New technologies are altering the face of trade finance, bringing a host of opportunities and challenges for corporate treasurers. Joon Kim, Global Head of Trade Finance Product and Portfolio Management at BNY Mellon Treasury Services explores the changing trade finance landscape.

Having remained largely unchanged for decades, the trade finance industry is now experiencing a significant transformation. The combined force of technological innovation, shifting client demands and the unprecedented Covid-19 environment are propelling trade finance toward a digital future.  

New automated technologies available to banks

The implementation of new technologies – from machine learning and optical character recognition (OCR) to digital signatures and distributed ledgers – lies at the heart of these digital efforts, and is helping to transform the historically time-consuming, manual-intensive and paper-based business of trade finance into a streamlined and efficient machine.  

While these rapid changes are posing fresh challenges, they are also opening up a range of opportunities for banks to better support their clients. And as these solutions begin to deliver on their potential, we are now on the cusp of significant gains. With this in mind, what can banks do to ensure they can continue to drive this digital transformation?  

Obstacles in compatibility to overcome

Almost 80% of trade finance is now conducted in the open account space, where goods are shipped and delivered before the payment is due. While it has become by far the most prevalent means by which to conduct trade finance, several weaknesses remain – including the lack of a network to effectively and securely exchange information  

In lieu of such a network, treasurers working in the open account space typically have to structure their trade finance deals on a bilateral basis and onboard several different proprietary systems.

Not only is this a time-consuming process, but it also brings a number of complications. For instance, it creates a system that is more susceptible to financial crime.

With no standard network to exchange information, fraudsters can use a single invoice to obtain multiple lines of credit from different banks.

The turbulent landscape created by the COVID-19 pandemic, which put extreme pressure on global supply chains and liquidity, served to exacerbate these issues. As a result, it became clear that an effective and secure system was needed to support, facilitate and optimize open account transactions.     

Industry collaboration is key

In order to make open account trade more secure and efficient, several networks are being developed – and industry-wide collaboration is proving key to their success.  

One such example is the Marco Polo network, a  consortium of approximately 45 banks that leverages blockchain technology to provide an open software platform for trade, payments and working capital financing. The network is removing the need to integrate a host of external systems and replacing this with a single point of access on a cloud-based blockchain-powered network.  

The use of blockchain technology means that the moment both parties agree that the transaction terms are correct, the trade can be confirmed in real time.

This means the data in trade documents can be checked, matched and confirmed by both parties almost instantly. This is also reducing the risk that the same trade instruments could be used to secure working capital from multiple liquidity providers.  

By enabling the seamless, secure and fast exchange of trade information and transactions, partner banks are able to more efficiently insert liquidity into the international supply chain via a host of supply chain finance solutions, including both payables financing and receivables discounting.

Working towards a more efficient trade finance future

Trade finance is truly transforming, with the use of emerging technologies driving efficiencies and streamlining processes. But, while significant progress has been made – particularly with the COVID-19 pandemic pushing the industry away from the paper-based processes and towards digital alternatives – the era of digital trade finance is only just beginning.

Banks will need to keep up with the pace of change, participating in the industry initiatives, such as the Marco Polo Network, and investing in cutting-edge technologies – ensuring they can provide the support, tools and solutions their clients need to flourish in the new digital world. 

Over the past decade, the integrity of LIBOR—a benchmark interest rate used for all manner of financial contracts, from home mortgages and student loans to derivative pricing and receivables finance—has been increasingly called into question. 

The death knell of LIBOR began to sound in 2012 when it was discovered that various banks had manipulated the rate in their favour—leading to hundreds of thousands of contracts being mispriced. In the wake of this, regulators stepped in to make sweeping changes. Not long after, however, diminishing volumes of interbank unsecured term borrowing—the basis for the reference rate—led regulators to set in motion the phase-out of LIBOR once and for all. In its place, regulators began to develop “risk-free rates” (RFRs), which use historical transaction data to derive a new benchmark. 

With LIBOR used for millions of financial contracts worldwide worth more than USD$240 trillion[1], the decision sent shockwaves across the financial industry—not least within trade finance, where a huge number of contracts are either directly or indirectly linked to LIBOR. Given that the majority of these transactions are denominated in USD, the replacement of the USD element of LIBOR with an RFR—known as the Secured Overnight Financing Rate (SOFR)—will have by far the biggest impact. So amid these sweeping changes, some of which will be fully implemented at the end of 2021, what does this mean for banks and how should they prepare? 

Understanding the change 

Though SOFR will effectively serve as the replacement for USD LIBOR, there are some crucial differences between the two rates. For example, SOFR is a single daily, secured overnight rate, while LIBOR is split across seven different maturities. As a result, SOFR will require a daily compound to be calculated on an overnight basis—adding additional complexity to interest rate calculations for longer-term loans, such as those predominant in trade finance. This means that for a 360-day trade finance loan, the daily compound interest will need to be calculated 360 times—rather than once using a USD LIBOR with a 12-month maturity. 

This adapted structure will also mean that SOFR rates cannot be calculated in advance—as the rate is backward-looking, compared to the forward-looking nature of LIBOR. This creates issues with respect to establishing discount rates and calculating risk premiums—a critical consideration in trade finance. As SOFR is likely to be lower than LIBOR, this spread will also have to be accounted for. 

Key considerations

These significant differences mean that USD LIBOR cannot be simply swapped out with SOFR in existing contracts. As a result, preparation will be key—and banks will need to factor in a wide array of factors, including technology upgrades, model recalibration, contract renegotiations and fallback language. 

