How Investing In Trade Finance Can Help SMEs Uplift?

1. The trade finance gap has reached $1.7 trillion, excessively affecting small & medium-sized enterprises (SMEs).
2. New technologies can have a vital role in transforming trade finance assets into profitable market products. 
3. A multitasker approach is essential to ensure the easy accessibility of trade finance instruments for SMEs.

Trade acts as an accelerator that gives a boost to a country’s economy, 80-90% of international trade requires financing out of which, around 90% of the organizations are owned by SMEs and over half of the jobs globally according to the World Bank. Generally, these are the SMEs that are underserved and lack reasonable trade finance. One thing is clear: unless SMEs are capable of executing trade transactions with the support of financing, the economy cannot improve.

According to the latest report issued by Asian Development Bank (ADB), SMEs are adversely affected by the $1.7 trillion trade finance gap ie. the difference between the number of trade finance applications by SMEs involved in global transactions and the number of approvals. As per the data, SMEs face 40% of these rejections which is quite higher than their share of applications. In this regard, ADB partnered with Seabank to expand trade finance in Vietnam. 

Why SMEs don’t have easier access to financing options? 

The main reason is that banks are not capable of providing the necessary financing to SMEs. On one hand, the rules & regulations of the bank make it costly for them to approve lending to companies. While on the other hand, it is also because of the inability of SMEs to provide any security to the loan, and smaller balance sheets. Due to this, the process becomes lengthy and results in trade finance approval. Additionally, “Basel IV” rules further fuel this issue. This is why SMEs opt for trade finance

Also, banks are shifting from a “buy-and-hold” strategy to an “originate-and-distribute” model. An improved balance-sheet turnover enables more margin income that can adjust the increased capital cost. 

Institutional investors, on the other hand, are looking for yields above comparable benchmarks. The good thing is that trade finance can be an asset class. For sure, investors have been willing for some time to invest in the asset class as it regularly pays above the risk equivalent to the yield level.

Enlarging Trade Finance Access

This way, trade finance holds all the components, making it a profitable investment option among investors. It is a multi-trillion dollar asset class depending on the shipment of ordered goods and services, making it less vulnerable to financial market volatility. Simultaneously, trade finance services come with lower default rates and the time of recovery in the event of default tends to be shorter compared to other credit products.

But what is the reason behind trade finance being the only asset class that doesn’t get distributed from the bank’s balance sheets? Even though institutional investors had access to repackaged mortgages, credit cards, car loans, and student debt for decades, at present, the distribution of trade finance services is still very low. 

The reason is the lack of digitization and automation, making any distribution too expensive for this low-risk and low-yielding asset class. Due to the increased cost, it is difficult for exploring opportunities in trade finance. Operational costs are high due to the asset granularity and the short instruments' tanors. Capital market participation has also been limited due to the requirement for repackaging portfolio risks and the broad reporting necessities. Digitization, automated work processes, and repackaging can now help decrease those friction costs and deliver improved access to trade finance.

Although a higher Net Interest Income (NII) for banks and access to a strong asset class for institutional investors are vital focus points, the SMEs will be all-time beneficiaries through more improved & affordable liquidity. Here is what it takes to make it happen:

1. Develop technology proficiency and collaboration

New trends & technologies are reshaping the trade, no doubt, especially in the trade finance sector. The infrastructure is enabling end-to-end & to-the-point processing of multiple instruments cost-effectively. This is empowering asset managers to get direct access to trade finance assets and compels investors to pay attention to more capital into the market.

The finance industry is also getting transformed through blockchain technology. For example, blockchain technology-based Security Token Offerings (STOs) are delivering an improved alternative to the repackaging of revolving trade finance pools into notes, issued by Special Purpose Entities (SPEs). Smart contracts permit any trading pair to adjust tokens while reducing counterparty risks. Tokens also offer partial possession and therefore can genuinely democratize access to trade finance. 

The very first of such transactions has been effectively concluded with the Tradeteq distribution technology and the blockchain platform delivered with the XDC network. This achievement fueled investors’ willingness for investing in tokenized assets, including those related to SMEs' workflows. It gathers receivables and delivers a fast, and safe way for asset managers to keep a track of the related trade transactions. Ultimately, SMEs with trade finance instruments connected to those funds will have an approach to the capital they require to finance their daily activities pretty quicker compared to traditional ways. The trade finance industry is also considering DLT technology adoption.

One type of collaboration that is required for this advancement to rise is the one between asset managers and the developers of these new technologies. A lot of asset managers still are dependent on conventional methods of investments and, due to this lack of knowledge about technological advancements, they are prone to miss bigger opportunities of investing in this new asset class. 

The very first step to filling this trade finance gap is to incorporate a cross-industry exchange. The TFD initiative, for example, brings the trade and institutional investors communities on a single platform to express & exchange ideas on the complexities & opportunities of the distribution market. These collaborations are critical to helping increase education, trust and reach among more participants in both the communities.

2. Avoid Administrative Vulnerabilities Through Frontier Guidelines

The progression of cash for this low-risk & real-economy-based asset class would get extreme benefits from further administrative developments. A report released by the World Economic Forum and the World Trade Organization figured out that the international legitimate acknowledgment of electronic transactions and documents is a vital influencer of the adoption of trade technologies. 

The report also highlights that there is no standard meaning of token and that the distinctions among guidelines could make vulnerabilities. Future guidelines must clearly distinguish between unregulated utility tokens and regulated security tokens contributions or stable coin offerings. The security token offerings will possibly take off if tokens are capable of being traded on administrative exchanges. The draft regulation is accessible for some markets but it requires more confirmation and coordination. 

The drafting of new guidelines would benefit from public-private cooperation. In particular, the private sector can make it easier to understand the scope for regulators along with the complexities of these frontier technologies and make sure that the new regulations could efficiently use these opportunities associated with them.

3. Ensuring Trade Finance Gets Stuck To The Targeted ESG Activities

Investors are striving to improve their portfolio's compatibility in the support of environmental, social, and corporate governance (ESG) commitments. Even smaller definitions of ESG funds find that they presently stand at around $2 trillion and this value is expected to increase fast. This trend, along with the new regulation on ESG disclosure, enables trade finance-related funds to ensure that the underlying trade instruments which are being financed are reserved for green and socially responsible activities. 

Initial endeavors have been initiated. Whether it is Singapore bank's partnership with SGTraDex to digitize green trade finance or Incomland Capital’s ESG invoice financing program that focuses on raising $500 million. As these efforts are in the beginning stage, further public-private work is required to connect the trade finance community with ESG industry pros and regulators.

New technology combined with capital markets infrastructure and tokenization is fulfilling investors’ willingness for safe and reliable asset classes with the requirements of SMEs and their efforts to join global markets. With the help of collaboration, technological advancements, and consideration of societal and environmental viewpoints, investors can have a vital role in trade finance - not only to create a sustainable portfolio of assets but also to contribute towards bridging the trade finance gap and enabling future economic growth.

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