The need for a revolution in trade finance

Over the last decade, there’s not a single industry that hasn’t been re-shaped by technology in one form or another. However global trade and trade finance is one of the few exceptions where change has been somewhat slow, but things are changing for the better. As 2021 begins, now is the time for trade finance to double down on technological change.

The current landscape

Trade finance has long been the domain of large banks, providing the capital for corporates and SMEs trading internationally. As time has progressed, this small group of industry players have found it harder to provide finance to smaller companies in the market. Inevitably this has created a trade finance ‘gap’ between what banks can provide while meeting regulatory requirements and what businesses need. In 2016, this was estimated to be USD1.6 trillion – 10% of global trading activity – and has likely only grown in the interim period due to the effects of COVID-19 on global trade and economic activity.

Put simply, there is a need for greater and more diverse participation in the provision of trade finance in order to close this gap. Fortunately, institutional investors are eager to get involved with this low-risk asset class.

However, the industry historically lacks the infrastructure to make it happen in a seamless, electronic and scalable manner. To distribute trade finance, banks, investors, credit insurers and other industry participants need to ensure they have the right technology in place.

Implementing the right technology

Trade finance is a centuries-old industry that remains largely paper-based and reliant on manual processes. With the need for automation and digitisation becoming the norm in all industries, the need for physical documentation is quickly becoming unfeasible.

There are numerous benefits that arise from this, such as the credit scoring process. In trade finance, automation is particularly helpful in analysing quantitative data, as there are usually many repetitive small transactions. The nature of trade finance means that there is a lot of non-traditional data available.

When it comes to credit scoring transactions, banks and other trade finance providers need to assess the risks of funding a transaction between a business and its counterparty. Automated models that use AI to analyse large quantities of information offer a very efficient tool for data and risks analysis.

This approach goes far beyond the traditional credit scoring process, which is often outdated and remains reliant on a small number of historical accounting entries – a major barrier that prevents many small companies from accessing trade finance.

No longer a bank-dominated club

Historically, trade finance has been limited to a handful of banks, with only a very small number of institutional investors having access to the low-risk asset that trade finance offers. However, with the advancements in technology led by a new generation of fintechs, as well as a recognition to adapt to the changing regulatory landscape, the industry is looking to opening the market for more investors.  

An infrastructure which connects participants and embeds automation throughout the process can connect different groups together and facilitate better trading. If executed effectively, banks will be able to parcel up trade finance transactions into assets that can be bought by institutional investors.

This is key to tackling the aforementioned trade finance ‘gap’. Banks will be able to work their balance sheets harder, allowing them to issue more trade finance without taking on additional risk, and remain compliant with international regulatory frameworks.

Compliance ready

Compliance with Basel IV’s more stringent capital requirements is increasingly on the radar of banks and other financial institutions. It is an example of general banking regulation which applies to all financial services and requires more capital to be set aside based on the amount of risk that is held on their balance sheets.

However, the regulation fails to consider the nuances of individual markets like trade finance, which is short term, based on tangible goods and has a reduced risk profile compared to other asset classes or complex financial derivatives.

As a result, the effects of Basel IV on the trade finance divisions of banks will be considerable. The amount of capital that banks need to put aside when offering trade finance to SMEs, for example, can double during the phase-in period, starting in January 2022.

These higher capital requirements mean banks are becoming extremely selective about the companies they lend to. This will have a significant impact on the availability of trade finance globally, with the World Trade Organization expecting the trade finance shortfall to increase to USD2.5 trillion by 2025.

Trade finance is moving with the times

For such a long-standing industry that plays a crucial role in global trade, banks need to move quickly to comply with regulations in a way that does not impact their profitability nor their ability to serve clients.  

Fortunately, the industry is now innovating and moving with the times. This USD15 trillion a year industry is ready to seize the significant opportunities presented greater automation, digitisation and distribution of trade finance assets.