How technology is transforming trade finance

The complexity and cost of international trade was already trending higher before the disruption caused by the Covid-19 pandemic and the war in Ukraine. Looking ahead, however, it will be tighter regulatory compliance, rather than economics or geopolitics, that adds further cost pressures, squeezing out some players but also creating opportunities for new technology to help mitigate the impact of such change.

The need for tighter regulatory compliance is not in question, but to avoid negative side-effects, such compliance needs to be accompanied by a transformation of the way trade finance is conducted. It’s therefore reassuring to know that this transformation is already underway, driven by cutting-edge trade technology (tradetech), bringing new players and fresh liquidity to the sector. This is a trend that’s set to accelerate discernibly in the coming years.

Basel squeeze

Following the global financial crisis of 2008, the Bank for International Settlements unveiled new capital requirements for international lenders in the form of the Basel III requirements. The next iteration of the regulations, dubbed Basel IV, is due for adoption by lenders in the coming two years. In a nutshell, Basel III and IV require banks to increase regulatory capital and reduce free capital, because higher balance sheet costs are required to hold larger capital reserves.

Beyond such requirements, banks also face increased complexity and higher costs of onboarding due to tighter anti-money laundering checks, the result being that some banks have pulled out of some markets and geographies. This has made it harder for small and medium-sized enterprises (SMEs) to get trade financing from banks, thereby widening the SME funding gap.

New entrants in SME financing

As is so often the case, however, where there’s a need, there’s a solution to be found. Across the world, we see the emergence of new funders in the market — known as non-bank lenders — that are extending liquidity to SMEs through the provision of invoice financing services, filling the gap left by banks’ increased focus on their core client groups.

Using non-bank financial institutions is, of course, not a new concept. SMEs have used factoring companies for decades, when unable to get funding from banks. A factoring company buys a business’s unpaid invoices in return for a fee, which is deducted once the full payment has been collected from the customer. It injects liquidity by purchasing SMEs’ receivables at a discount.

Alongside the factoring companies, many alternative lenders have emerged in recent years, some of which are heavily using tradetech to essentially automate the process of funding invoices. These lenders extend liquidity to SMEs, lending on the back of invoices approved by the buyers. Those new lenders are very innovative and aim to close the SME funding gap.

Institutional investors

In addition to receiving support from such new entrants, banks themselves are starting to move towards a so-called originate-and-distribute model, which enables them to focus on servicing transactions while relying on third-party, non-bank liquidity from asset managers and institutional investors. Today, tradetech developments are making it possible to implement such a model on a much broader, automated scale. Banks are increasingly bringing capital markets players into the process, and offer them to access transactions they service, creating more capacity in the trade finance market.

With the industry at a tipping point, the originate-and-distribute model is a brilliant solution to handling capital constraints without restricting trade finance availability for clients the world over. It’s at this point the Trade Finance Distribution Initiative (TFD Initiative) has a significant and growing role, adding liquidity through its growing network — currently 80 members — that includes some of the world’s largest financial institutions.

The TFD Initiative recognises a common need between incumbent banks, factoring companies and the alternative lenders, namely third-party liquidity. This new source of liquidity can be found with institutional investors, including family offices, pension funds and credit insurers. The TFD Initiative mission is to convert trade finance into a liquid asset class that can be traded globally with transaction-level automation and standardisation, enabling huge cost efficiencies along with real-time processing.

Partnering on transactions

The specific skillset needed to source and originate trade finance deals and understand complex legal documentation has been identified as one of the biggest barriers to entry for institutional investors. The TFD Initiative is delivering the key to improving market access, making trade receivables investable to capital market players.

The breadth of research on the benefits of the originate-and-distribute model, coupled with growing interest in trade finance as an asset class for non-bank investors and the rise of the tradetech sector, are creating the perfect conditions for closing the SME funding gap.

Andre Casterman is CEO of the Trade Finance Distribution Initiative.