24 February 2009 Features

 

Empty Vessels

Tom Groenfeldt

As world trade drops off dramatically, banks' trade finance departments are facing many challenges.

Containers of leather from China destined for a US automobile seat maker are refused because there is no market for autos, and therefore none for auto seats ... Maersk, the giant Danish shipping line announces in December that it is laying up eight vessels for lack of business ... The World Bank predicts world trade will drop by 2.1% in 2009, surpassing the 1.9% drop in 1975 ... idle ships anchor off Cyprus ... Shipping costs, measured by the Baltic Dry Index, hit a record high of 11,793 points on 20 May but had dropped 94% by early December, bringing rates close to the actual costs of operating a ship ...

"The last 12 months have been a real roller coaster ride," says Tan Kah Chye, global head of trade finance, transaction banking at Standard Chartered in Singapore. "It is fair to say most practitioners have never seen such a drastic swing in the trade finance business. Commodity price shocks hit a peak seven or eight months ago and now are right at the bottom."

The financial and trade crisis has had a major impact on trade financing. Rather than depend on open accounts, exporters are asking their banks for the assurance of letters of credit. In some cases, back in October and November, they even asked solid banks to provide financial assurances of guarantees written by Citi and RBS.

In an open account transaction, the exporter depends on the buyer to pay up.  With a letter of credit, a bank steps in to assure that the payment will be made.

Swift reports that the number of letters of credit declined by 7.9% from October 2007 to October 2008 and thinks the current growth is a blip that will disappear when the crisis is over.

"Because of the current economic crisis," agrees Tan, "more and more exporters are fearful selling on open account. They would prefer letters of credit between them and the buyer for the comfort that the bank will make the payment."

As demand for trade finance has increased, the costs of financing have gone up. In some markets, it has gone up sharply - from 20 to 30 basis points in India a year ago to 200 to 300 basis points recently, says one banker.

"The credit crisis is generating this hike in pricing," observes Jean-Paul Riolacci, head of global trade solutions at BNP Paribas in Paris. "I think the documentary letter of credit will be even more widely used in this time."

With third party players dropping out and many banks constrained by the credit crunch, trade finance has been in short supply in many markets.

It all adds up to a busy time for the trade finance departments in global banks. While the volume of trade is off sharply, the percentage of trading transactions using some form of bank guarantee is up, leading banks to a form of financial triage - with limited balance sheets they are focusing on clients who have demonstrated they value a relationship, not just the best price of the day.

Exporters who might have found financing in capital markets are returning to banks looking for financing and guarantees to shipments through instruments such as letters of credit.

At RBS, Daniel Cotti, global head of trade finance, saw rising demand for letters of credit in the second half of last year, especially in emerging markets, as other sources of financing disappeared.

"A year ago you could fall out of your doorstep and find 15 people willing to lend you money. Now the only person outside the door willing and able to lend is the house bank; all the others have disappeared," he says.

Standard Chartered's Tan says trade finance was so strong that by December he had run out of capacity among the European banks who participated in some of his financing."They had such a good year they didn't need to book any more business for 2008; they were keeping capacity for 2009. Every crisis has opportunities."

Swift's traffic shows that the largest share of global letter of credit traffic is within Asia at 45%. "Our letter of credit traffic is pretty much flat, but when we look at world trade, that is growing by 20% a year, a lot of the letter of credit trade is now moved to open accounts," explains Connie Leung, head of trade and supply chain markets, Asia Pacific at Swift in Hong Kong.

"Moving to open account depends on the buyers' and sellers' relationship. Many of the corporations in US and Europe are global entities with global footprints. Therefore a significant percentageage of their trade is conducted within their own network of subsidiaries. Asia as a strong export market is more seller driven where there is a greater need for guarantee payments and credit; therefore the letter of credit is a good means of trading."

One drawback for banks is the fee structure of an open account transaction, which earns them $15 compared to $300 to $400 for a letter of credit.

While the financial downturn has reduced the total demand for trade financing, the availability of credit has fallen further, and faster. Companies which had chosen credit providers based solely on price are finding that the major banks are slow to return their calls. They are favouring their long-term customers when it comes to providing trade finance.

"Just as companies don't like buyers who shop around, neither do we like customers who pass us for one basis point difference," explains Tan at Standard Chartered.

HSBC also values loyal customers. Wee says many companies were looking just at price when it came to trade finance. "Another set of customers value the relationship they have with the bank, and in these times it cuts both ways.  We support our customers who come to us with a long-term view of partnership and commitment to quality."

RBS sees a cautious return of trade investors in the beginning of 2009. "It's too early to call it a trend," warns Cotti. Other banks which have invested in trade paper are starting to open up their books again, he says.

"I have a cagey team that buys and sells trade finance papers, but the market was very illiquid in the second half of last year." RBS is selling more than it is buying, to investors in Asia, the Middle East, Europe and North America.

Through RBS buyers and sellers can extend their commercial contracts and obligations - letting the bank mitigate the risks, providing settlement and payments, liquidity through finance and giving buyers real-time information through MaxTrad, an RBS web-based solution.

