Technology is needed to reduce the trade finance gap

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Frances Gagua
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Financial Services
Information Technology

Trade finance is generally seen as sound finance, underwritten by long-standing practices and procedures. The World Trade Organization (“WTO”) estimates that some 80 to 90 per cent of world trade relies on trade finance. These estimates are made with the acknowledgement of the absence of comprehensive and reliable data on trade finance flows.

World merchandise trade as published by the WTO was US$19.05 trillion in 2019. We are told that the trade numbers contracted by 5.3% in 2020, generally ascribed to the effects of the COVID-19 pandemic, but that they are expected to grow 8% in 2021 and 4% in 2022. With the projected growth and a base of some US$18 trillion to grow from, trade finance represents a very sizeable addressable market for financiers.

Having said this, there is a reported shortfall in trade finance availability – known as the “trade finance gap” – of some US$ 1.5 trillion, estimated by the Asian Development Bank (“ADB”) in its latest (2019) published survey. The ADB first published the trade finance gap in 2013; therein, the “trade finance gap” was defined as a financial institution’s inability to meet the demand for any form of trade finance, and represents the amount of trade finance that is not available to support imports and exports resulting in less trade than would be if there was no gap.

The trade finance gap should probably be considered with a pinch of salt, for a number of reasons. The results are based on survey responses and not on precise statistical data. It cannot be assumed that all rejected applications for trade finance should have been capable of being approved. An application may be for a limit larger than the actual amount needed: utilisation levels of approved credit limits in banks tend to not be maximised. Having said this, a trade finance gap most surely exists, and the work of the ADB has been invaluable to bring this to attention.

Key reasons for the trade finance gap, identified as ‘barriers to trade finance’, identified in the 2019 survey include:

  • AML/KYC requirements
  • High transactions cost or low fee income
  • Low credit ratings of the obligor’s countries and obligors
  • Regulatory capital requirements for banks

Closing the gap
Addressing the key reasons identified for the trade finance gap, it is noted in the latest ADB report that more than ¾ of surveyed banks highlighted the requirements on Anti-Money Laundering (“AML”) and Know-Your-Customer (“KYC”) as the largest barrier to expanding trade finance.

Trade-based Money Laundering (“TBML”) is defined as the process of disguising the proceeds of crime and moving value through the use of trade transactions in an attempt to legitimise their illicit origins. Key to solving this is the need for information sharing (and overcoming the barriers to information sharing) with the use of emerging technology.

Rejection rates of business entities that fail the KYC process is not the primary impediment to trade finance (such entities should indeed not be financed). Rather, it is the high costs that financial institutions incur to perform KYCs. Use of eKYC and Legal Entity Identifiers can be part of the solution for improvement in efficiency, data reliability and cost.

Creation of regulated exchanges for trade finance that would allow financial institutions to finance any exchange-enrolled business entities can be a way to overcome the KYC challenge. A prime example is the Trade Receivables e-Discounting System (“TReDS”) in India, on which financiers provide invoice finance to micro, small and medium enterprise (“MSME”) suppliers onboarded and KYCed by the TReDS exchanges. These MSMEs may otherwise be underserved by financiers due to the high cost of KYC.

Recent reported trade finance fraud events have the unfortunate consequence of reducing trade financing availability to legitimate financing applicants. There is a need to prevent fraud, and this need should focus not on large value transactions only but also small value transactions to meet financial inclusion objectives. A prime example of the use of technology for this is the deployment by India’s TReDS exchanges of a solution that prevents duplicate financing of the same transactions, which provides more confidence to financiers to extend trade finance to MSMEs.

Successive ADB reports highlight that unmet demand for trade finance is highest amongst SMEs and women-owned firms. That SMEs face greater difficulty in obtaining trade finance compared to large corporates is unsurprising. World trade is vital to economic development and prosperity, and financial inclusion of underserved sectors is needed. Technology is expected to play an important role to close the trade finance gap.