The Evolving Landscape of Trade Finance Due Diligence

The past decade has redefined the finance industry –  not least due to the steady stream of regulatory and compliance measures introduced in the aftermath of the global financial crisis. And while, in practice, such measures promise a fairer and more secure global economy, the path to ensuring proper practice has become mired in complexity. When it comes to trade finance, this rings even truer: with the eruption of non-bank, alternative financiers – coupled with intricate and convoluted supply chains – adding to the concerns for trade financiers. The result: a rise in demand for specialist due diligence providers.

While banks previously dominated the lending space, the industry has been rapidly evolving to include a plethora of non-bank financiers. They are welcome providers, offering many borrowers more flexible options. In part, they are a response to the introduction of regulations such as Basel III, which have imposed harsh liquidity constraints on banks – forcing them to scale back on lending. This is particularly true with regards to trade finance, which typically carriers higher risk and offers lower profit margins.

Of course, these alternative lenders provide a much needed injection of liquidity. Yet, when it comes to diligence, their size dictates that – in the majority of cases – they do not possess the in-house infrastructure required to undertake the necessary checks. Checks, what’s more, that are notably more complex when it comes to trade finance. Indeed, unlike working capital loans, trade finance deals are dependent on deal structure – perhaps capturing receivable flows operating under various contracts. They also often include more complex security, which can involve highly-specialised collateral or assets.

Coupled with the length and complexity of trade finance supply chains, it’s clear the internal infrastructure necessary to undertake such a process is not financially viable as an in-house solution. Instead, there is a growing appetite for outsourcing due diligence to specialists. And it’s not just non-bank lenders behind this trend. Banks are also increasingly looking to outsource their due diligence, not least due to the threat posed by increasing regulatory requirements – and the severity of the punishment that comes with non-compliance.

Growing obstacles

The hurdles are not small. At the top of a growing list of priorities, know-your-client (KYC) and know your client’s client (KYCC) legislation has been introduced to make sure that, not only are potential clients operating legally, with legitimate sources of funding, but that their clients are too. A large part of this is to comply with anti-money-laundering (AML) regulation that ensures illegal money is not entering a business’s supply chain – even indirectly. Given the breadth and complexity of trade finance supply chains, due diligence here must take an approach more affiliated with detective work – using expert individuals that possess the intuition to investigate the necessary avenues.

Another key concern for businesses are the US Office of Foreign Assets Control’s (OFAC) economic and trade sanctions. These dictate that anybody in the US, or doing business with or within the USA, must not financially interact with any sanctioned country or person, under any circumstances. Given America’s status as a global financial powerhouse, this has in effect become an international standard with steep penalties for non-compliance. Indeed, one need look no further than BNP Paribas’ record fine of US$8.9 billion in 2014 to be concerned that this is a sanctions regime with teeth.

Counter-Terrorist Financing (CTF) regulation also requires expertise to navigate. Along with the obvious counterparty risk, the issue of “dual-use” goods must be taken into consideration. The list of items that can be categorised as such is extensive and includes otherwise benign products such as vehicles, which could potentially be used to facilitate the transportation of machine guns or other armaments. To detect the potential for such a breach is often a delicate task and requires the proficiency of individuals with a thorough understanding of the licensing requirements that might permit such a transaction.

Options available

While trade finance participants must now spend an increasing amount of time and money on compliance, artificial intelligence is presenting tempting, time-efficient options to automate the process. Favoured by many banks and large corporates, technology such as “World Check” promises to streamline the due diligence process. Of course, such automation is useful in flagging any obvious discrepancies – or in transactions involving limited counterparties. Yet, when it comes to the increasing complexity of trade finance transactions, this technology is simply not sophisticated enough.

Indeed, due diligence is not just a simple case of checking whether a company or its counterparties adhere to regulations. Accessing this information in the first place poses a significant obstacle. In the US, for instance, only publicly traded corporations are obliged to file their accounts in the public domain. In the remainder of cases, due diligence professionals must rely on co-operation from businesses when sourcing information. What’s more, clients and counterparties operating in developing economies often do not have measures in place to ensure records are properly kept, or do not have the infrastructure – such as internet access – to store easily-accessible digital data. In order to properly investigate, it is often necessary to have someone on the ground with the resources and relationships needed to source the required information.

Certainly, the nature of trade finance deals means there are a vast range of counterparties involved in any one deal, as well as highly detailed security and repayment structures. As such, outsourcing due diligence to specialists capable of assessing risk in the right level of detail is becoming an increasingly popular – and necessary – option.

Companies such as RedRidge Diligence Services provide a highly-specialised service – assessing the scope of investigation required in a given case and carrying out the necessary auditory and field exams based on this assessment. RedRidge’s protocol is to test at least 10 completed trades with proposed counterparties to ensure the cash is followed “from cradle to grave”. Bills of lading, quality certificates, certificates of origin and packing lists are all analysed, along with the contracts themselves and the outcome of the trade.

Such assessments go far beyond standard desk-based checks. The ability to conduct investigations globally – placing officers on the ground where necessary – is invaluable when it comes to undertaking bespoke, thorough, inspections. The data extracted then provides a firm basis on which to screen a deal for fraudulent activity – as well as the means to assess the creditworthiness and profitability of a proposed deal.

Looking into the future, the onslaught of regulation does not look set to slow down, and will continue to play a central role in ensuring only competent players are allowed to participate in the sector – while stemming any criminal activity. Yet with punishment for non-compliance ranging from eye-watering fines to the prosecution of individuals, making sure due diligence is entrusted to experts with the right toolset is increasingly the key to mitigating risk and ensuring a business stays on top of regulatory developments.

About RedRidge

RedRidge Diligence Services performs financial due diligence for funds, banking institutions, and privately held and publicly-traded companies. Due diligence offerings include: M&A advisory, lender services, specialty finance and business valuations. Utilizing decades of financial due diligence experience, RedRidge takes a unique and efficient approach to client services. The RedRidge advantage is driven by an issues-based focus and an exceptionally qualified team dedicated to meeting client expectations and deadlines.