Trade Finance
An asset class positioned to rise in the New World?
None of us could have anticipated what 2020 had in store.
A combination of a global pandemic, social unrest due to racial discrimination, oil market crash and protests across the world against autocratic regimes all happening in the space of 8 or so months is unprecedented. Of course, all of these events have a severe impact on the global economy and financial markets.
Investors and consumers alike got worried about the prospects of prolonged recession and sloppy recovery after some of the largest GDP contractions on record that followed the lockdowns. As a result, governments across the world have released extraordinary levels of stimulus programmes both in ‘money printing terms’ and reductions in interest rates to almost negative territory. This level of spending by governments sets a new record and dwarfs what happened in 2008 or any other recession in contemporary history.
If we look at the US as an example since they are the biggest spender and compare the numbers — results are staggering:
- At the peak of the 2008 crisis, FED was pouring $30BN per month
- At the peak of the 2020 COVID-19 crisis, FED was pouring $75BN per DAY
The result is well illustrated by the staggering growth of FED’s balance sheet that has surpassed $7 trillion in assets at the time of writing and is shown on the chart below
This had led to yields on publicly traded fixed income instruments including bonds shrinking drastically, a spike in inflation that for now went into stock prices with the ‘Buffet Indicator’ reaching bubble territory at 188% and a start of dollar devaluation. At the same time, the economic data has not been particularly encouraging, and a V-shape recovery looks very unlikely. The fact is further confirmed by the IMF’s announcement, stating that this to be the worst economic crisis since the 1930s, with only a ‘partial recovery’ forecasted for 2021.
The real effects of this monetary experiment, though, will be seen over the next few years. If you want to be well-positioned to respond, I suggest reading Ray Dalio’s fundamental work: Principles For Navigating Big Debt Crises. This creates a challenging environment for investors that are searching for alternative asset classes that can act as a hedge and offer a reliable yield.
Are there any viable alternatives?
Luckily, the answer is yes — Trade Finance and more specifically, Supply Chain Finance (SCF).
Trade Finance is the oldest type of financing; as old as commerce itself. It’s been a core activity and the main source of growth for a lot of banks across history, including a well-known Medici bank in Renaissance Italy. In its most basic form, it is when a financier provides capital linked to a specific trade transaction instead of the general credit of the borrower. According to the World Trade Organisation, an estimated 90% of world trade is related to some form of financing, keeping the goods moving across borders and fuelling our modern economy.
From an investment perspective, Trade Finance is an alternative fixed-income asset class with consistent returns, low volatility, and limited correlation against the broader financial market.
Performance
To assess the performance of the asset class, we will review ‘Eurekahedge Trade Finance Hedge Fund Index’ comprising 41 active funds that focus on trade finance strategies. The index returned 6.70% throughout 2018, despite the escalating trade tension around the world and particularly between the US and China. Trade finance funds in the index returned 5.34% in 2019 and were up 0.82% over the first five months of 2020.
The chart below depicts the performance of the index against comparables such as fixed income hedge fund managers, global investment-grade bond and the US high-yield bond markets.
As can be seen from the graph above, trade finance funds have managed to generate an average return of 6.82% per annum, outperforming both their fixed-income counterparts and the global investment-grade bonds which returned 5.43% and 2.58% per annum respectively since the end of 2009. The high-yield bond markets generated a marginally lower annualised return of 6.58% over the same period while showing significantly higher volatility. Full figures are available here.
The exceptional risk-adjusted returns shown by Trade Finance as an asset class were mostly due to (1) low default rates characterising the asset class, (2) minimal volatility due to its short-term nature and (3) limited correlation to other assets.
Recession-proof asset class
Trade Finance has been deemed a ‘recession-proof’ asset class by S&P Global. The rating agency cited the 2017 report by Greenwich Associates, a market intelligence company, which found that even during the worst of the financial crisis, the asset class did not post a single month of negative returns.
Data from Eurekahedge Trade Finance Hedge Fund Index further confirms this notion by showing that over the last five-year period ending May 2020 Trade Finance funds posted a maximum drawdown of 0.31%, providing excellent downside protection during this time of uncertainty.
