate.
In a typical situation, the importer’s bank will present a letter of credit to the exporter’s bank, securing payment once the exporter presents a bill of lading or other documents proving that the shipment of the goods has been completed. place. Essentially, the letter of credit puts the onus on the bank to pay the exporter. During this time, the exporter can obtain a short-term loan, usually less than four months, pending payment from the importer, so as not to tie up his working capital. Once they receive payment from the importer, they can repay the loan.
Facilitate market growth
Large commercial banks have long dominated trade finance. This puts small businesses at a disadvantage, as most loans go to large businesses. In addition, given the current globalization of the economy, the lack of credit seriously disadvantages small importers and exporters.
Even though trade finance is already a multibillion dollar industry, there is still huge room for growth. Limited access to credit is particularly acute in emerging and developing countries, which tend to be export-oriented. The International Finance Corp estimates that there are $ 5.2 trillion in unmet financing needs in developing countries each year, 1.4 times the current level of loans to micro, small and medium enterprises.
Ultimately, focusing on trade finance in these markets level the playing field and facilitate global trade. In addition, providing capital to small businesses helps them grow and allows them to place larger orders.
Why invest in trade finance?
While commercial banks still dominate the $ 15 trillion trade finance market, a shift is occurring in the industry as regulations such as Basel III limit the amount banks can lend. This has opened the door for institutional lenders, family offices and qualified investors to step in and fill this need.
Investing in trade finance assets is attractive for a number of reasons. First, trade finance as an asset class is unusually short term, making investment relatively less prone to business cycles than fixed income credit ratings backed by consumer, mortgage, commercial or other debt. of credit cards. Low volatility is attractive to investors who seek stable income and want to avoid fluctuations in the stock and bond markets.
Another interesting feature is that trade finance assets historically have a low default rate, even when financial conditions are tough. During the 2008 global financial crisis, default rates on trade finance assets were low and recovery rates high. According to the ICC Trade Register, only 0.0021% of the 8.1 million trade finance products defaulted between 2008 and 2011. In addition, defaulted assets posted a recovery rate of 52%.
Unlike corporate bonds, where investors are exposed to a single counterparty risk, trade finance asset-backed notes are backed by cash flows generated from a diversified pool of receivables. This not only reduces counterparty risk, but also improves portfolio diversification.
Last but not least, trade receivables finance helps provide working capital to small businesses in emerging and developed markets. Because promoting small businesses is crucial for economic growth in most economies, investing in trade finance assets helps create jobs in supply chains.
Trade finance may not be widely understood, but it is the engine that powers trade around the world.