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At the 2024 Trade Finance Investor Day (TFDI) conference in London, TFG’s editor Deepesh Patel spoke with Nick Stainthorpe, Partner at Reed Smith, on ways to unlock capital investment into the trade finance and receivables world. As banks’ distribution capabilities plateau, the trade and receivables finance industry is constantly on the lookout for alternative sources of investment capital but often faces challenges due to its perceived complexity compared to traditional asset classes. 

Compared with other asset classes—mortgages and bonds, credit cards, student loans, collateralised loan organisations (CLOs), and so on—trade finance assets are unusual for their lack of consistency. These assets vary significantly in risk and tenor.

Securitising trade finance assets could fulfil the unmet demands of the trade finance gap, lowering barriers to entry for prospective investors (including funds, capital markets, etc.). The risks and complexities of trade finance securities, though real, can be overcome and are often outweighed by the benefits for both investors and originators.

From receivables to securities

In traditional asset-backed securitisation, securities are sold on the public capital markets or privately placed to a smaller group of investors. Private securitisation, however, offers a tailored approach compatible with the unique needs of the trade finance industry.

By creating entities to buy receivables and separate these assets from sellers, investors can buy exposure to a firm’s debtors in the form of tradeable security, letting them access less easily traded assets than traditional methods. Private securitisation structures are handled as off-market transactions and are not listed on a stock exchange, unlike public securitisation structures. In both structures, the receivables are shielded from a seller’s potential bankruptcy by being transferred to a special purpose vehicle (SPV). This ensures that investors face lower risk exposure related to the seller’s financial stability. 

This is especially attractive for those wanting to invest in trade and receivables finance but who are deterred by the risks of instability and insolvency. Through securitisation, investors can obtain credit ratings.

Securities in non-traditional sectors can be attractive to diversify investors’ portfolios, said Nick Stainthorpe, Partner at Reed Smith. “Trade and receivables finance securities are uncorrelated to things like real estate values or equities; their underlying assets are relatively short-dated, which allows structures to be wound down quickly where there are signs of trouble, making for a great asset class”. 

Security provides protection by ring-fencing specific assets from other creditors, while securitisation goes further by removing those assets from the company’s balance sheet entirely, offering additional protection from the company’s potential bankruptcy.

Unique risks in trade finance securitisation: credit, fraud, and dilution

All securities involve some risk, but investing in the trade finance asset class presents unique challenges. Investors must consider both general risks, like credit exposure to underlying debtors, and specific risks, like dilution and fraud. The latter is a particularly tricky aspect of trade finance securities, as fraud is inherently difficult to detect and mitigate.

Double invoicing, misinvoicing, and carousel fraud (operations involving nonexistent goods) are all risks unique to trade finance and can seem difficult for investors to protect themselves against. Because insurance against fraud can be hard to get, and getting full coverage is almost impossible, investors and lenders must focus on prevention instead: background checks on exporters and importers, KYC checks, and increased awareness of the risks all protect investors against potential losses due to criminal activity. Companies such as MonetaGo are addressing these challenges by developing solutions like a Secure Financing platform, which prevents duplicate financing fraud by creating unique digital fingerprints of trade documents.

Credit risk

Beyond the risks of fraud, trade finance securities are vulnerable to non-payment because of the inherent complexity of trade transactions. This would generally be non-payment by the underlying debtor, who might pay late or default entirely, but could also arise at the level of the originator if the originator becomes insolvent while holding collections or fails to properly transfer/assign the receivables. 

In addition, businesses must consider exposure to insurers and account banks, rethinking their approaches to adapt. Long approval timelines further hinder efforts to streamline processes.

Luckily, this is a much easier risk to protect against. Some mitigants include:

• Due diligence and monitoring, such as reviewing a supplier’s financial health and performance.
• Credit ratings to evaluate how likely a company or entity is to repay their debts.
• Financial instruments like letters of credit, bank guarantees, and so on.
• First loss pieces, in which one party agrees to take the first set of losses before others are affected.
• Over-collaterisation, providing more collateral than the value of the loan/obligation for extra security.
• Recourse to legally claim or demand compensation.
• Assets pledged as security.
• And, of course, credit insurance to protect against non-payment.

Taking out credit insurance cannot completely offset the various vulnerabilities within trade finance-backed securities but is a useful buffer to help manage non-payment risk. 

Credit insurance contracts can be intricate and require buyers to understand the terms necessary to avoid claim disputes. Most insurers will not cover the entire risk, requiring investors to have some “skin in the game” to incentivise them to have high levels of oversight and diligence. 

Securitisation: a bridge over the trade finance gap?

By unlocking sources of funding that have remained inaccessible until now, securitisation could play an important part in narrowing the estimated $2.5 trillion global trade finance gap, which disproportionately affects small and medium enterprises (SMEs). Financing SMEs through securitisation offers the potential for high returns with relatively low risk. 

“In some cases, you’re getting, for example, SMEs who are prepared to pay the financing cost that an SME will pay, but whose credit risk is much more creditworthy than that cost of finance would imply,” said Stainthorpe. 

However, this is not easy – particularly given the unique challenges of SME financing. Large portfolios of small, diverse businesses and the relatively higher default rates among SMEs lead many lenders to be wary of financing this sector. Though automated systems have emerged to handle the large volumes of data processing needed for SME financing, portfolio management and information sharing between stakeholders remain key obstacles. A promising approach is to focus on SME suppliers to larger corporations, provided the debtor’s credit risk and structure are carefully assessed.

The learning curve is steep but worthwhile for investors considering entry into this space. Before taking on these assets, investors should “take time to educate themselves about the product, look at different partners and investors who are operating the market already, and compare and contrast the ways they do it,” said Stainthorpe.

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For those investors who do their homework, trade and receivables finance offers an emerging avenue for capital deployment in the sector—a market where the promise of high risk-adjusted returns and unique diversification benefits awaits. 

Securitisation could also be a powerful tool in trade finance, providing much-needed funding to close the trade finance gap. With proper education and resources, securitisation has the potential to transform the trade finance market, providing new opportunities for funding and reducing the global trade finance gap.