Supply Chain Finance in emerging markets as an ethical alternative investment

With its low default rates, stable yield and limited correlation to other asset classes, trade finance offer banks and asset managers a way to capitalise on the world’s COVID-19 recovery while also satisfying clients’ growing demands for sustainable, ESG investments.

Too often, however, the SMEs and emerging markets that contribute most to global trade – and which have the potential to offer investors the best risk-adjusted returns – fail to get the investment they need, due to misperceptions about their risk profile and the traditionally high costs associated with due diligence and onboarding. This has contributed to a growing trade finance gap that threatens economic growth and exacerbates inequality.

Fortunately, technology already has a solution to many of the problems that feed that gap, with supply chain finance (SCF) platforms like Finverity taking much of the legwork and risk out of funding emerging market SMEs. This enables investors to enjoy strong, stable returns while contributing to the UN’s Sustainable Development Goals associated with poverty reduction, job creation and women’s economic empowerment.

Trade finance gap hinders global economic recovery

According to the ADB’s 2019 Trade Finance Gap, Growth and Jobs Survey report, emerging markets continue to bear the brunt of the ongoing $1.5 trillion global trade finance gap, with developing Asia, Africa and Latin America accounting for over half the total. Trade finance rejection rates in Africa, for instance, have historically exceeded 50%.

But while 52% of respondents to the ADB’s most recent survey identified high country risk as an impediment for providing more trade credit for transactions in developing markets, the real risk of doing so looks very different. For example, the ADB’s trade finance programme recorded zero defaults or losses in the 10 years from 2009 on its more than $36 billion of trade lending, the majority of which was done in the emerging markets of Bangladesh, Pakistan, Sri Lanka and Vietnam.

Small and medium-sized enterprises (SMEs) suffer additional barriers wherever they are located. Nearly three-quarters of the trade finance gap is concentrated in mid-cap firms and SMEs, with 45% of SME applications for trade finance rejected compared with 17% for multinational corporation (MNC) applications, according to ADB figures. Women-owned businesses also have it harder, with trade finance rejection rates of 44%, versus 38% for male-owned companies.

The impact of the trade finance gap spreads far further than the emerging market SMEs that are its principal casualties. Trade plays a vital role across society – helping create jobs, reduce poverty and propel economic growth – so is more important than ever following an economic crisis.

In a July 2020 joint statement with six multilateral development banks, the WTO flagged the crucial role that small firms play as job creators across the world economy, particularly in the emerging markets that will drive global trade in a COVID recovery. SMEs are responsible for 90% of Cambodia’s exports, for instance. The statement also stressed that shortages of trade finance impede imports of essential food and medical goods as well as exports of key income-generating products.

The OECD made a similar argument in a June 2020 report that stated keeping the wheels of trade turning was vital to save lives and livelihoods throughout and beyond the pandemic. It highlighted, in particular, the importance of supporting supply chains and improving transparency across global trade eco-systems.

And even before COVID-19 brought swathes of the global economy to a near-standstill, the World Economic Forum (WEF) warned in a February 2020 report that trade finance is among the three main export obstacles for half the world’s countries. By noting that traders usually abandon transactions when their applications for trade finance are rejected, it underscored the immediate link between trade finance availability and economic activity.

Technology weakens barriers to entry for lenders

There are numerous barriers to lenders providing trade finance and reasons why applications for trade finance are rejected. Some such challenges are sound, but others are highly solvable with the right technology.

For example, anti-money laundering (AML) and Know Your Customer (KYC) requirements were cited by 76% of respondents to the ADB’s 2019 survey as an obstacle for providing trade finance, followed by high transaction costs or low fee income, with 59%, and low credit ratings of companies’ and/or obligors’ country, with 52%. Among lenders’ reasons for rejecting financing applications, ‘lack of additional collateral’ topped the list, with 20% citing this. In comparison ‘serious KYC concerns’ came third with 18% and ‘not profitable enough to process’ came fifth with 15%. Although little can – or should – be done for those applications that 19% of respondents consider ‘completely unsuitable for support’, fintech and digitisation offer promising solutions for many others, the ADB said.

Blockchain technology, AI and big data can, for example, reduce the cost of financial services, with digital platforms able to streamline and strengthen the onboarding, underwriting and ongoing operational processes that present a particular challenge when lending to SMEs.

“Banks rarely have sufficient processes and systems in place from a KYC perspective to invest in trade finance as widely as they’d like,” notes Viacheslav Oganezov, co-founder and CEO of cross-border supply chain finance platform Finverity. “This inability to conduct thorough due diligence affordably and run transactions efficiently means they write off too many trade finance applications as high risk and reject them.”

While technology like Finverity’s can do little to shrink that part of the trade finance gap caused by companies’ insufficient credit strength, simply fixing broken processes has the potential to take out a significant chunk, he adds.

Default rates for supply chain finance and other forms of trade finance are already low compared with many other forms of lending, as highlighted by the most recent ICC Trade Register Report, because of the short-dated, self-liquidating and asset-backed nature of the financing.

But with the right technological solutions reducing costs and mitigating some of the risks and barriers associated with emerging market lending, the risk-adjusted returns on offer are even better.

Not only ethical but also an attractive alternative investment

In the current low-interest-rate environment, trade and supply chain finance in emerging markets offers a good, stable yield with limited correlation to traditional markets. For the right credit, annualised returns can be as high as 9% or 10% with default rates that are still below 1%.

The performance of the closest SCF benchmarks demonstrates this over the past decade. Eurekahedge Trade Finance Hedge Fund Index, which comprises 41 active funds focusing on trade finance strategies. In 2018 and 2019, both of which were characterised by trade tensions and broader economic headwinds, the index logged returns of 6.70% and 5.34% respectively. And even in the first five months of 2020, during the peak of the first COVID-19 wave and near-global lockdowns, its returns were modest but positive.

At a time when asset managers in Europe are witnessing double-digit growth in demand for ESG investments, and in the US – a relative latecomer to the movement – sustainable investing now accounts for a third of all assets under management, trade finance offers another way for institutional investors to source the sustainable transactions clients are asking for.

The pandemic will likely accelerate future growth in demand for sustainable investing as the ‘ESG risk multiplier’ effect – as flagged by Sustainalytics, which monitors company activities that create undesirable ESG effects – injects new urgency into the sector.

The WTO and World Bank have already stressed the vital role that trade plays in integrating developing countries into the global economy. The ADB argues more specifically that shortages of trade finance pose a direct threat to seven of the UN’s 17 Sustainable Development Goals (SDGs), particularly those related to poverty reduction, economic growth and gender equality.

SDGs impacted by the trade finance gap include SDG 1, to end poverty; SDG 2, to eliminate hunger; SDG 5, to promote gender equality; SDG 8, to create decent work and sustainable economic growth; SDG 9, to promote sustainable industrialisation; SDG 12, to ensure sustainable consumption and production patterns; and SDG 17, to revitalise global partnerships to help achieve the SDGs.

For example, supporting agricultural trade helps strengthen food supply chains, boost productivity, reduce food-price volatility, improve food security and combat hunger. And given we already know female entrepreneurs and emerging market SMEs are more likely to be rejected for trade finance, trimming the trade financing gap will help improve the economic empowerment of poorer women.

“This is why Finverity exists,” notes Oganezov. “We wanted to facilitate flows of capital from places like London into emerging markets where it is much more needed, so we developed a technology platform that would open up trade finance investments to a wider pool of capital and make them possible at scale.”

“As well as offering stable, attractive returns to lenders; trade finance is sustainable, ethical and helps the real economy at a time when it is most needed.”