Global trade volume in 2014 was
estimated at USD 18 trillion. According to the WTO 80-90% of that volume
requires some form of financing. Trade finance plays a critical
role in the international finance and in the domestic finance of both advanced
and developing economies.
Traditionally the financing of
global trade has been provided by commercial banks around the world. Over many years and in some
cases many centuries, these banks had developed effective and adaptive risk
management procedures that allowed them to lend to developing economies which
often faced significant headline risks. Now with balance sheets
constrained, banks can be hard pressed to meet the demand for financing
especially in the developing world.
According to a survey by the
Asian Development Bank in 2014 as much as USD 1.6 trillion of demand for trade
finance was unmet with a significant amount of the shortfall residing in Asia
and Africa.
Financial investors who
cumulatively control well over USD 100 trillion in assets worldwide have been
largely absent from the market. The worlds of commercial
banking and financial investment management have remained essentially invisible
to each other.
The mechanics of more
structured trade finance facilities present formidable barriers for financial
investors, and although the trade finance
market is huge it is also fragmented with few sources of comprehensive data.
The high risk adjusted returns
from trade finance, especially those domiciled in developing economies, deliver
a return profile that is very competitive when compared to financial assets
while maintaining low to negative correlations with the major equity and fixed
income indexes.
It is for this reason that Federated
have been successfully investing in trade finance assets since 2006 and
currently manage approximately half a billion USD. Their trade finance strategy is
based on the credit culture of Federated. They analyze each deal to identify the
risks embedded in the transaction and the structural elements which mitigate
those risks to an acceptable level. For example, in the course of a given year Federated might see 600-800 discrete deals and make investments in only 80-100 of
those.
So what are the risks that
might adversely impact performance of a transaction? They can be broadly categorized
into credit risk, market risk, liquidity risk, and operational risk.
Risk Management
Credit Risk
Credit risk is the risk that
the counterparty to a deal is unable or unwilling to make good on its payment obligations.
Traditional credit risk analysis is focused on assessing a counterparty’s
ability and willingness to make financial payment at a future date.
Structured
trade finance deals, however, are often also dependent on production risk. This is the risk that the minerals cannot be mined,
the oil cannot be pumped, or the crops cannot be grown. Once the goods are
produced they can serve as the collateral for the transaction and in turn the risks
involved in the deal are significantly reduced.
The success of trade finance
deals depends on the actual production of the physical commodity underlying the
transaction. The ability and willingness of a counterparty to successfully
produce this commodity is often treated distinctly from performance risk.
In general, credit risk
analysis often begins with a macro-level assessment of the country risk
associated with the transaction. Sovereign credit ratings from the major rating
agencies are reviewed along with independent and internal country credit and
economic analysis. A similar sector-level risk analysis can also be performed
where the current state and outlook for the relevant industrial sectors are examined.
The relative importance to a sovereign of a particular industry sector or, in
some cases, individual firms can also be taken into consideration in order to
estimate the level of implicit support that might exist for an obligor or
market.
Establishing limits is one way
to manage credit risk as well as to encourage diversification, such as in
Federated’s Project and Trade Finance investment strategy. In this particular
case, there are geographical limits on the percentage of the overall strategy
that can be invested in any one of four regions. Investments are also subject
to per-country limits that depend on the specific sovereign rating of the
country. Limits are also placed on the underlying transaction security types to
further enhance credit risk protection.
To measure and manage
performance risk, Federated begins with S&P Capital IQ ratings, a review of
independent technical reports and credit analysis, and in-depth Q&A
(questions and answers) on the credit with the mandated lead arranger (MLA)
credit team. The MLA will also liaise with
the agent bank (usually a wholly owned subsidiary operating in the country in
which the deal is originated) which is responsible for monitoring the deal
locally and for the control of the collateral pledged to the transaction.
Further research on the
performance of the deals which the MLA has originated in the past and how the
bank has dealt with stressed situations, can also be performed. If the banks
investing in the deals provide stress scenarios, these are used as baselines
and stressed further where deemed appropriate.
Once an investment has been
made real time follow up is important. The agent bank provides direct
information to investors on the performance of each transaction. This
information would include confirmation on the production status of the goods,
the transfers of money, collateral monitoring, and delivery schedules.
Market risk
Market risk is the risk that
changes in market factors that can adversely affect the value of a transaction.
