The COVID-19 pandemic has changed the way the trading markets function and is sure to provide more insight into how shares are traded.
But aside from equity market trading, the coronavirus has altered the way people actually trade – that is finance the movement of physical goods- how it is done and will be done in the coming months and years. Traders Magazine editor John D’Antona Jr. spoke with Tradeteq Chief Executive Officer Christoph Gugelmann to gain insight into trade finance and how this more esotoric area has become important now in the current coronavirus pandemic and how it conducts business and how technology helps.
TRADERS MAGAZINE: What is the trade finance market and why is it so important?
Christoph Gugelmann: When you think about global trade, most are conscious of the ships, air cargo, ports and lorries which carry goods across borders. Less obvious are the financial mechanisms that facilitate this transportation: trade finance.
Trade finance is arguably the engine that powers global trade. This market is worth USD18 trillion a year and accounts for 40 per cent of global trade financing. It provides the financing that enables corporations and SMEs around the world, from Seattle to Singapore, to trade with each other. Without an efficient and thriving trade finance market, global trade will grind to a halt.
This financing is typically provided a group of Tier 1 banks which dominate the sector, and is becoming increasingly important to their global operations. Data from Coalition found that the top twelve investment banks’ revenues from transaction banking – which includes both cash management and trade finance – increased by nine per cent in 2018 to $31.3bn.
TM: What are the current problems with the trade finance market?
Gugelmann: Trade finance is under the spotlight for a number of reasons, with changes being driven by both ‘internal structural’ changes and ‘external’ pressures.
Let’s start with the internal, structural changes which is being driven by the industry itself. It is widely acknowledged that trade finance is reliant on archaic, paper-based processes that have no place in the 21st century. Most transactions involve numerous counterparties with copies of paper documents needing to be passed between them.
It is estimated that the average trade finance transaction requires 36 original documents, the involvement of 27 entities, 240 copies of these documents, costing USD81 billion in unnecessary supply china costs for Fortune 500 businesses. This is hugely inefficient and costly. Innovative technologies such as Artificial Intelligence (AI), instant payments and blockchain are being rapidly adopted by banks, corporations and SMEs, transforming the trade finance market for the better.
There is also the issue of the trade finance gap. More than USD1.5 trillion worth of trade finance requests are currently rejected. Banks cannot meet this demand because of numerous balance sheet pressures. This highlights the need for banks to move from an ‘originate-to-hold’ model to an ‘originate-to-distribute’ model.
There is significant momentum behind this, with more than 30 industry players working together to establish trade finance as an investable asset class, make it more appealing to non-banks and create a liquid and efficient secondary market.
This ties in nicely with the single biggest ‘external’ concern for the industry – the incoming Basel IV rules. This will significantly increase the capital requirements that banks are required to put aside when extending trade finance to corporations and small businesses.
For example, a bank lending USD100 million to an SME and with a current capital requirement of three per cent might need to put aside a total of six per cent for loss absorption going forward. Average capital costs of 12% would therefore result in a total of 72bps of capital costs going forward.
The higher threshold will have a significant impact on the availability of trade finance, with the World Trade Organization expecting the trade finance gap to increase to USD2.5 trillion by 2025. This could have a profound impact on the global economy.
The current uncertainty around international trade is also an ongoing headache, and this has placed the functioning of global trade finance into the spotlight. Trade wars, the implementation of tariffs and barriers and numerous geopolitical issues are causing a slowdown in global trade and undermining confidence.
TM: How does Tradeteq fit into the market?
Gugelmann: My co-founder, Nils Behling, and I set up Tradeteq in 2016 and we went live with the first iteration of our technology solutions in 2018. Our combined 40+ years of experience in various roles meant that we had seen first-hand the issues faced by corporations and SMEs when accessing trade finance.
There were a couple of issues we set out to address. Firstly, we developed technology which enables banks and issuers to accurate assess the riskiness of clients, vendors or individual transactions using artificial intelligence. This technology is being used participants connected to Singapore’s Networked Trade Platform and subscribe to our service – and includes multinational corporations, SMEs, trade financiers, shipping companies, and other logistical and service providers.
We also created technology and infrastructure that enables trade finance products to be repackaged and transformed into capital markets products. This is currently being used by banks around the world to reduce their balance sheet pressures. Most recently, ING has used our technology to distribute its commodity trade finance exposures to Federated, a large American institutional investor.
Last, we operate an electronic trading platform that allows banks and institutional investors to seamlessly transact trade finance assets with each other. This now provides the infrastructure for the Trade Finance Distribution Initiative (TFD Initiative), which has more than 30 members and is an industry-wide effort to create a secondary market in trade finance with buy-side participation.
The TFD Initiative recently began formal cooperation with the International Trade and Forfaiting Association (ITFA), highlighting the growing interest in extrapolating the benefits of Tradeteq’s ‘originate-and-distribute’ model.
