TRADE FINANCE: EVERYONE NEEDS BUT NO-ONE WANTS A REVOLUTION IN TRADE FINANCE

A SUMMARY AND FULL REVIEW OF THE DISCUSSION AT THE WEBINAR ON 7 OCTOBER 2020

                                                                                                                 SUMMARY


Trade finance is bedevilled by paper documentation and analogue processes, which inflate costs and risks, and reduce the capacity of the industry to finance world trade.   


Trade is naturally fragmented, with a typical transaction engaging 20 to 30 parties in multiple jurisdictions, making it hard to agree on a single set of terms or standard documentation.


The Covid 19 pandemic has accelerated the adoption of digital documentation because physical documentation and processes could not function with everyone working from home.


Both new digitisation services such as Contour and Marco Polo Network and long-established ones such as Bolero and essDOCS are making an impact and working together. 


The International Chamber of Commerce (ICC) has launched a Digital Standards Initiative to boot inter-operability between digitisation initiatives. 


The ICC is also leading efforts to establish the legal foundations of digital documents; encouraging banks and FinTechs to work together; and setting the industry digitisation milestones.


With large corporates dominating world trade, and 90 per cent of global trade finance written by just 13 banks, the industry is highly concentrated, but hampered by a long tail of counterparties. 


Increasing numbers of banks are exiting trade finance or concentrating on larger counterparts, because of counterparty and regulatory risks, including actions and fines for KYC, AML, CFT and sanctions screening compliance breaches.


The loss of experienced risk management personnel has not been offset by investment in effective technologies such as digital identities and AI, so fraud and counterparty risk are poorly managed.


There is clear scope for trade finance to use digital technology to combat fraud, reduce compliance and operational costs, while digital identities can cut the costs of customer due diligence.


Data is a potentially lucrative opportunity in trade finance, whose benefits include expanded capacity, dynamic pricing, reduced fraud and lower operational costs.


                                                                                                               FULL REVIEW


Trade finance rivals insurance as a byword for archaic processes and limited digitisation of data flows. Many people working in the industry can still remember carrying documents from the office to the bank, where they found a punctuation error was sufficient for the trade finance department to decline the business. 


Inefficient manual processes increase the costs and risks of being in the trade finance business  


Things are not as bad as that these days, but paper still abounds, and paper multiplies costs and risks, including the cost and risk of fraud. This has prompted regulators to lay obligations on banks that further inflate costs. As a result, banks are abandoning the trade finance business, cutting corporates – especially smaller ones – out of world markets. 


This is one factor in shrinking trade volumes. World Trade Organisation (WTO) data shows that world merchandise fell 14 per cent by volume and 21 per cent by value in Q2 2020. So fixing the inefficiencies that drive banks out of trade finance is worth doing. It would bring banks back, increasing the volume of trade that can be conducted across national borders. 


A company such as earth moving equipment manufacturer JCB, for example, needs an efficient trade finance industry to reduce the amount of paperwork it has to process. The company manufactures in 23 countries, sells in 150 through its dealer network and maintains an inventory of 96,000 spare parts for immediate despatch anywhere in the world. 


Yet JCB finds manual reconciliation and processing of paper, such as letters of credit and bills of lading, still exist. It also finds that, although digital forms of communication, automation and reconciliation have emerged, they remain poorly connected.


Inefficiency is a consequence of the multiplicity of parties in trade financing


This inefficiency matters because, even in its less-than-optimal state, world trade generates a high volume of transactions, and a typical trade financing involves a lot of parties as well as a lot of paper. 


Manufacturers, shipping companies, warehouses, port authorities, correspondent banks, insurers, government agencies and others – 20 to 30 parties to a transaction is not uncommon - all contribute to the process by which banks decide whether to finance a shipment of goods or commodities, buyers decide to pay for them, and sellers decide to release the shipment. 


So trade finance is a naturally fragmented industry, involving multiple industries, entrepots and intermediaries in almost every country on the planet. Each link in the chain produces its own version of the transaction in the form of a fax, an email or a PDF. Standard terminology and electronic messages to ease communications between systems are conspicuous by their absence. 


