TRADE FINANCE AS A FINANCIAL ASSET: RISKS AND MITIGANTS FOR NON-BANK INVESTORS - by Robert Kowit, Federated Investors, Senior VP - Product Specialist

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.