Trade finance – a sustainable asset class for institutional investors?

But the ADB estimates that the global trade finance gap was $2.5trn (€2.6trn) in 2022, representing an increase of 47% from the $1.7trn gap in 2020. Clearly, COVID together with macroeconomic factors including rising geopolitical tensions and the Russian invasion of Ukraine were among the significant reasons for this. 

Another more disturbing long-term trend has been the increasing reluctance of the banking sector to get involved. This, however, says Ali Shafqat, founder and CEO of Qbera Capital, represents an opportunity for institutional investors to participate in an asset class that differs from traditional public and private debt. 

Trade finance is an asset class that not only offers attractive uncorrelated and consistent returns but is central to the UN’s 2030 targets for achieving its Sustainable Development Goals (SDGs).

Shafqat says the major global banks such as HSBC have been cutting down dramatically on their international networks that have supported global trade for many decades: “When I was in HSBC in 2007, they had a presence in 83 countries. Today they are in just 62, with another 12 on the exit list.” 

He says it has partly been down to the stronger capital requirements imposed by the Basel banking regulations and others implemented in the wake of the global financial crisis. They have made trade finance more expensive for the banking sector, which then reduced exposures particularly to mid and small-sized companies. 

There was less impact on large companies, Shafqat says, because banks were prepared to treat trade financing activities as loss leaders, enabling them to develop closer relationships to be able to target lucrative investment banking transactions. As a result, there has been a ‘flight to safety’ and a rebalancing of banks’ portfolios towards larger better-rated companies at the cost of SMEs and emerging markets.  

Shafqat says banks are still keen on financing trade. Trade finance assets have proven to generate higher returns on a risk-weighted use of capital by virtue of the opportunities they provide for earning fee income from using trade instruments such as documentary letters of credit or bonds and guarantees. 

But the costs of compliance have become so high and the penalties for failure so severe that banks are not willing to engage. Fines imposed on BNP Paribas, Standard Chartered, HSBC and others are examples. 

Opportunities for investors

Despite the growing volumes of trade, the bank finance to provide liquidity to keep trade flowing has not been able to keep up. It is an opportunity for fund managers and investors to help bridge the gap. 

“The banking sector does not appear to be able to satisfy the growing demand for the financing of international trade”

Trade finance exists because in the trading of goods there is usually a time lag between the dispatch of goods by an exporter and their receipt by the importer. As exporters usually require payment upfront while importers would prefer paying only on receipt of the goods, this gives rise to the intermediation of trade financiers. 

Trade finance reconciles the timing lags by providing short-term credit usually intermediated by third-party financial institutions that have both the security of the underlying goods, as well as additional guarantees. As a result, unlike other credit transactions, trade finance involves three parties – the exporter (seller), the importer (buyer) and the financing institution. 

Shafqat says this triangulation is one of the main reasons for the extremely low default rate compared with other forms of credit: “Neither exporters nor importers are incentivised to interrupt the transaction, as doing so would have irreversible consequences on their businesses.” 

The transactions are secured on the assets being traded, and mostly on a self-liquidating basis. Each transaction is unique and finances a specific flow or transformation of goods or services, not the borrower’s general operations, and the debt also ranks senior in the borrower’s capital structure. Interest-rate risk is limited, given the floating nature and short duration while FX risk is limited given that most natural resource trade is in US dollars. 

This ability to influence outcomes makes trade finance particularly attractive for impact and ESG investors, especially where trade has proved to be an engine for development and poverty-reduction by boosting growth. 

China has been the poster child of trade finance. Its success in lifting hundreds of millions out of poverty through developing an export-led economy illustrates the potential for other emerging markets. Shafqat argues that the integration of emerging markets into the multilateral trading system helps their long-term growth prospects by providing them with access to new markets, technologies and investment, leading to sustainable development. 

Given the crucial role of trade finance in development, it is not surprising that trade finance funds have a focus on ensuring ESG criteria are incorporated into their own decision-making. All Qbera’s deals  have to pass an ESG hurdle to be eligible for funding, in addition to measuring its impact potential, and each borrower undergoes annual ESG analysis. 

Despite setbacks in globalisation, international trade should continue to grow. The ADB’s survey found that companies identified access to financing as a major challenge to trade. Of the banks surveyed, 80% view sustainable finance as an opportunity and “anticipate a surge in demand for related products and advisory services”. 

The banks blame a lack of harmonised standards and data collection along with reporting mechanisms to demonstrate compliance as the reasons that progress in sustainability has been impeded.  

Strong demand

However, the reality is that the banking sector does not appear to be able to satisfy the growing demand for the financing of international trade. The fact that structures can be complex, involving a significant amount of documentation, legal review and ongoing monitoring and management, does not make it easy for banks and investment managers. 

The capacity for firms in this space may be a few hundred million dollars at most but trends towards digitisation, standards harmonisation, and enhanced data reporting will make it easier for investors and banks to gain exposure. For SMEs globally, and those in emerging markets in particular, and for investors focused on impact, that is a development that will be welcomed. 

_{* ADB Briefs No. 256: 2023 Trade Finance Gaps, Growth and Jobs Survey}

Joseph Mariathasan is a contributing editor to IPE, a partner of Peak Sustainability Ventures and a director of GIST Impact