Even where progress is made, as with electronic bills of lading, it takes only one link in the chain to insist on a paper version of the document for the automated chain to break down and continue its journey as manual, paper-based process. In other words, seamless horizontal connectivity between the vertical silos that make up a trade finance chain is still, and electronic bills of lading for decades, absent. 


The global Pandemic has boosted the prospects of digitisation initiatives in trade finance


These shortcomings are now well understood by all parts of the trade finance industry. As in other industries, the Pandemic has highlighted the need to adopt digital solutions, because the shortcomings of semi-automated or manual processes have become so visible. In the spring and summer, for example, there was a surge in the use of electronic bills of lading, because paper documents were demonstrably failing to move. 


Banks engaged in trade finance had another reason to favour faster digitisation. In the early weeks of the pandemic, they found their business continuity plans (BCP) were not working. Back-up plans based on healthy parts of a bank picking up work from the parts that are down were irrelevant when everybody is working from home – and unable to access the documents. The result was a surge in the use of digital documents as well.


There is now widespread recognition that Blockchain, Application Programme Interface (API) and Cloud technologies are rich in potential to transform inefficient processes. Between them, they promise the end-to-end digitisation of trade finance, and multiple initiatives are in train to exploit them. 


New and old digitisation initiatives are making progress


Some, such as Contour – the blockchain-based trade finance network was set up in January 2020, and which went live in October 2020, – are new. Another blockchain-based vendor, the Marco Polo Network, was formed as recently as 2017 to replace paper with simultaneous access by all parties to a transaction to the same digitised sets of data.


Other digitisation initiatives are older. SWIFT MT 700 payments messages are long established. The e-documentation and corporates-to-banks connectivity services of Bolero date back more than 20 years. ELCY was founded in 2001 and essDOCS in 2005. Such services did not scale as quickly as expected, partly because of the siloed processing that they were set up to solve, and partly because FinTechs and RegTechs entering trade finance have created new siloes.


However, digital service providers have now begun to work together. Bolero, for example, offers electronic bills of lading as a service that can be accessed via Contour and the Marco Polo Network. For its part, Marco Polo has welcomed third party service providers to complete the KYC, AML, CFT and sanctions screening work, the digitisation of bills of lading and the environmental, social and governance (ESG) certification and reporting. SWIFT is making its FileAct secure file transfer service available to the parties to trade finance transactions.


The ICC has launched a series of groups to accelerate adoption of digital solutions and standards


The International Chamber of Commerce (ICC) is trying actively to ensure these disparate services can inter-operate. It launched a Digital Standards Initiative (DSI) in March 2020, with the aim of facilitating inter-operability between the various trade finance technology platforms and blockchain networks through an industry-wide agreement on open data formats and standard processes. 


Importantly, the DSI has the support of all four major development banks, which are directly involved in covering trade finance risks and have a significant interest in closing the perceived lack of capacity in the industry. 


The DSI is led by a former head of data strategy at mining giant BHP, Oswald Kuyler, who understands the problems and recognises that the solutions must embrace the whole of the global trade industry – including the owner-operators, the freight forwarders, the insurers and the port authorities - and not just the trade finance banks and funds. 


But agreement on global standards, in the absence of a major inter-governmental initiative, is nevertheless likely to take a long time. Electronic bills of lading are only one of circa 30 trade finance documents that need to be digitised and standardised, many of them more complicated than a bill of lading. Indeed, among the most intractable of all will be government-to-government documentation such as sanitary certificates and certificates of origin. 


In an effort to encourage the industry to change what it can without official inter-governmental support, the ICC has published a “digital trade roadmap” outlining what trade finance market participants need to do in order to digitise. The ICC also has work in hand to establish a solid legal foundation for digital documents. This is a major obstacle to digitisation, because users have to commit to the legal framework that sets the rules when they are on-boarded.


Trade finance suffers from serious concentration risk


The ICC has also convened a FinTech adoption group to make it easier for trade finance FinTechs to work with banks. Banks and FinTechs have much to learn from each other. But, with or without the help of FinTechs, no group of market participants could do more to accelerate digitisation than the major banks. After all, a recent ICC survey estimated that 90 per cent of all trade finance is written by just 13 banks, and the majority of that by no more than five banks. 


