Interest in trade and supply chain finance (SCF) as an asset class has been growing in recent years. Viacheslav Oganezov CEO of Finverity, a cross-border supply chain finance platform for mid-market and alternative lenders, explains why.
A low yield environment pushing yield-seeking investors into alternatives and an increasing need for this type of financing among corporates globally has been driving this trend.
The partial withdrawal of large banks from this sector since 2008, as a result of the Basel III increase in capital requirements and the increasing complexity of operations, has nevertheless resulted in a US$1.5trn trade finance gap arising. A number of alternative lenders have stepped into this sector where yields are significantly more attractive than those offered by mainstream fixed income products. From an investment perspective, trade and SCF is an alternative fixed-income asset class providing consistent returns, low volatility, and limited correlation against the broader financial market, making it an attractive proposition, especially in the current environment.
The question of how to invest in this asset class has come to the forefront of lenders’ attention worldwide in the wake of the Greensill debacle and ongoing investor education and engagement will have a vital role to play. In this regard, S&P cited a 2017 Greenwich Associated report surveying 56 key decision-makers at European institutional lenders, which found that only about one in 10 had a solid understanding of how secured and unsecured trade finance investments work. Given this, the potential for misunderstanding and abuse to arise must be clearly understood by lenders who are new to the asset class.
SCF is a sub-product within the trade finance umbrella and is nothing new per se. The financing of payables is a centuries-old practice, whereby a corporate buyer partners up with a lender and/or technology provider to offer early payment to its suppliers in exchange for a discount. This provides both the supplier and buyer with improved working capital. What is much newer is making SCF more widely accessible to non-bank lenders, a group that has been growing in the last ten years, and offering it to mid-market companies that represent the largest portion of healthy credit profiles within the gap. Both of these are only feasible with the help of technology.
The COVID-19 pandemic has significantly widened that gap, creating enormous demand for this type of financing, especially from companies in emerging markets that represent over 60% of the gap and from SMEs and midcaps that account for 74%. Many of these companies have good credit profiles for companies of their size. Nevertheless, they are mostly rejected by banks due to the time and cost associated with performing KYC/AML checks and risk assessment required to execute the transactions. The brutal truth is that for most banks, unless the deal size is large, it is simply not economically viable or attractive.
As SCF is not a publicly traded asset class, a useful proxy to gauge performance is the Eurekahedge Trade Finance Hedge Fund Index, comprising 41 active funds focusing on trade finance strategies. The index returned 6.70% throughout 2018, despite the escalating trade tensions around the world, 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 bonds and the US high yield bond markets.
As seen from the graph above, trade finance funds generated 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 a 2017 report by Greenwich Associates, 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 the 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 a time of uncertainty.
Low rates of default
The 2019 Trade Finance Report by the International Chamber of Commerce (ICC), a global body supporting cross-border trade, shows that trade finance products exhibit low global default rates, with a particular emphasis in the report being placed on supply chain finance, which shows the lowest global default rates outside Letters of Credit, at only 0.11% in 2017 and 0.13% in 2018.
The key reason trade finance shows low volatility is that transactions are asset-backed and have a self-liquidating nature. Trade finance and supply chain finance have 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 and the underlying assets are well-diversified. For example, it is possible to hold a hardware distribution deal between the UAE and Africa and a grain transaction between CIS and the UK within the same portfolio.
Minimal correlation to traditional markets
The low correlation can be seen from data in the table below, which shows that the Eurekahedge Trade Finance Hedge Fund Index has correlation values of 0.41 or below with all of the three other peer indices.
Yet, despite the attractiveness of supply chain finance, several key challenges remain for lenders looking to invest, including sourcing and origination of deals, the difficulty of performing due diligence cost-effectively without compromising on quality, lack of standardisation and traditionally high operational costs. Significantly more education around the asset class will also be required for many of the institutional lenders seeking to enter the asset class or existing ones wishing to grow their books sustainably.
To address the above issues, technology solutions must be coupled with an understanding of current shortcomings such as those exposed in the Greensill case. Tech-enabled solutions to address those shortcomings include:
These are exactly the issues that some SCF platforms were built to solve. Working with platforms that offer both origination of high-quality SCF deals and technology-enabled servicing that automates the vast majority of ‘back and middle office’ tasks will enable lenders to grow in a scalable and safe manner without sacrificing the quality of their underwriting or operations.
Given the increasing demand for supply chain finance from the corporate side and the influx of capital into the sector, we expect the asset class to continue growing in size. The lenders who work with the most efficient and high-quality SCF platforms that already address the Greensill red flags will be the beneficiaries of this growth in the long-run.