- 2019 Trade Finance Report of International Chamber of Commerce, a global body supporting cross-border trade, shows that Trade Finance products continue to exhibit low global default rates. With a particular emphasis in the report being placed on Supply Chain Finance (SCF) that has become the hot topic within Trade Finance. SCF shows the lowest global default rates outside Letters of Credit, with only 0.11% in 2017 and 0.13% in 2018.
- The key reason why Trade Finance shows low volatility is that transactions are asset-backed and have a self-liquidating nature. The capital injection’s purpose is to either release trapped working capital from the supply chain or to allow the generation of additional income from trading activities. In either case, created working capital is sufficient to pay back the loan, making it a very sustainable type of financing for the business and ensuring the resilience of exposure for the lender. Furthermore, the short lifecycle of the financing (generally between 60 and 120 days) allows the lender to manage their exposure well through consistent monitoring. It also, however, requires a lot of operational work from the lender to generate enough assets to deploy capital consistently. The solution to that issue is SCF, which provides additional benefits. Since it is structured as a revolving facility to finance recurring trade between a buyer and their suppliers, it maintains the benefits that come with the short-term nature of the underlying assets (invoices), while reducing workload and cost as the facility once set-up can operate for several years.
- Finally, Trade Finance has minimal correlation to the traditional markets. Its instruments are not publicly traded and are minimally impacted by central bank interest rate policy due to their short-term nature. The underlying assets are well-diversified since you can have a hardware distribution deal between UAE and Africa and a grain transaction between CIS and the UK within the same portfolio.
The lack of correlation can be seen from the data in the table below, which shows that the Eurekahedge Trade Finance Hedge Fund Index has correlation values below 0.4 with all of the three other aforementioned indices.
Market shift
Trade Finance is an industry that has historically been dominated by large global banks, which have mainly been withdrawing from the space or decreasing their allocations since 2008 due to increases in capital requirements introduced with BASEL III and their increased operational overheads. This has resulted in a $1.5 trillion funding gap in the sector, according to Asian Development Bank, and was projected by the World Economic Forum to reach $2.5 trillion by 2025. We can rest assured that COVID has significantly accelerated that trend creating enormous demand for this type of financing, especially from companies in Emerging Markets that represent over 60% of the gap and from SMEs & Midcaps that account for 74%. A lot of these companies have good credit profiles for companies of their sizes. Still, they are mostly rejected due to the time and cost associated with the need to perform specialist structuring, AML checks and risk assessment required to execute the transactions. The brutal truth is that for most banks unless the deal size is immense, it is simply not economically viable or attractive.
As a result, there has been an influx of alternative capital in the sector looking to fill in the gap. The consistent and uncorrelated returns offered by trade finance strategies and unparalleled unmet demand is driving the growth of Alternative Lenders in the sector such as trade finance funds, institutional investors and other private sources of capital.
Yet, several key challenges remain for investors and fund managers looking to invest in trade finance, including origination, the difficulty of performing due diligence, lack of standardisation and high operational costs. There also needs to be significantly more education around the asset class for institutional investors seeking participation.
Technology and digitalisation are the way forward for the industry. Yet, to address the above issues, the technology must be coupled with an understanding of current shortcomings and a new approach catered towards the changing needs of both clients and funders.
Finverity is a cross-border supply chain finance platform for mid-market with a focus on emerging markets whose mission is to close the funding gap in global Trade Finance by using technology to make the financing of mid-market companies economically viable worldwide.
The platform connects companies in need of working capital optimisation and institutional investors seeking access to this alternative asset class with limited correlation to markets and reliable yield. By using technology to automate most of the expensive ‘back-office’ tasks and specialist knowledge of the team to assess, structure and standardise transactions, they are opening up access to the asset class to a broader pool of investors. Finverity is offering a scalable, efficient and reliable way to participate in the asset class.
At a time when we are reconsidering our lives and are looking to adapt to the ‘new normal’ might it be the time to also reconsider our investment choices and diversify the portfolio to include an asset class that has proven itself in times of uncertainty?