Standard Chartered runs an active securitisation program through which it can bundle and sell its risk to specialised trade investors. It shares risk with European banks which don't have the capacity to originate trade finance in Asia, the Middle East or Africa but know the regions well.

"They understand the knee-jerk reaction presents them with an opportunity to participate in certain risks with pricing that is significantly more attractive that it was 12 months ago," says Tan.

HSBC's Wee says that while the liquidity situation in Asia is not as strong as before, he is beginning to see banks returning to the market with very aggressive pricing.  "For example, India and Taiwan are cases in point. The liquidity situation in Asia is not as strong as it was before. With the recent change in economic landscape, there is a greater emphasis and more time spent proactively managing and pricing risk."

As the quantity of transactions drops, banks are focusing on how to deliver more quality to their clients.

For Standard Chartered, this is a time to work more intensely with its leading customers. Wal-Mart and Marks & Spencer will not be stuck with empty shelves.

"We are working very closely with leading importers to understand who their key suppliers are. We want to engage these top customers," says Tan.

Suppliers are becoming selective, says Wee at HSBC, which believes that strategic long-term relationships benefit both buyers and sellers, as well as banks. Exporters will move to a letter of credit if they have concerns about the buyer.

"Banks have an important role to assist companies particularly, in the process, improving the working capital of both the customers and their suppliers.  HSBC adds value in risk mitigation because we are on both sides of a transaction between big buyers in the US and Europe and suppliers here in Asia."

Swift's Leung notes that banks that move customers from letters of credit to open account will see their revenue per transaction decline from $300 or more to about $15 and hope to make up for it by acquiring more cash management and payment business.  The big players in trade finance offer a wide range of services to their clients, including helping them deal with risks such as payment, currency, counterparty and political risk.

During 2009, Cotti says banks will have to stay alert and focus on monitoring risk." We will have more counterparties and more countries that will enter into difficulty as we go through the year. That is part of the economic cycle we are in, and this is a bad cycle that is going to take much longer than initially anticipated."

Pricing risk is the business of banking, notes Tan.  "For us to run away from the business of risk management we might as well close up shop. We are one of the stronger banks, and we are very much open for business."

Tan says some of his clients are running a big risk financing US dollar trade with local currencies. "There is a risk element using domestic currency to support cross border trade," adds Tan. "Exporters are exposed to fluctuating USD movement, so we advise them that while borrowing dollars may be expensive and borrowing in local domestic currency may be cheap, that masks the risk you are exposed to on foreign exchange volatility. They really have to hedge; there's no point in gambling away their profit margin in FX fluctuation. While exporters understand their profit margin very well, not many people understand how badly they can be hurt with FX volatility."

From his vantage point in Singapore, he watches Asian currencies against both the US and Australian dollar. While the US dollar has defied expectations of a sharp decline, for now at least, the Australian dollar has declined 20 to 30%.

"If you are not hedged on the Singapore to Aussie exposure - well, I don't think a lot of people make a 20 to 30% profit margin. You may be borrowing cheap on Singapore dollars, but you run the risk on FX volatility."

Wee confirms reports of factories closing in China. The number of toymakers dropped from 12,000 to 4,000 in 2008. As an intermediary, the bank works with major buyers who want to ensure their source of supply.  Again, relationships are key.  If the buyer is trying to get the lowest possible price and regards the transaction as a zero sum game, the relationship is unlikely to work, he said.

HSBC has hosted vendor conferences explaining a mutually beneficial open account approach where there is collaboration between the bank and the buyer and the vendors.  "Over the years the buyers have been going just for cost reduction; the result is fewer and fewer suppliers willing to do the work at those levels. It used to be a buyer's market but now vendors can choose who they want to work with." 

Another banker referred to news reports from China predicting riots if growth falls below 8%. In difficult times, banks want to support their best customers; it could be an issue of the company's survival, he says.

Standard Chartered's Tan sees a positive side to the crisis - banks and companies are getting back to focusing on good business practices.

"After a lengthy period of a credit and economic boom, the market had become very insensitive to risk insensitive. The crisis has sent us back to basics with a focus on risk, adequate returns, and prudent trading terms."

Banks and vendors, including Swift, have invested heavily in trade finance, but it is still pretty far from foreign exchange when it comes to straight through processing.

"If you look at the end-to-end process, it must be one of the most archaic, paper-intensive processes you can do today," says Tan. "It takes a shipment of one million barrels of crude a day from Singapore to Indonesia, but you'd be doing pretty well to get the trade documents over there in three or four days."

Processing has improved, especially between major hubs such as Singapore, Hong Kong, Australia and Shanghai. Serious delays arise when shipments cross more than one border or multiple forms of transportation - ship to truck to rail, for example.

"STP can only be as strong as its weakest link," notes Tan. Bankers, logistics firms and customs agents can all add to delay.

Swift has developed its Trade Services Utility to work on open account  trading which has been growing, according to Leung. "We try to standardise exchange of information between the buyer bank and the seller bank, by improving the visibility of information in open account transaction help these banks mitigate risks. Banks in Asia Pacific who have joined the TSU expect to capture the open account business from their customers." she added.