TM: What role does AI play in your platform?
Gugelmann: In trade finance, artificial intelligence (AI) is particularly helpful in analysing quantitative data. AI conducts a peer analysis which compares the relative risk of lending to a business or buying a trade finance instrument. It can also look at the reliability of a business’s supply chain to assess the risk amongst its suppliers. Together, this data can produce an accurate risk profile of any business, even in the absence of account or filing histories.
We have developed a neural network AI which assesses businesses on two fronts not normally addressed by traditional credit reporting.
Firstly, it performs a peer analysis which compares the relative risk of lending to a business in comparison to similar companies. Secondly, it looks at the reliability of their supply chain to assess the risk across its suppliers.
Tradeteq’s AI is able to assess the risk of each transaction, instrument and company. If the AI knows of all of the warning signs present in the historic data, it can look for these in the current transaction process, predict any new risks and provide warnings in advance.
Tradeteq’s AI-driven credit scores are integrated into our electronic trading platform, which provides an end-to-end solution enabling investors to access trade finance in a standardised and efficient form. This technology is the key to achieving greater transparency with credit scores, minimising the risks of global trade flows and opening up access to trade finance for SMEs and emerging markets.
TM: How does trade finance distribution help to close the funding gap?
Gugelmann: Trade finance is a capital-intensive business and attracts high levels of capital requirements. This means banks must be selective about who they lend finance to.
The ability to distribute these assets can free up cash which banks can lend to corporations and SMEs that otherwise would not be able to access financing. Of course, this requires a buyer to purchase that asset; fortunately, there are many ‘cash-rich’ non-bank investors looking to invest in the trade finance market and benefit from the lower levels of risk and potential yields it offers.
Previously, they have been withheld from accessing this market by the difficulties relating to infrastructure and standardization. With our electronic trading platform, trade finance investments held by banks are packaged into investable notes for distribution in a standardized format they investors understand.
TM: How does this create new investment opportunities?
Gugelmann: With many bond yields in negative territory and low volatility in other financial markets having an impact on returns, investors are now turning to alternative assets – such as trade finance. This determination to diversify their portfolio is helping to overcome legacy technology issues that currently present barriers to entry.
The low risk profile of trade finance as an asset class is widely acknowledged. With increased non-bank participation, trade finance has the potential to grow in status and be seen as a truly investable asset class.
We believe it could be worth USD3 trillion by the end of the next decade and become a viable alternative to equities and bonds.
However, the inability to access the market and the lack of an efficient trading infrastructure has long been a barrier for institutional investors. Therefore, the key to addressing the trade finance gap, lies in the creation of a liquid and scalable trade finance marketplace.
We are creating a whole new asset class for investors. Trade finance is the final frontier yet to be broken into capital market investors, primarily due to their inability to access the asset class. By creating investable notes, Tradeteq is finally allowing for non-bank players to enter this market at scale.
More than 30 banks and institutional investors are using Tradeteq’s electronic trading platform to transact trade finance instruments such as letters of credit, factoring, export credit and insurance between each other. This is the first-time trade finance instruments have been traded in such a standardised and electronic manner.
TM: What can be done to keep supply chains moving during and after Covid-19?
Gugelmann: The coronavirus outbreak has fundamentally changed the way in which the world operates. All the things we are lucky enough to take for granted – international travel, freedom to visit our friends and family – are no longer available to us. Yet, while many things remain unknown, there still need to be plans in place that will help shape the world for when these restrictions are lifted.
The UK Government has already announced an unprecedented guarantee package for businesses to keep them afloat during the period of uncertainty. These guarantees will save many that are directly affected by the crisis. However, loan guarantees and additional liquidity lines granted by the Bank of England are often less effective to keep corporates’ supply chains moving than access to trade finance. Future decisions from Number 10 need to take into account alternative methods to ensure trade and commerce can continue.
Providing funds to banks, specifically for trade finance lending, will help support trade, retain jobs and maintain supply chains at a time when these areas are most at risk. To help exporters, I would urge the Government to explore the possibility of buying or guaranteeing banks’ trade finance exposure.
The British Business Bank, the state-owned development bank, is already coordinating a Coronavirus Business Interruption Loan Scheme for small and medium size enterprises. It relies on banks to extend credits to small business with lenders receiving a guaranty on 80% of the loans issued. A natural extension to trade finance instruments could be implemented along the same principles.
If this initiative was enacted, banks would be in a better position to lend more freely to exporters – reassured that their exposure would be purchased by the Government. As low risk trade finance exposure is purchased, this would in turn free up further capital for lending. This scheme would provide exporters with the funds needed to sell their wares, keeping this essential part of the economy active through this period of uncertainty.
The Government has pledged £330 billion, signalling its strong intent to support the economy and its workers during the outbreak. To ensure that this intent is carried to the entire economy, the Government has the potential to make a substantial difference to the number of exporters and jobs – both now and after this issue comes to an end.