Insight & Analysis

Businesses bank on new sources of funding

Published: Aug 2022

Institutional investors have the potential to significantly reduce the global trade finance gap – so why is private credit still a relatively small component of this market?

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Earlier this year the International Trade and Forfaiting Association published a whitepaper on making trade an investible asset class, noting that banks alone will be unable to address demand for trade financing. They referenced the need to advance the evolution of trade finance as an asset class for alternative investors such as asset managers, insurance companies, and pension funds.

Christoph Gugelmann, CEO at Tradeteq observes that investors have been interested in accessing this asset class for some time as it regularly pays above the risk commensurate yield level. But distribution from banks’ balance sheets has been too costly for what is a low yield as well as low risk asset class. Operational costs are high because of the short instrument tenors and the need for repackaging of portfolio risk and the extensive reporting requirements are further barriers.

“For an investment bank to execute on behalf of a client, the transaction costs would regularly exceed the asset spread of short-term bank exposure,” he explains. “This limits access to a small portion of riskier assets.”

Credit is the primary risk and there are also risks arising from delays in payment and dilution, although these can be mitigated by access to payment behaviour data.

“Trade finance involves financing literally thousands of invoices and thus requires a robust infrastructure to monitor payment flows and ensure contractual obligations are met and this investment is a barrier to new entrants,” says David Newman, CIO Global High Yield and Portfolio Manager of Allianz Global Investors’ trade finance strategy. “However, once the infrastructure is set up, trade finance is broadly similar to monitoring a credit portfolio.”

Operational complexity can mean anything from know-your-customer (KYC) challenges to non-standard or bespoke documents for each transaction to the operational burden of purchasing and servicing of granular pools of invoices.

According to George Nijborg, Head of Trade Finance and Insured Debt at Aegon Asset Management, there are two evolving themes within trade finance helping to tackle these operational complexities. “The first of these is reliable technological infrastructure to allow investors to access and manage trade finance portfolios,” he says. “The other is standardisation of documentation and reporting to improve and make KYC, credit and legal analysis more efficient.”

Attention needs to be paid to precisely explaining the risk and reward structures involved. Understanding the total picture per transaction is crucial in making a proper assessment and opportunities should be filtered in a way that is mindful not only of relative value and risk-adjusted returns, but also of the portfolio construction, capital attraction and operational impact for investors.

That is the view of Suresh Hegde, Head of Structured Private Credit at NN Investment Partners, who notes that money laundering and fraud are idiosyncratic risks in international trade.

“Working with well-respected parties and establishing long-term relationships between buyers and sellers are effective first steps in reducing these risks,” he says. “Fund managers also must develop and practice enhanced due diligence processes to control the risk relating to the entities and the transactions that are being financed.”

When accessed in a robust and diversified way, Hegde describes trade finance as a powerful diversifier as part of a traditional credit allocation. “It can also provide an effective platform to realise responsible investment objectives and can be a catalyst for sustainable economic growth as it is at the heart of more than half of the UN’s sustainable development goals,” he says.

As trade finance liabilities self-cancel at maturity, there is no reliance on capital markets for refinancing and this helps generate uncorrelated returns. “However, as trade finance is a credit asset class there will be correlation to short dated credit markets,” concludes Newman.

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