Co-Founder & Co-CEO at Drip Capital, defining the strategic vision and overseeing product, business development and global operations.
International trade has increasingly become a key force behind global GDP growth. With steady increases in transaction size as well as payment periods, a lot of this trade has become reliant on trade finance facilitation by lenders. In fact, up to 80% of international trade requires some kind of financing.
Since the earliest days of commerce, trade has primarily been financed by institutions and individuals with deep pockets. These financial institutions have been focused heavily on financing large businesses and trading companies that have a reasonable assurance of success.
As a result, small and medium-sized businesses (SMBs) have been left out of the trade finance circuit, despite contributing significantly to global trade. The Asian Development Bank estimated that nearly 45% of SMB trade finance applications are rejected by banks and traditional lenders.
However, a new class of financier has stepped up to the plate in recent years, in the form of alternative finance providers. Data-driven and agile, these fintech firms (to include our own) are pushing to close the gap, relying on technology to break the barriers faced by traditional lenders in servicing SMBs. The success of these newer players in originating high volumes and strong credit quality — key requirements for institutional investors —has resulted in the resurgence of a particular investment asset: trade finance receivables.
The Return Of The Trade Receivable
In a cross-border transaction, there are two parties: an exporter and an importer (i.e., a buyer). A third party (a financier) is introduced when one party needs advance payments. When an exporter generates an invoice against an order from a buyer, with the expectation the buyer will pay that invoice, that invoice is a trade receivable. The exporter sells this invoice to the financier at a discount in exchange for getting paid sooner, creating an uncorrelated, short-duration trade finance receivable.
Trade finance assets have traditionally been ignored by investors because they perceive them as a complicated and unstructured asset class with multiple variations dependent on geographies, commodities or goods, and counterparty. But in recent years, this lesser-known asset class has drawn increasing interest as an uncorrelated investment with low risk and the possibility of high returns.
A 2019 report by global asset management company Insight Investment notes that trade finance can offer yields significantly above Libor (as well as above commercial paper yields). Short duration and consistent returns make these assets a strong consideration for alternative fixed-income or cash management/treasury portfolios. Furthermore, exposure to multiple underlying commodities, finished goods and geographies lends strength to this asset class through diversification.
These qualities have led to renewed interest in trade finance receivables as an asset class in the past decade. According to one estimate, there were nearly 15-20 trade finance-focused funds globally at the end of 2019, with the number expected to grow. These funds have opened the trade finance asset class — long considered accessible only by banks and large qualified institutional investors — to all private credit investors.
The Covid-19 Impact
In May, the International Chamber of Commerce published a paper discussing the role of trade finance in the global economic recovery from Covid-19. A call to arms for governments and the private sector, the paper theorized that global trade recovery will require trade credit of $1.9 trillion to $5 trillion to return to pre-Covid-19 levels in 2021. Of that, the paper estimated $0.8 trillion to $1.9 trillion will need to come from bank-intermediated provisions, such as letters of credit and guarantees. This leaves a gap of $1.1 trillion to $3.1 trillion that will most likely be plugged by the rising numbers of alternative finance lenders, with a corresponding rise in trade finance receivables.
Investors are leery of entering markets and sectors they have little knowledge of, and the amount of information on global trade can be daunting for even the most rigorous investor. To solve this problem, trade finance funds and organizations have set up specialized investment vehicles to provide investors expertise and transaction portfolios.
Analyzing Trade Finance Investments
When analyzing any investment opportunity, investors need to conduct due diligence to understand key risk factors. With trade finance assets, investors should consider these three factors:
• Asset: Truly understand the underlying trade asset (i.e., pre- or post-shipment, credit enhancements, forex risk if any, etc.).
• Structure: Know the nature of the entity where the trade asset is held (i.e., liquidity terms, first-loss protection, investment mandate, etc.).
• Firm: Research the experience, risk and credit management frameworks utilized and the track record of the originator.
With an appreciation of the above, an investor can then consider their overall portfolio and how diversified the pool of trade receivables is. Understanding the risk of concentration across key variables of the underlying pool of trade assets is critical. For example, if one would have invested in a portfolio of trade assets focused on China receivables from one exporter, selling one type of product (luxury goods) to one buyer overseas (a luxury retailer in the U.S.), the security may have performed poorly during the early days of the coronavirus outbreak in Q1 2020 given disruptions in the supply chain and underlying health of the one exporter and one buyer. Hence, diversification within trade assets is important.
A Rising Asset Class
Covid-19 has further widened the gaps and inequalities generated by the global financial crisis of 2007-08. While banks become ever more constrained and reluctant to enter the trade finance space, demand for credit has grown in international trade. At the same time, falling yields (downloadable report) across traditional investments, such as U.S. Treasury securities and government and prime money market funds, have left investors with surplus liquidity and an increasing need for portfolio diversification. With short-term returns, competitive yields and low correlation to more commonplace investments and the market, trade receivables are poised to meet investor needs and continue to grow in popularity as an asset class.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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