Originally designed as a risk management tool among banks, trade asset distribution has now transformed into an indispensable means for capital and liquidity optimisation, inviting a broad spectrum of non-bank investors. 

With the tighter regulatory capital requirements, pressure is mounting on the books of corporate banks restricting their ability to meet trade finance needs, in particular for those who need it most: SMEs. 

As a result, trade distribution has become a must-have for banks nowadays, allowing them to free up their balance sheets, enhance credit availability and create additional capital. 

The range of benefits of the originate-and-distribute model, along with the growing interest in trade finance as an asset class from non-bank investors and the rise of the trade tech sector, are converging to create the ideal setup to help bridge the SME funding gap.

At the Trade Finance Investor Day, Andre Casterman, CEO of TFD Initiative spoke with Mark Abrams, MD, Trade and Receivables Finance at Trade Finance Global (TFG) and Nils Behling, COO and Co-founder of Tradeteq. 

The rise of trade finance assets

In the aftermath of the COVID-19 recovery, the surge in trade volumes has elevated the importance of injecting liquidity into supply chains. Nevertheless, in its latest survey, the Asian Development Bank reported an increase in the global trade finance gap, reaching an estimated $2.5 trillion last year. 

Yet, as with every challenge, this gap has given rise to an enticing market opportunity for investors, especially in an environment of heightened geopolitical uncertainties, volatile bond yields and stubborn inflation. 

As an investable asset, trade finance has several attractive features, including typically low default rates, attractive yields (compared with traditional instruments), short-term tenors, and a self-liquidating nature, all of which make the asset class tick all the boxes that investors look for.  

Abrams said, “Trade finance as an asset class represents the real economy. It is real goods such as coffee, sugar, vehicles, toys, and services being traded across borders.” Together, these factors contribute to the growing appeal of the asset class. Consequently, there has been a noticeable uptick in non-bank lending by private credit investors in the trade and commodity finance sector. 

Behling said, “Trade finance is a growing asset class. There is a lot of demand.”

Moreover, with the current macroeconomic conditions and tighter regulatory requirements, banks have been moving towards the originate-and-distribute (OTD) model. Adopting the OTD model allows them to reduce regulatory capital requirements and keep a significant portion of their lending portfolio off their balance sheets while relying on third-party, non-bank liquidity from asset managers and institutional investors. 

In addition, advancements in the technology sector have facilitated the implementation of such a model on a much wider, automated scale. 

As a result, banks are now able to involve non-bank investors in the process, thereby creating the much-needed extra capacity in the market. Abrams noted, “From a macroeconomic perspective, with inflation, the regulatory burdens and changes that are going on, there’s an increased demand for capital.”

Legitimising trade finance assets: A closer look

Representing 90% of businesses and more than 50% of global employment according to the World Bank, SMEs are undoubtedly the backbone of global trade. However, these vital economic players, encounter major barriers that restrict their full integration into the global trade ecosystem. 

One of the primary challenges faced by many SMEs is the absence of the necessary collateral, typically required by banks to mitigate the risk of SME lending. 

Furthermore, many banks may be reluctant to finance SMEs. They face the increased complexity and higher costs of onboarding due to stringent know-your-customer (KYC) and anti-money laundering (AML) checks. 

Consequently, some banks have pulled out of certain markets, exacerbating the challenge for SMEs to obtain funding and subsequently widening the SME funding gap. 

Abrams highlighted, “It’s very important to understand that there’s a relatively small number of banks that are funding into a relatively large gap.” 

This gap predominantly impacts mid-sized enterprises and SMEs, which are already struggling with global economic shifts and persistent inflation. To address this funding deficit, banks have been adopting an originate-and-distribute model for their trade portfolios, to not only enhance their net interest income but also unlock additional capacity. 

As Abrams explained, “We see a scarcity of capital, a mismatch between what a borrower and an actual corporate are looking for and what’s there from a liquidity perspective. There is interest and need for finance.” 

In response, alternative lenders are emerging as a crucial force in reducing this funding gap. They extend their financial support not only to SMEs but also to large corporations. Abrams said, “Alternative lenders are stepping into that gap, and fund SMEs as well as large corporates. They provide greater capacity, smarter and faster.” 

Despite the evident need and the growing interest, more needs to be done to truly scale and legitimise this asset class. Behling emphasised two critical requirements to enable non-bank investors to effectively bridge this funding gap: standardisation and transparency.

Currently, the lack of standardised reporting leads to tailored portfolio presentations, as different non-bank investors typically ask for different risk metrics, from solvency capital consumption to payment history. 

On the other hand, since investors rarely allocate their entire investments to a single originator, they have to deal with multiple reporting styles from different originators, preventing portfolio aggregation. The missing piece to overcome such a limitation is nothing but standardisation.

Additionally, trade assets lack transparency as trade finance data is not accessible through public domains. The present process of paper documentation in trade finance limits investors’ ability to comprehensively analyse and evaluate their portfolio structure. 

As Behling stated, “Transparency is important for investors to understand what’s happening in their portfolios.” Given that data forms the foundation of transparency, the adoption of a unified digital platform like Tradeteq ensures its accurate collection. 

Such aggregated information can then be used to generate credit analytics and risk profiles, making trade finance data not only transparent but also actionable for investors. 

He underscored, “You have to bring in technology to create this transparency and the standardisation to transform trade finance assets into an investable product.” 

Shaping the future of trade finance asset distribution

Structural changes have set the stage for institutional investors to make their mark in the trade finance industry. The scaling back of traditional bank financing, the conventional suppliers of trade finance, has opened the door to these new participants. 

Alongside trade tech companies that have brought innovation to the industry, banks have been able to bring in institutional investors and grant them access to the transactions they service. 

Nonetheless, how banks cope with the regulatory landscape, the way they collaborate with investors and trade tech companies, and the way they develop innovative solutions and market-responsive ideas will define the course of trade finance asset distribution.

Although trade finance distribution growth, in terms of non-bank investors’ participation in funding trade finance assets, has increased, several key challenges remain for its further expansion. 

First, there is limited familiarity with trade finance assets outside the trade finance community. Therefore, engaging a wider spectrum of institutional investors requires collaborative efforts in educating potential investors and standardising industry terminology and products.

In addition, as trade asset distribution continues to increase, and a wider set of investors with multiple risk profiles involved, the focus has shifted towards increasing origination calling for closer collaborations among different stakeholders. 

Abrams illustrated this shift, noting, “There is a change of mindset from banks, funders, and institutional investors to work together and partner. We’ve done it recently at Trade Finance Global on the origination side, working to originate directly from corporates all through to SMEs.”

Besides, as a unique asset class, trade finance is characterised by its distinctive features and substantial information asymmetry. 

For instance, its self-liquidating nature may entail frequent payments, and though typically short-term, the tenor can extend based on the industry and clients’ working capital. 

Therefore, the difficulty of assessing and maintaining standards may dampen investors’ appetite to participate. This broad spectrum of trade assets drives the need to develop tailored solutions, a task that primarily relies on the wider adoption of technology and enhanced interoperability. 

As Behling pointed out, “The technology is available, but the imperative now lies in driving its adoption, ensuring seamless communication between different platforms.”