The Trade Finance Gap

The use of trade finance is an important funding method in Asia, one of the most vibrant, influential regions of the world. However, due to regulatory and other barriers, there is a large gap between supply and demand. Currently, the industry is being transformed by an increasing desire to marry trade finance with the wider capital markets, as well as by the internationalization of the renminbi (RMB).

Trade finance uses traded goods as collateral, unlike traditional lending, which lends against balance sheet or assets. As a result, a key component is the ability for banks to set up safeguards to take possession and sell the goods and commodities themselves. Bank-intermediated trade financing is also short-term in nature, with about $6.5 trillion to $8 trillion in short-term annual trade finance flows versus just $175 billion in medium- to long-term trade finance exposures.

Driving force: Regional risks and attributes

Trade finance is a hallmark of emerging Asia, with almost half of global bank-intermediated trade finance devoted to firms in that region. Its popularity there is due to the heightened risk that comes with such factors as: longer trade routes between Asia and its trade partners, product types, less established trade partnerships, weaker contract enforcement, lower degree of financial development and higher political risk. Europe, in contrast, has shorter trade distances and better established institutions that insure trade credits and discount trade receivables.
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Chart 1: Trade finance, trade credit insurance, and trade by geography

Sources: BIS.

Trade financing is thus able to come in with more complex, sometimes syndicated structures that shift the risk burden to banks, which can then monitor the transactions and exert greater control over the flow and receipt of funds. This is especially useful in situations where there is a lack of mutual understanding between parties.

Differences in regulations and legal frameworks have also created arbitrage opportunities and played a role in the regional popularization of trade finance. For example, in China, the degree of interest rate liberalization varies between RMB loans and trade finance. Also, the discount rates of RMB and foreign-currency letters of credit (L/Cs) were at times lower in offshore than onshore markets. These various reasons conspired to make trade finance instruments like L/Cs relatively cheap and popular instruments to finance working capital.

Barriers to trade finance

Despite the importance of trade finance in supporting production, job creation and economic growth, there is currently a funding shortfall of $1.6 trillion globally, and $425 billion in developing Asia alone. Based on the volume of rejected loan requests, there exists a substantial amount of unmet demand for import and export finance.

Ongoing regulatory change is one major barrier for trade finance. Basel III requirements have increased operating costs and capital allocation to trade loans, making profitability more difficult, and possibly increasing pricing and decreasing liquidity. Under Basel III, credit risk conversion factors increased from 20 percent (under Basel I and II) to 100 percent, and other elements like the liquidity coverage ratio, the net stable funding ratio, and the asset value correlation multiplier have contributed to hiking capital requirements.

Other barriers that have created a trade finance gap include: banks’ poor payment records, low credit ratings, weak capacity, unsatisfactory performance, lack of dollar liquidity, weak overall banking systems and low country ratings.

Recent developments

There has been a surge in securitization deals backed by trade finance loans, as banks look to divvy up risk and offset trade finance capital requirements. Trade finance assets are mainly generated by banks and were traditionally traded only in the interbank market, but a recent spate of issuances has increased non-bank investors’ (i.e. capital markets) access to trade-finance assets.

Standard Chartered led the way in 2007 with Sealane I, a special-purpose vehicle (SPV) set up to sell protection against the portfolio to the bank and to issue securities to the public. Banks can ordinarily distribute and offset trade finance risks by directly selling their loans or through credit insurance. In the past two years, though, six large public issuances have followed, indicating that outright and synthetic securitizations for investors might become a more frequent path for banks. One caveat is that different regulatory and tax regimes may make this pursuit complicated in Asia.

Chart 2: Trade finance securitization deals.

Source: Company press releases.

Another change is the increased use of RMB in payments and trade financing. With more companies considering the practice, more banks are developing their own RMB trade finance capabilities to meet those needs. Though the figure is purported to be inflated by shadow lending practices, the RMB recently replaced the euro for the No. 2 spot in terms of world usage in trade finance. This represents a growth opportunity for financial institutions, as China continues to liberalize its capital account.

On the other hand, the effect upon the trade finance business will be limited until more commodities start to be priced in RMB. Though commodities trade will gradually convert to RMB settlement in some areas, much of it is still denominated in U.S. dollars. Asian and European banks in particular are well-positioned to adapt to the change, due to offshore centers and hubs in Hong Kong, London and Singapore.

Chart 3: Trade finance currency usage

Source: SWIFT.