Most international fixed income bond funds are exposed to two primary types of
market risk - interest rate risk and foreign exchange risk. Interest rate risk
is primarily the risk that rising interest rates will reduce the present value
of future interest and principal payments, while foreign exchange risk is related
to the possibility that an adverse change in foreign exchange rates can reduce
the value of those payments when they are translated back into the base
currency of the fund. In the case of trade finance, it is possible to reduce
market risk exposure greatly due to the structure of many of the deals.
As trade finance is dominated
by short-maturity, floating-rate commitments, direct interest rate risk is
inherently low. The impact of changing interest is minimal given that deals are
floating rate indexed to either one month or three months.
Foreign exchange risk is
minimal as virtually all elements of the transactions invested in are
denominated in US dollars. There is no currency mismatch as the goods being
financed trade in US dollars and the buyer pays in US dollars. Interestingly,
in situations where the local currency in the borrower’s country of origin
comes under pressure, the hard currency earned by a trade transaction becomes
even more valuable. Local governments tend to make significant efforts to
insure the performance of deals which bring hard currency into their country.
Further measures that can be
applied to an investment portfolio include adopting limits on the weighted
average maturity and effective duration of the portfolio.
Liquidity risk
The primary form of liquidity
risk relating to a trade finance fund is the risk that a fund or account
managed in accordance with the strategy will not have the ability to meet
investor redemptions. There is generally little or no secondary market for structured
trade finance deals and liquidation of existing deals prior to maturity can prove
difficult and, if possible, costly.
Having said that, neither
internal (i.e. investments by other Federated funds) nor external investors in
Federated’s Project and Trade Finance investment strategy face lock-up
provisions. All investors are, however, strongly advised about the relative
illiquidity of the asset class and their investment, and internal investments are
formally defined as illiquid and are held in the investing fund’s illiquidity
allocation bucket, which typically range from 10 to 15 per cent of assets.
While these measures do not guarantee that redemption requests will not come
from either internal or external investors, they do help in ameliorating
liquidity risk.
Given the illiquid nature of
the assets, it may take an extended period of time to fund a liquidation or
redemption request. For example, it may take up to 31 days to return cash to
the investor. Trade finance assets held in the strategy’s portfolio typically make
interest and principal payments either monthly or quarterly and are
self-liquidating with an average maturity of 15 months. In addition, in the
event of extreme market stress where it is impossible to sell assets, investors
may receive investments held in the portfolio in-kind. As ever, the reality can
be somewhat more favourable, and, for example, in the 3 years that the Project
and Trade Finance investment strategy has been available to outside investors,
investors have in fact been able to receive cash with little need to sell
assets.
The second major operational
risk relevant to trade finance deals is known as structure risk.
Structure risk can be further broken down into counterparty risk, agent
risk, legal risk, payment risk and damage/loss of goods and
quality/quantity risks.
While some of these risks (e.g.
counterparty risk) might appear to be more appropriately handled under other
risk management efforts (e.g. credit risk) there are certain aspects of these
risks that should properly be considered a
form of operational risks. An example of this could be the reliability and timeliness of the
information provided by the borrower on which the risk assessment is made and the ability to gather
accurate information from the borrower to measure and manage the risk throughout the life of the
deal.
Given the importance of the
banks’ monitoring role in these transactions, an accurate assessment of
counterparty risk, from an operational risk perspective, is highly valuable.
To manage agent risk, it
is worth verifying that all the transactions have agency teams from top banks, which are also deemed to
be reliable, and have extensive and appropriate experience and resources.
Legal risk is largely handled through the use of outside counsel
and by careful selection of the controlling legal venue. For example, all deals
for Federated’s Project and Trade Finance investment strategy are governed by
ether US or UK law, which Federated feels affords an appropriate level of
creditor rights as well as a stable means of exercising those rights.
CONCLUSIONS
With a global volume estimated
at US$18 trillion in 2014, trade finance plays a critical role in international
finance and in the domestic finance of both advanced and emerging economies.
Trade finance is a significant business line for many banks and is an area of
growing interest for non-bank financial players as well. Trade finance,
critical and attractive as it is, however, is not for the unsophisticated or
faint-hearted, especially in complex structured transactions. There are many
risks faced by investors in trade finance that could seem quite daunting to the
novice in this arena.
Disclaimer: This information does not constitute legal advice and is for education purposes only. You should not rely on this opinion as an alternative to seeking legal advice.