But technology is not enough, simply because so many parties are involved. Key market participants, and especially the major industrial and commercial corporations in the energy and commodity sectors that generate most of the work for other participants, need to support digitisation by investing in and adopting digital services. 


Yet neither concentration risk this intense, nor the high volume of transactional information that must be processed by a small number of banks as a result, has so far proved sufficient to spur the digital transformation of trade finance. That is because there is an obvious inhibitor: the fact that both corporates and banks have to deal with thousands of less sophisticated counterparts all over the world. 


A long tail of counterparties in a variety of jurisdictions inhibits digitisation


Although the digitisation of documentation has made progress in North America and western Europe, trade is a global industry and plenty of countries remain addicted to paper and bureaucracy. In some jurisdictions faxes and photocopies are still used in trade finance transactions, and their progress through the bank is hampered by long chains of rubber stamp-wielding bureaucrats of a kind familiar in London or New York 50 years ago. But sheer lack of resources is another problem.


A small bank in, say, Zambia, might find itself at the end of an elongated global trade finance chain. Its volume of business gives it little incentive to invest in digitisation, even if it had the budget and the skills to adopt it, which it does not. Although large corporates and banks could help smaller banks digitise, the benefits would accrue not to them in the form of immediate cost savings, but to the entire industry, so they have no meaningful incentive to help. 


Trade finance capacity is shrinking as banks opt to cut the counterparty and regulatory risks


Indeed, it is much easier for a major bank to refuse to deal with such counterparties. Inevitably, the pandemic has provided perfect cover for less generous credit assessments, not least because banks can claim to be following the example of the export credit departments of governments around the world. All are reassessing sovereign risk. 


It is also easier for banks to improve profitability by cutting costs than improving the efficiency of smaller banks. The most drastic form of cost-cutting is exit, and many banks have done exactly that, especially in commodity finance. Because commodity finance tends to drive trade finance activities at any bank, this weakens the appetite of banks for doing trade finance. Many more major international banks are now pondering whether it makes sense to maintain a presence in trade finance at all. 


Fraud and KYC, AML, CFT and sanctions screening risks are now a major cost and deterrent


A paramount consideration is the rising costs and risks of Know Your Client (KYC), Anti Money Laundering (AML), Countering the Financing of Terrorism (CFT) and sanctions screening checks when on-boarding clients. The cost of these customer due diligence assessments alone is put at between US$30,000 and US$60,000 per account. 


Even where it does not provide an incentive to exit the business altogether, that cost still provides a strong incentive to confine trade finance business to the larger corporations that account for the bulk of business rather than small and medium-sized enterprises (SMEs). 


Despite the checks they make, banks are still losing hundreds of millions of dollars in fraudulent trade finance transactions. The pressure to cut costs, by replacing with automated systems the experienced and expert middle office staff which used to monitor collateral, track facility usage and make physical visits to warehouses, has unfortunately diluted old-school forms of customer due diligence. 


This would not be a problem if banks had replaced them with truly effective modern technologies such as corporate digital identities or machines that can crunch through large volumes of transactions to help human experts in risk management and compliance identify anomalies before they become problems. But they have not.


The consequent reality is that trade finance banks do not always have a deep understanding of who their client actually is, even though 80 per cent of world trade is financed on an open account basis - that is to say, the good are shipped and delivered before payment is due. This exposes banks to fraud. 


Digitisation can cut fraud, compliance and operational costs 


The digitisation of processes can reduce that risk of fraud. An obvious instance is the replacement of paper bills of lading – which can be copied easily and presented at many different banks – with digital versions tied to a registry of single holder titles at essDOCS or Bolero.


Another is the use of artificial intelligence (AI) machines to check the unique numbers on bills of lading for duplicates, including paper as well as digital bills of lading once the number is entered into a system. 


KYC, AML, CFT and sanctions screening checks also provide an incentive to digitise. These are an operational burden imposed by regulators not just to prevent money launderers and terrorists stealing or laundering money but to prevent commodities disappearing at sea and halt transactions that benefit sanctioned states and individuals. But the burden can also be an incentive to digitise.


