The Trade Finance Gap Explained
Part 2 — The Gap and a Novel Solution
The trade finance gap is often mentioned as a barrier to global trade growth. But what is the gap, and how did it come to be a significant barometer in international commerce? Looking forward, how will the gap be closed? In this two-part series, we will explore the history of global trade, its current state, and the solution that may close the gap and broaden the opportunities for both investors and traders.
Recap
In part one, we explored a history of global trade to gain a perspective on its current state. Since 1950, trade volumes have increased from US $62 billion to as much as $19.4 trillion in 2018 before dipping to $17.5 trillion in 2020 during COVID-19 lockdowns. Like trade itself, trade finance dates back over two millennia and provides opportunities for working capital for both buyers and sellers. It is commonly estimated that 80% of global trade involves some form of trade finance.
The Importance of Trade Finance
For hundreds of years, banks have filled the void of shipping time in transit through trade finance. During critical times, trade finance may decline as it did during COVID-19, particularly in developing countries and with small to medium-sized enterprises (SMEs). However, the demand for finance only rose in the last couple of years amidst the pressures of the pandemic.
Trade finance has grown to represent a significant portion of trade volumes, estimated at around 80%. It is a low-risk source of funding and sees over US $10 trillion in annual flows (WEF, 2020). It is easy to conclude that international commerce would become hobbled without the intricate support of this financial system. Yet, a large portion of businesses, the SMEs, do not have access to it.
What is the Secondary Market?
Through its monetary policies, a country’s central bank places limitations on how much capital a commercial bank may lend out. The standard formula historically dictated that a bank may lend the amount of deposits it has on its balance sheet minus a certain amount held aside in cash reserves, which typically ranges from 0–10% in the US. The actual lending formula is more complex and includes factors such as a bank’s portfolio risk, number of transactions, and its overall health. Simply stated, there are limits to how much in loans outstanding a bank can have at any time.
Because of these limitations, banks have developed corresponding and partner bank relationships throughout the years. In trade finance, an issuing bank typically works with the buyer in a trade deal to issue a financial instrument, such as a Letter of Credit (L/C) or bank guarantee, that will provide assurances (with recourse or without recourse) to the seller. As the issuing bank accumulates a certain volume of these instruments, they may look to off-load them from their balance sheet as they creep toward their lending thresholds.
Money loaned out is considered an asset on a bank’s balance sheet. They may sell a package of these assets to a secondary bank or institutional investor to lower the amount of loans carried on their balance sheet. This is a common practice in many areas of bank lending and creates a vibrant secondary market of investment possibilities. In turn, the bank frees up its own capital in order to lend out more again.
Trade finance is low risk, in general, and therefore attractive to secondary market investors. It is typically a short-term arrangement that self-liquidates. If one deal goes bad, the bank can isolate it quickly and control losses. Average default rates from 2008 to 2018 were low across all products and regions (ICC, 2020):
The Trade Finance Gap
As banks have well-established lending patterns with their clients, there are capital needs that go unmet in the trade finance sector.
The trade finance gap happens when there is more demand for capital than there is capital available.
The gap represents the difference, and it ballooned to US $1.5 trillion in 2019. The trade finance gap is now estimated to be at least $3.4 trillion due to negative trade impacts from COVID-19 (ICC).
Those most affected by the gap are SMEs and micro businesses, particularly those in developing countries. Banks rejected more than 40% of trade finance applications from SMEs. Women-owned businesses faced additional challenges as well (Standard Chartered, 2020).
Several factors contribute to these rejections, including SMEs lacking collateral requirements, creditworthiness, and knowledge about trade finance. Other risk factors, like political and currency risks, also contribute to the trade finance gap. Yet, one of the biggest challenges lies with the banks themselves and their lack of resources to extend credit to and audit solvent and viable SMEs.
Thus, the trade finance gap remains a serious situation. It is one of the top three export obstacles for half of the world’s countries. Traders generally abandon transactions if rejected for trade finance, and the WTO is working to address the problem of trade finance shortages.
To put this in a different perspective, the world economy would not function properly without SMEs. That their access to working capital is diminished in favor of larger corporations, who are sometimes competitors, is a significant concern for world markets. The widening trend of the trade finance gap is one major indicator that should be given close attention and resources.
Fintech to the Rescue?
