So, let’s consider what happens when a company decides that they want to sell goods abroad. As it turns out, it can be quite expensive to achieve financing because there are so many risks involved in trade.
So what drives up the costs of trade finance? In order to mitigate the risk of non-payment, sellers want to get paid as soon as they ship. But, buyers, on the other hand, want to mitigate the risk of non-delivery and wish to pay only after receipt. And, along the way are a host of risks ranging from natural disaster, piracy and outright fraud to contend with.
In order to adequately underwrite these various risks appropriately, an army of people must do a number of manual tasks to verify the existence of the goods, verify that the goods are being shipped, verify when they go arrive and go into customs and verify when they get out of customs and make it to the final destination warehouse. This heavily manual process takes time and costs money.
Historically, banks only disintermediate approximately 36% of total trade finance transactions with the remainder as cash-in-advance transactions or open account transactions 1. These other methods shift the risk to either the buyer or the seller. Bank disintermediation is a way to reduce these risks by bridging the gap between the shipment and the receipt of goods. By providing credit, payment guarantees, and insurance, suppliers of trade finance facilitate trade. Currently, there are two primary forms of trade finance: intercompany credit and letters of credit.
Intercompany credit accounts for open account transactions where one company provides credit to another company based on their relationship or ability to extend credit. Letters of credit require a bank. This segment of the market has grown over the years, primarily because most trade credit is short term in nature. It is less than 90 days and carries a lower risk of default and a higher recovery rate. But, while this business model is attractive, the ability of banks to service the growing needs of the market has been hindered by regulatory and compliance limitations. Specifically, because of the way that Basel III continues to treat trade finance on the balance sheet, banks are less able to provide this relatively low risk service, pushing other institutions and shadow banks to step in to provide this important service 2.
A 2017 survey by the Asian Development Bank suggested a gap in global trade finance of $1.6 trillion annually, which would be needed to service the growing volume of trade 3.