For contracts being written today, banks need to make sure they take into account the end of LIBOR, with regulators recommending banks should stop issuing new LIBOR contracts as soon as possible. For existing LIBOR contracts that extend beyond the deadline, exposure needs to be identified and dealt with. Many contracts will include provisions—known as “fallback language”—that stipulate what should be used as a replacement rate in the event that LIBOR is not published. Such language, however, is often inconsistent across products and institutions, as well as intended for the temporary, rather than permanent, unavailability of LIBOR. This should, therefore, not be depended on—and lengthy renegotiations and repapering of many outstanding contracts will likely still be needed. 

Fortunately, in response to growing concerns that many banks would be unable to implement the necessary volume of changes and renegotiate certain legacy contracts ahead of the 2021 deadline, the Financial Conduct Authority (FCA) recently announced an extension for the most widely-used USD LIBOR tenors—i.e. overnight, one-, three-, six- and 12-months— until June 2023. As a result, there will be far more contracts that will naturally mature before SOFR comes into effect, resulting in a decreased workload for banks. 

But of course, the original deadline still applies for one-week and two-month settings of USD LIBOR—as well as other LIBOR currencies. What’s more, in spite of the deadline extension, regulators are advising banks that no new USD LIBOR contracts should be issued after 2021. Banks should therefore still be alert to the requirements of the upcoming December deadline. 

Now is the time to prepare 

Indeed, while the industry may find some respite in the deadline extension, there is still a lot to get done. From ensuring operational and technology systems are ready to use the new RFRs, to identifying and amending existing financial instruments and contracts that may be affected, there are myriad considerations at play—ones that banks need to be aware of and get right. As we continue to move forward on this journey, banks should look to establish dedicated teams that are committed to facilitating a seamless and successful transition away from LIBOR. Amid an already challenging environment, having such a comprehensive strategy in place will prove critical in the coming months and beyond.

The views expressed herein are those of the author only and may not reflect the views of BNY Mellon. This does not constitute Treasury Services advice, or any other business or legal advice, and it should not be relied upon as such. 

  [1] https://www.bloomberg.com/opinion/articles/2019-12-06/wave-goodbye-to-libor-welcome-its-successor-sofr

The current, unprecedented circumstances have forced banks operating in global trade – an industry not necessarily renowned for being nimble – to adapt quickly.  So what changes are banks making to ensure the cogs of trade continue to turn? Joon Kim, Global Head of Trade Finance Product and Portfolio Management, BNY Mellon Treasury Services, explores.

Over the past few months, the global trade industry has faced a number of profound challenges. As countries continue their lock-down measures, or begin the long journey to ease them, value chains, logistics networks, spending and production in many areas remain heavily impeded. Against this backdrop,

Volumes of international trade have fallen significantly – with the World Trade Organisation predicting that global trade will fall by between 13% and 32% in 2020.[i]

But as the pandemic shifts us into a “business unusual” environment, what is being done to mitigate the impact on trade? For one, the trade finance industry has been forced to rapidly implement measures that move away from more traditional, paper-intensive practices. So, while in the short-term trade volumes may be impeded, an opportunity to create a new, more agile environment for the future has been created – one more willing to embrace digital change.

Risk appetites changing

The extraordinary circumstances of the last few months have called for an extraordinary response. Banks have rapidly set in motion their business continuity plans (BCPs) to curtail disruption, while also seeking to optimize the flow of trade finance transactions and protect their balance sheets. As the situation changes, and numerous nations begin easing their lock-down restrictions, these BCPs are being continuously evaluated and adapted to evolving conditions.

But what are the primary considerations in this rapidly-changing landscape? The likelihood of rating downgrades for various corporates and financial institutions, as well as the heightened chance of a recession in the jurisdictions worst hit, mean that risk profiles have increased across the board.

Combine this with the fact that the shifting conditions have created opportunities for fraud, and the need for additional due diligence and improved cybersecurity measures has become more critical than ever.

Consequently, many banks have adjusted their risk appetites and are more judicious in choosing counterparties, providing financing primarily to core clients with whom they have long, trusted relationships.

Creating the new digital norm

Amid the short-term challenges, there are some potentially long-term benefits. The trade finance industry has long sought a workable solution to bringing the heavily manual, paper intensive business into the digital age.

With airports operating at reduced capacity, courier services shutting down and end delivery addresses being closed for business, there are numerous logistical difficulties in getting crucial, physical trade documents to the necessary counterparties. What’s more, with original documents going back and forth multiple times among parties to a trade, it is critical to ensure that employees and clients are suitably shielded from potential risks.

To enable trade processes to flow effectively, concerted efforts are being made to find ways to migrate to digital formats and to reduce the use of paper. These efforts are driving the industry towards a common goal: the optimisation of transactions through digitalisation.

So far, considerable progress has been made.

For example, rather than putting pen to paper, trade finance distribution transactions can now be approved through e-signatures, while manual pickups are being reduced within export collections through the use of digitalised cover letters.

And while some paper-based elements are harder to digitise than others, particularly with regard to Letters of Credit, the current situation is changing attitudes – making the industry more willing to collaborate, advocate and drive digital adaptation across all aspects of trade finance.

The changes that are occurring now and the shift in attitudes they engender, are providing the industry with an opportunity to leverage technology to create a new norm. Once the world settles, rather than looking backwards, the industry can look forward to an era of more efficient, streamlined, value-added transactions.

[i] https://www.wto.org/english/news_e/pres20_e/pr855_e.htm