Emerging markets will benefit most from finance distribution

Access to trade finance is crucial to SMEs’ internationalisation, particularly in emerging markets, yet they often struggle to get bank support due to their limited collateral. Making it easier for banks to distribute trade finance risk with institutional investors has the potential to change this dynamic and revive trade growth on a global level.

The most authoritative measure of the SME trade finance gap is the Asian Development Bank’s (ADB) Trade Finance Gaps, Growth, and Jobs Survey. Every year for five years, the ADB has surveyed hundreds of banks and thousands of corporates to evaluate the trade finance shortfall. In 2017, the report included the participation of 515 banks from 100 countries and 1,336 firms from 103 countries, and found that in 2016, the trade finance gap stood at US$1.5tn.

Of rejected trade finance transactions, 40% came from Asia and the Pacific, 23% from the Americas and 14% from the Middle East and Africa. Banks reported that 74% of rejected finance proposals were from micro, small and medium-sized enterprises (MSMEs) and midcaps.

In a 2017 report, the World Trade Organisation (WTO) also found that globally, over half of trade finance requests by SMEs are rejected, against just 7% for multinational companies. “Global liquidity tends to be concentrated within the biggest institutions and their clients,” it said, adding that the problem is even more marked in developing countries. According to the WTO, the value of unmet demand for trade finance in Africa is estimated at US$120bn (one-third of the continent’s trade finance market) while it is some US$700bn in developing Asia.

Arguably, this difficulty in accessing trade finance is contributing to the global slowdown in trade growth: the ADB asked firms what happened to the trade transaction after rejection, and about 60% of them said they failed to execute the transaction when their application for trade finance was rejected. The accumulation of rejections among firms in emerging markets is therefore bound to have an impact on overall economic and trade growth.

Technology-led diversification

Alternative financiers such as invoice discounters, factoring firms and private funds have emerged in recent years to help plug the gap. Transportation firms such as UPS and Maersk have begun offering credit lines to SMEs. The opening of the peer-to-peer lending sector has created opportunities by facilitating invoice financing. There are now auction platforms where invoice buyers — such as hedge funds, asset managers, family offices, and high net worth individuals — can bid in real-time to determine how much of an invoice’s value they want to provide, shortening payment times for small companies and freeing up liquidity for other uses. More recently, some crowdfunding platforms started offering trade finance, too.

In some emerging markets, these alternative funders have become more popular than in others: respondent firms in Africa and South America resorted to informal financial providers more than firms from other regions, the ADB report adds.

But corporates are not always aware of their existence, and when they are, they often find them out of their budget. The survey reveals that more than half (53%) of firms rejected by banks didn’t look for any alternative sources of financing, and among those, only half ended up using the alternative solution— the other half found it too expensive.

E-commerce providers such as Amazon, PayPal, eBay and Alibaba have also made great strides in offering less cumbersome loans to SMEs, while providing them with targeted training and advice. And distributed ledger technology (DLT) advances are expected to broaden SMEs’ access to trade finance by automating processes and cutting costs on financiers’ side. These very recent fintech developments led to a small reduction of the gap in the past year, from US$1.6tn to US$1.5tn.

The diversification of financing sources is good news for the SME sector of course, but to make bank finance more accessible - and alternative finance more affordable - the distribution of risk will be key.

Sharing the risk burden

Interestingly, the ADB survey reveals that the main reasons for rejecting trade finance applications are know-your-customer (KYC) concerns (29%) and a lack of collateral or information (21%). The rise in regulatory requirements for banks has gradually led them to reduce their exposure to the SME market, particularly in “risky” emerging markets. At the same time, it has resulted in the diminution of correspondent banking relationships, with large international banks shying away from transactions with the small local banks who would be more likely to know, and therefore fund, the small corporates of their country.

While individual institutions are more and more risk-averse, there’s an opportunity to make SME trade finance in emerging markets more of a team effort. Already in Europe, the we.trade initiative, a blockchain-based platform designed to simplify domestic and cross-border trade for SMEs in Europe, promises to change the game this year. Created by the Digital Trade Chain Consortium, which consists of Deutsche Bank, HSBC, KBC, Natixis, Rabobank, Societe Generale, Unicredit and Santander, the platform will be hosted on IBM Blockchain and powered by Hyperledger Fabric. The idea is to connect buyer, buyer’s bank, seller, seller’s bank and transporter on a platform that will be accessible from any device.

As more and more of these projects see the light of day and start gathering data on small corporates’ financial information, the transparency and visibility of SME trade will continue to improve. But the process is likely to be longer and more difficult in emerging markets, where the level of reporting requirements varies greatly and there are many more micro-SMEs than midcaps. In these markets, bringing institutional investors, whose risk appetite is much different from banks’, into the equation, is the way to go.

We already know that trade finance assets are low risk (thanks to the annual International Chamber of Commerce Trade Register), but the main thing investors need in order to add liquidity to the market is the right technological platform - one that would give them transparency and predictability over their investments. This added layer of distribution would help banks and other trade finance providers to free up some capital and risk appetite to reach smaller and smaller corporates.

Secondary market involvement

A recent survey of European asset managers, conducted by Greenwich Associates on behalf of the EFA Group found that trade finance as an asset class remains in its infancy, with only 5% of the institutions polled having invested in it. Another 14% had looked into it, but never invested. Yet the investors that did make the leap saw great results: Federated Investors for example has seen monthly returns of up to 1.2%, and an annualised Sharpe ratio (a measure that uses the US Treasury's one-month constant maturity yield to calculate risk-adjusted returns) of over 3%, which is considered excellent.

But the majority of funds that invest in trade finance have specialised in it, and usually provide direct loans to emerging market SMEs that were rejected by the banking system. Allowing institutions to get involved in the secondary market, with a bank or non-bank provider offering the initial trade finance loan, then turning to investors to purchase the risk of that loan (or of a whole portfolio), would make the process less cumbersome for all involved, and unlock enormous amounts of new liquidity.

Many banks have already implemented an originate-and-distribute model whereby they sell trade finance assets immediately after providing their loans to corporates, but these efforts have been focused mostly on bank-to-bank transactions. Other types of investors need to be brought into the ecosystem if liquidity is going to be abundant enough to reach the riskiest layer of the world’s supply chains: emerging market SMEs.

This is what Tradeteq aims to facilitate, with an efficient cloud-based platform where financiers can present their trade finance portfolios for distribution, and institutional investors can have visibility over a low-risk asset class they tend to be unfamiliar with - all with standardised reporting processes and maximum transparency. The company was launched in London but recently opened an office in Singapore, the perfect base from which to connect with Asian originators and investors of all sizes and work to plug the world’s largest trade finance gap.

According to Organisation for Economic Co-operation and Development (OECD) figures, SMEs account for 40% of exports in OECD countries, and a somewhat smaller share in developing countries, yet stringent financial regulations and the consequent risk aversion shown by trade financiers have meant that many of them have been left in the lurch. Technology is helping to correct this in many ways, and the growing recognition of trade finance as a profitable asset class will also contribute to solving this issue.