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Investing in trade finance can pay off and help SMEs thrive

  • The trade finance gap has reached $1.7 trillion and small and medium-sized enterprises (SMEs) are disproportionately affected.
  • New technologies can enable the transformation of trade finance assets into profitable capital market products.
  • A multi-stakeholder approach is needed to ensure that SMEs have better access to affordable trade finance.

Trade is the backbone of any economy and 80-90% of global trade requires finance. Small and medium-sized enterprises (SMEs) account for around 90% of businesses and more than half of jobs worldwide, according to the World Bank. It is often these SMEs that are underserved and lack access to affordable business financing.

The Asian Development Bank has found that SMEs are disproportionately affected by the $1.7 trillion trade finance gap – the difference between the number of applications for financing business participation in international operations and the number of approvals. SMEs represent 40% of these rejections, much more than their share of applications.

The main problem is that banks are not able to provide all the financing needed by businesses. Banking regulations make it expensive for them to lend to businesses. The new rules, known as “Basel IV”, further exacerbate this trend. Banks are therefore increasingly interested in moving from a “buy-and-hold” strategy to an “originate-and-distribute” model. An increase in bank balance sheet turnover allows for greater margin income which can then offset the increased cost of capital.

Institutional investors, on the other hand, seek returns above comparable benchmarks. The good news is that trade finance can be such an asset class. Indeed, investors have been interested in accessing the asset class for some time as it regularly yields above the level of return commensurate with risk.

Expanding access to trade finance

Trade finance therefore has all the components that investors are looking for. It is a multi-trillion dollar asset class based on the flow of physical goods and services, which makes it less susceptible to financial market volatility. Default rates for trade finance products are generally lower and recovery time from default tends to be shorter than for other credit products.

But why is trade finance the only asset class that is not distributed from bank balance sheets? Institutional investors have had access to repackaged mortgages, credit cards, car loans and student debt for decades, yet even today trade finance distribution volumes are still very low.

COVID-19 has shocked global markets already strained by trade tensions. With trade and investment changing rapidly, businesses and governments need to put in place strategies for open and resilient markets.

The World Economic Forum’s platform for shaping the future of trade and investment informs business and political action for dynamic, inclusive and sustainable trade and investment that drive growth and Development. It aims to facilitate the movement of goods, services and investments, to ensure open and stable trade, to support sustainable and fair value chains and to develop cross-border digital activities.

Contact us for more information on how to get involved.

Until now, the lack of digitization and automation has made any distribution effort too costly for this low-risk, low-return asset class. The opportunity was therefore largely untapped due to high costs. Operational costs are particularly high due to the granularity of assets and the short duration of instruments. Participation in capital markets was further limited due to the need to repackage portfolio risk and extensive reporting requirements. Digitization, workflow automation and programmatic repackaging can now reduce these frictional costs and provide efficient access to trade finance.

While higher net interest income (NII) for banks and access to a new asset class attractive to institutional investors are key objectives, the ultimate beneficiaries will be SMEs through more affordable liquidity . Here is what is needed to make it possible.

1. Improve technology literacy and collaboration

New technologies are revolutionizing trade and this is particularly true in the area of ​​trade finance. The infrastructure now exists to enable straight through end-to-end processing of hundreds of thousands of instruments at a lower cost. This gives asset managers direct access to trade finance assets, allowing alternative investors to channel more capital to the market.

Blockchain-based security token offerings (STOs) can provide an effective alternative to repackaging revolving trade finance pools into notes issued by special purpose entities (SPEs). Smart contracts allow any trading pair to settle for tokens while eliminating any counterparty risk. Tokens also facilitate fractional ownership and therefore can really democratize access to trade finance.

The first of these transactions was successfully concluded with the Tradeteq distribution technology and the blockchain platform provided by the XDC network. This breakthrough taps into investors’ appetite for investing in tokenized assets, including those tied to SME operations. It aggregates receivables and provides asset managers with a fast and secure way to track related business transactions. As a result, SMEs with commercial instruments linked to these funds will have access to the capital they need to fund routine activities much faster than they traditionally would.

A crucial form of collaboration to make this innovation flourish is that between asset managers and the developers of these new technologies. Many asset managers still rely on traditional investment pools and, due to the lack of awareness of new innovations, might miss the opportunity to invest in this new asset class.

A first step in bridging this gap is to foster interprofessional dialogue. The TFD initiative, for example, brings together communities of professional and institutional investors to discuss the challenges and opportunities of the distribution market. Such collaborations are essential going forward, helping to increase education, trust and reach among more members in both communities.

2. Avoid regulatory uncertainty through border regulation

The flow of money for this asset class based on the real economy would also benefit enormously from further regulatory developments. A joint report by the World Economic Forum and the World Trade Organization found that global legal recognition of electronic transactions and documents is a key driver for the adoption of trade technologies.

The report shows that there is no standard definition of what a token is and that differences in regulations can create uncertainty. Future regulations should clearly distinguish between unregulated utility tokens and regulated security token offerings or stablecoin offerings. Security token offerings will only take off if the tokens can be traded on regulated exchanges. Draft legislation is available for some markets, but more clarity and harmonization is needed.

The development of any new regulations would benefit from public-private cooperation. In particular, the private sector could help regulators understand the opportunities and challenges of these advanced technologies and ensure that new regulations make the most of the opportunities that come with them.

3. Make sure trade finance is targeted at ESG activities

Investors are increasingly looking to make their portfolios compatible and supportive of environmental, social and corporate governance (ESG) commitments. Even narrower definitions of ESG funds show that they are now around $2 trillion and the value continues to grow rapidly. This trend, alongside new regulations on ESG disclosure, encourages trade finance related funds to ensure that the underlying trade instruments financed are linked to green and socially responsible activities.

First attempts have been made. Incomlend Capital, for example, has launched an ESG invoice funding program that aims to raise $500 million. As these attempts are at an early stage, further public-private work is needed to connect the trade finance community with ESG industry experts and regulators.

New technologies, with capital market infrastructure and tokenization as good examples, match investors’ thirst for safe and reliable asset classes with the needs of SMEs and their desire to join international markets. Through collaboration, technical innovation and consideration of societal and environmental aspects, investors can play a more active role in trade finance, not only to build a profitable portfolio of assets, but also to contribute directly to closing the trade finance gap and enabling future economic growth.

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