As mentioned previously, trade finance creditors and financiers understand the need to implement technological strategies to better service the needs of SMEs, especially those in developing countries. In doing so, the trade finance gap should begin to close. However, the 2019 ADB report indicated that, while 86% of the banks surveyed understand the importance of this, there is little evidence of progress being made. How long will SMEs have to wait?
Fortunately, the wheels are turning on digitization of trade finance negotiable instruments such as electronic signatures, documents, and contracts. Highly specialized fintechs have become the innovation catalysts for many financial institutions who want to become early adopters.
Trade and trade finance are ancient industries. Their modern versions are often loaded with legacy systems that have been in existence for some time, are massive and restrictive to their singular use case. Fintechs work to bridge these systems with the new technology that beckons a new level of interoperability.
André Casterman is the Founder and Managing Director of Casterman Advisory, which he founded in 2016. His expertise in global trade finance extends beyond his 25 years with SWIFT prior to that, and he maintains advisory roles with prominent international trade agencies while working to promote digital innovations in the financial sector.
In a February, 2021 article titled, Mapping technology innovations to trade originators’ priorities, Mr. Casterman notes the major market transformations that fintechs are making in the emergence of digital assets and tokenization, among other areas.
Necessary for innovative achievements, he specifically cites the regulatory and electronic transactions progress achieved in India, Singapore, AbuDhabi, the UK and the EU.
By adopting fintech solutions . . . trade originators are actually upgrading their existing front-to back-office capabilities with new value and with limited impact and cost.
— André Casterman, Founder and Managing Director of Casterman Advisory
Mr. Casterman continues to advocate for fintech solutions that propel trade finance options beyond their current reach.
A Novel Solution
What if the secondary market could have easier access to the trade finance asset class through innovative TradeFi solutions and still maintain its low risk profile?
Tradeteq is a technology provider for trade finance asset distribution. Based in London and Singapore, their core business focuses on the secondary market — from originators to institutional investors. Tradeteq was founded in 2016, and through advanced technology and automation, they seek to reduce transaction costs in commercial credit and trade finance, thereby expanding opportunities for more to participate.
When more institutional investors are able to buy trade asset packages on the secondary market, the trade finance gap will shrink.
XinFin Fintech launched the XDC Network’s mainnet in 2019 as a Layer 1 blockchain network built for speed, scalability, and trust — features that are ripe for an industry looking to automate and grow, such as the trade finance secondary market. The network’s architecture provides for business and financial applications to benefit from a private, trusted blockchain state, and at the same time, benefit from permanently recording a transaction’s open data on the public distributed ledger.
Blockchain automation is still a new, unearthed concept in most business markets. When a novel use case is discovered, enthusiasm abounds amongst developers and stakeholders.
Trade finance asset distribution will not seem like a thrilling prospect to most people. Yet, most are directly impacted by the trade finance gap. If the small business that procures and sells hard-to-find minerals from somewhere in Asia cannot get access to financing their exports, the lost opportunity affects them directly, but also other businesses in the supply chain and ultimately consumers down the line.
Tradeteq saw a way to incorporate blockchain’s distributed ledger technology into its tech stack and explore innovative solutions for trade finance asset distribution. In doing so, a broader secondary market would be given access to this asset class. As a result of that, more capital would become available for SMEs and others left out of traditional trade finance offerings.
How could this work?
Tradeteq repacked with Dublin-headquartered invoice finance company Accelerated Payments as the asset originator, trade finance assets into non-fungible tokens (NFT’s). Investors can buy and sell these tokens, that represent the value of the off-chain pool of trade finance assets. The owners of those NFTs hold the legal entitlement to the pool of repackaged underlying trade finance assets.
In September, 2021, the NFT was deployed on the XDC Network. The network is inexpensive to transact on, especially when compared to Ethereum’s prohibitively high gas fees, and offers compliance with ISO 20022 financial messaging standards. ISO 20022 is a common language for payment transactions worldwide. It is the message that accompanies a cross-border transfer of funds and provides the receiving institution with the payment details.
By complying with this standard, the XDC Network is already well-positioned for SWIFT’s adoption of the new payment messaging standard coming in November, 2022. In its current state, Ethereum is not capable of carrying the ISO 20022 payload due the protocol’s transaction finality and prohibitively high gas fees. There are only a handful of other blockchain networks that can, at this point. This gives an enormous edge to the XDC Network for utilization by financial institutions and others working in that periphery.