The TSU went live in April 2007 and now has 81 banks from 29 countries, including 10 Chinese  banks. Version 2, due out this year, moves beyond document matching to include an optional payment obligation which the buyer's bank can offer to facilitate the exporter's obtaining finance from its bank.

From outside the banks, the Pan Asian e-commerce Alliance is bringing together buyers, sellers, shippers and government services to provide a single window into corporations, a first step to developing standards for other participants in the supply chain like Swift has developed in banking.

Susan Feinberg, senior analyst at TowerGroup, thinks Swift's TSU volumes are still too small to make much difference. "There is just very, very little activity. The banks are signed up for the TSU but little is happening from what I have been able to determine, although Swift won't actually tell you. Right now it doesn't have any impact."

While third party systems exist for trade finance, they are not big enough for the major banks. Tan says Standard Chartered has spent $40 million on its trade finance because it can't buy technology which can support the scale of its operations.

Moving trade finance to electronic channels is a challenge because the process has been so paper intensive and reaches well outside banks to factories and shippers.

"STP in trade finance compared to the payments world is a bit of an illusion," said Cotti at RBS. There is still a high degree of manual intervention required when settling trade transactions.

RBS is one of the banks working with Swift on the TSU. He sees the TSU as a catalyst to drive automation into the space of international trade as an evolution, rather than a revolution, which means it will take time.

"Many electronic services are there, but as most people don't trust technology. They always print and keep a paper copy and then deal with the paper."

Companies are looking for flexibility and visibility in trade finance automation, says HBSC's Wee. They want the bank to take the message formats they already use and return information that can go directly into an ERP system.

"Once the economy shows signs of recovering, the CFOs and big buyers will again return to how to better increase efficiency in the supply chain using technology." BT

Case Study: SEB's integrated approach to trade finance

Since improving trade finance processes can have a big impact on capital, it should be tightly linked to cash management according to SEB, which in 2006 moved its trade finance group into Global Transaction Services, alongside cash management and custody.

One client SEB worked with is now saving SKr4.2 million (£372,000) a month from improvements to its trade finance processes. That's enough to get the attention of a company treasurer, and that's just the bank's target.

Traditionally, says Lars Millberg, global head for trade finance at SEB, corporations have left the details of trade finance to offices and factories around the region or around the world, since that was seen as the best way to deal with the paper-intensive business.  But increasingly banks and companies are taking advantage of simple technology, such as scanning and emailing documents, to change the way they do business.

The solution isn't always obvious to prospective clients. Patrik Zekkar, head of trade finance for Sweden, recalls visiting a Danish company which explained it needed to conduct its trade operations through a bank which had a local branch, so it could send documents over by courier.  The process took about three days; Zekkar explained that SEB could do it electronically in an hour and a half.

Several of SEB's trade finance professionals came from cash management, an area where Nordic companies are some of the best in the world. But most of the companies haven't understood how much capital they are wasting in trade, especially trade with emerging markets. SEB has developed a survey with 40 to 50 questions to help companies uncover weak processes that are slowing their cash flows.

"We want the issues on the table of the treasurer, not just the risk manager," explains Millberg. "Before, everyone was happy if the risk was covered at a decent price and they allowed the process to be inefficient."

By mapping letter of credit processing among 50 customers, the bank found the average time to get corrected documents that trigger release of funds was 41 days; the best company did it in 10.

"Since we understand how the leaders conduct their trade finance, we can use their competence to find the weak spots at other firms," says Zekkar.

The people responsible for letters of credit measure their work by risk management and document quality; they have little awareness of working capital issues. With electronic channels, trade finance can easily be centralised.

"You don't need to have your trade finance people spread out all over the world," explains Zekkar. "You can have them in one place monitoring transactions with Europe and with emerging markets from China to Brazil."

One client averaged 33 days to complete a letter of credit; it had an 89% error rate in the first submission, 43% in the second round, and even after the documents were completed it waited another 16 days to prepare an invoice, package materials and prepare the certificate of origin - work that should not have consumed more than two days. How much does 14 days cost in a company's capital? The answer in this case was Skr2.2 million a month.

"That was enough money to get some people very, very upset in treasury."  But the logistics department was rated as doing just fine - it met its key performance indicators  in shipping on time and within budget, but the high error rate in documents and the resulting payment delays weren't part of its evaluation.

"We can have totally automatic solution where we don't even touch the documents," says Zekkar.  "The customer makes the changes when we ask for them and then we send the file on to the other banks."

By centralising trade finance and tying it to cash management, companies can track which counterparties are slow to pay; some emerging market banks take five to seven days.

"You should have a credit policy when you select your counterparty," says Millberg. "But the time you open a letter of credit it is too late. SEB understand that it needs to transform the world of trade into a language of capital tied up in processes and employee FTEs, language that a CFO or treasurer can understand."

After Zekkar moved from cash management to trade finance, he recalls, he revisited corporate treasurers to ask them about trade. Most had no ideas of their trade finance operations; it wasn't their responsibility.