The “global advisory” issued by the U.S. Department of State, the U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC), and the U.S. Coast Guard in May 2020 on countering deceptive shipping practices used by Iran, North Korea and Syria to evade sanctions, for example, provides clear guidance on best practice, which can then be designed into compliance systems.


In addition, ports and customs and coastguard authorities could become supporters of digitisation if they are convinced that it can facilitate and enhance their work. An estimated 60 million containers reach ports in the United States every year, and the authorities are able to inspect less than 1 per cent of them. Digitisation of documents could increase transparency and help them focus their efforts more effectively. 


Digital identities can make customer due diligence more efficient


Digital identities are yet another application of digital technology that could help the trade finance industry increase efficiency and expand capacity, and they are being developed. The Marco Polo Network, for example, offers every participant, whether it is an SME in Bangladesh or a multinational in Germany, a digital passport. 


It includes a digital identity linked to Legal Entity Identifiers (LEIs) that allows other participants on the network to verify the identity of their counterparties, and which is kept up-to-date. A variant of this passport - the pre-approved, trusted trader - can be used to expedite the movement of goods between the United Kingdom and the European Union after Brexit is completed. 


But digitalisation is in the end about efficiency rather than customer due diligence and sanctions screening. And any combination of rising due diligence costs and counterparty and regulatory risks will provide the senior management of banks with powerful arguments for exiting the trade finance business. 


Diminishing capacity and cost cutting are worrying regulators and customers


This shrinkage of capacity is worrying development banks, central banks and international regulators. It is also exasperating the users of trade finance. Governments, companies and individuals do business with companies they trust. So they are naturally much more interested in the efficiency, effectiveness and responsiveness of the process than the amount or quality of customer due diligence conducted by the bank. 


Users want digital documents, but they also want experienced bankers to talk to when something goes wrong. Above all, they want what trade finance was invented to deliver: letters of credit on the banks of the buyers to be confirmed, irrevocable and drawn on large and reputable banks, if necessary by convincing the buyer to appoint another bank. 


If the needs of corporates from the trade finance industry are straightforward, they are incurring the costs of trade finance processes that are anything but straightforward. Systems that are siloed and paper-based are adding costs and risks. 


Now regulators have added further manual processes, in the shape of KYC, AML, CFT and sanctions screening tasks and ESG reporting, to a basic trade finance process that itself remains embarrassingly manual. It is not surprising that industry capacity is declining, and less business is being done.


Better use of industry data can help restore capacity – and profits


More and better use of the data generated by the industry could help to solve this capacity problem. Good quality data about counterparties can provide the reassurance needed to contract with new counterparties and finance more transactions in markets that are presently regarded as too risky. It can also be used to detect and reduce fraud, further encouraging banks to stay in the business. 


Data could even be used to introduce more dynamic pricing. If data from detection devices on goods in transit and the Internet of Things (IoT) could be captured and used immediately, interest rates could be adjusted. Similar discounts could be offered to companies that meet ESG requirements. Indeed, banks are already offering lower rates on sustainable transactions.


On the operational side of the industry, data can automate compliance with government import and export regulations and taxes and expedite the progress of goods through ports. In fact, the most lucrative opportunity in the digitalisation of trade finance today probably lies not in greater operational savings, or even in the financing of a greater volume of business, but in data harvesting, analysis and presentation.


Questions to be addressed at the next Trade Finance discussion


1. How can digital technology help trade finance restore lost capacity?
2. What can regulators do to encourage digitisation?
3. What needs to be standardised in digital finance?
4. How can peripheral parts of the industry best be digitised?
5. Will the various digitisation initiatives in trade finance be consolidated by market forces alone?
6. What are the sources of data in trade finance that are valuable enough to be mined?
7. Do conventional trade finance banks have an incentive to capture and use the data they process and create?


The Future of Finance is always open to hold further meetings to answer these and other questions and to continue the conversation. If you would like to sponsor such a meeting please contact Wendy Gallagher at the number or email address below. Also view our upcoming meetings elsewhere on www.futureoffinance.

Wendy Gallagher
Tel: + 44 (0)7725 160903
Email: wendy.gallagher@futureoffinance.biz

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