Conclusion
The successful packaging of trade finance assets, deployed as an NFT on the XDC Network, heralds a new era in international trade and TradeFi, in general. It is a giant step towards shrinking the trade finance gap and making capital available to businesses of all sizes around the globe as brand new investor groups now have access to low-risk assets.
There must be more done to address the ever-widening trade finance gap. Creative technologies will likely offer solutions, such as creating NFTs to package assets and make them available to a broader secondary market. While the steps to achieve this were complex, given the nature of trade finance, the execution on the XDC Network was seamless.
— Christoph Gugelmann, Co-Founder and CEO of Tradeteq
The standard has been set for the tokenization of fixed assets, whether from trade finance or some other financial asset class. If these transactions become mainstream in the coming months and years, other innovative TradeFi concepts may emerge and broaden the reach that blockchain technology brings to enterprise applications. In the process, SMEs should see improved access to trade finance opportunities, thus shrinking the trade finance gap.
The content above represents my own individual perspective as an XDC community member and does not reflect the official stance of XDC Foundation.
References
Asian Development Bank. September, 2019. 2019 Trade Finance Gaps, Growth, and Jobs Survey. ADB Briefs. Accessed from https://www.adb.org/sites/default/files/publication/521096/adb-brief-113-2019-trade-finance-survey.pdf.
Casterman, A. February 24, 2021. Mapping technology innovations to trade originators’ priorities. Casterman Advisory. Accessed from https://www.linkedin.com/pulse/mapping-technology-innovations-trade-originators-andré-casterman.
ICC. June 5, 2020. ICC Trade Register Report reveals potential impact of COVID-19 on trade. International Chamber of Commerce. Accessed from https://iccwbo.org/media-wall/news-speeches/icc-trade-register-report-reveals-potential-impact-of-covid-19-on-trade.
IFC. November, 2020. Why Trade Finance Matters — Especially Now. International Finance Corporation, World Bank Group. Accessed from https://www.ifc.org/wps/wcm/connect/be423213-dd33-418f-b41a-09882f529cff/Trade-Finance-matters-COVID-19.pdf?MOD=AJPERES&CVID=nnxGNyA.
Standard Chartered. August 28, 2020. Global trade faces a USD 3.4 trillion financing gap. Standard Chartered. Accessed from https://www.sc.com/en/feature/global-trade-now-faces-a-us3-4-trillion-financing-gap.
World Economic Forum. February 10, 2020. Why exporters need to mind the trade finance gap. World Economic Forum. Accessed from https://www.weforum.org/agenda/2020/02/exporters-mind-trade-finance-gap.
International Trade Organizations and Initiatives
The following organizations are at the forefront of the efforts to safely and legally digitize international trade. They all promote collaboration and cooperation in this pursuit.
International Trade & Forfaiting Initiative. The ITFA was established in 1999 as a membership association for banks, financial institutions, and service providers engaged in trade asset origination and distribution. Mitigating risks through profitable and safe supply chain financing remain at the core of this organization.
Digital Negotiable Instruments Initiative. The ITFA established the DNI Initiative in 2020 to promote the digitization of bills of exchange and promissory notes. This would be achieved by combining advanced document technology and distributed ledger technology (DLT), improving the contract process, and lobbying governments when necessary.
Trade Finance Distribution Initiative. The member-driven TFD Initiative recognizes the need for connecting trade with capital — improving access to the trade finance asset class for institutional investors and helping banks achieve more asset distribution options. TFDI promotes a technology-focused platform for banks and non-bank financial institutions (NBFIs) to collaborate on broadening and improving the trade asset investment class and making it available to investors through standardization and automation.
United Nations Commission on International Trade Law. UNCITRAL is an international effort to promote harmony and modernization of international trade law, including cross-border legal frameworks. UNCITRAL works with inter-governmental and non-governmental agencies and is structured to represent the different legal and economic situations throughout the world.
Model Law on Electronic Transferable Records. Adopted by UNCITRAL in 2017 to foster a paperless trade environment, MLETR promotes the legal use of electronic records for domestic and international trade. These records would replace paper-based transferable documents, including bills of lading, bills of exchange, promissory notes, and warehouse receipts.
United Nations Conference on Trade and Development. UNCTAD was established by the U.N.in 1964 as a permanent intergovernmental body to promote and support developing countries to benefit from trade, investment, finance and technology. UNCTAD provides analysis and technical assistance while promoting consensus-building to achieve these goals.
