Safe to go back in the water…?   - Trade Treasury Payments

• Home
• Blog
• Articles
• Safe to go back in the water…?  

Safe to go back in the water…?  

Is it possible to engage in the commodity trade finance market without getting your backside bitten off by the sharp-toothed beasts that lurk therein? John MacNamara examines the case for re-entering the apparently bloody waters of commodity trade finance. 

The 1975 film “Jaws” scared the bejeebers out of everyone and was credited with prompting a dramatic loss of interest in ocean swimming off East Coast USA. Three years later, “Jaws 2” was marketed under the tagline “Just when you thought it was safe to go back in the water…”. Eventually of course we all did go back in, yet we all knew the man-eating Great White Sharks were all still out there. How does this work? Perhaps for starters might be to ask, how many people do you actually know who’ve been eaten by a shark? Yes it does happen, occasionally, but not on a daily basis and you need to be pretty unlucky.  So,  does Commodity Trade Finance (CTF) work the same way?   

Let’s start with the CTF positives. The big one is scale. For the average bank, the ‘New Client Adoption’ process for onboarding and keeping a corporate client is massively burdensome, and consequently commensurately costly. The familiar ‘KYC’ increasingly becomes ‘KYCC’ – Know your Customer’s Customer. This is not just for the assessment of Financial Crime risks, including Anti Money Laundering (AML), Countering the Financing of Terrorism (CFT), and compliance with sanctions, but also now looking at sustainability concepts like ‘Scope 3 emissions’, all before anyone even mentions ‘credit risk’. Then physically transacting say a documentary Letter of Credit (LC), is exactly the same amount of work for a container full of manufactured widgets worth $7,000 as for a commodity cargo of crude worth $70 million. CTF offers economies of scale. Relatively small teams in the lender’s office can process exponentially high volumes of trade, on which their fee percentage is based because the cargo unit size is so chunky. 

Then there’s the incremental cross-sell business:  add on further revenue from taking third-party credit risk (for example in confirming the LC of your customer’s buyer’s bank, or offering pre/post shipment finance), or FX, or interest rate management or commodity price hedging products, and it all adds up. On top, the actual incidence of default across the whole trade finance market is on average low. The ICC’s trade register, which collects data from 22 of the largest trade finance banks, across trillions of dollars’ worth of transactions, puts it at less than 0.2%, and has done for years.  The CTF lender can make big money pretty quickly.  So what’s not to like? Well unfortunately the challenge is that, with these big ticket sizes, if one customer does go South, you can also lose big money, and that can also happen pretty quickly. 

Modern generations of bankers have rather gotten used to the top tier of big international commodity traders making many multiples of the profits the bank makes, typically with less than 10% of the headcount. It wasn’t always this way. While the big boys are now very asset-diverse, in balance sheet terms, the whole of the rest of the commodity trader universe remains characterised by predominantly 90-95% current assets, matching (hopefully self-liquidating) current liabilities, minimal fixed assets and a very limited equity base. This ‘classic trader balance sheet’ is thus thinly capitalised, and therefore vulnerable to shock – what the credit colleagues call the ‘jump to default’, where out of a relatively clear sky, suddenly the erstwhile successful trader goes ‘bang’, which tends to spoil the rest of any lender’s day. In the 2020  wave of CTF defaults in Singapore, Dubai and elsewhere, this was exacerbated by the discovery that many of the transactional documents being financed, like Bills of Lading (BLs) and invoices were in fact fake. The next question then is often, is that Game Over for the lender’s CTF team, or even the CTF industry? 

Let’s look for a moment at the regulatory position. Here the Basel Committee on Banking Supervision sets the standards, which then local regulators must interpret and implement. In fact, the Basel rules have very little to say about Trade Finance in general, and even less to say about Commodity Trade Finance, yet as time has gone on, the collateral damage from the laws of unintended consequences has just got worse and worse, not least as the Basel committee has in the latest versions of their Credo effectively derecognised non-financial transactional collateral. Lenders can still take it, but banks should not expect any capital relief for doing so – there is no regulatory incentive to take collateral. 

So what is there? The first regulatory concept, which lies behind the risk weighting of any given asset, is ‘Probability of Default’ (PD). The good news here is that PD for all types of Trade Finance is generally low (remember that very low ICC default ratio), which of course is what most TF specialists would tell you from empirical experience.  The hard part is that this is effectively a meaningless number – is any given deal ‘twice as likely’ to default? Three times?  It’s an intangible concept, so the PD is effectively ignored by the average RORWA black box (the ‘Return on Risk-Weighted Assets’ model through which banks and others calculate their Key Performance Indicators/KPIs). The more tangible number is the ‘Exposure at Default’  (EAD) – how much do you actually have outstanding when the balloon goes up? This is a very real number and represents the maximum the lender(s) had at risk at that moment of default. It’s also the number you tend to see in the newspaper headlines – such as “Banks lose $4 bn on Hinleong collapse” which Singapore story was plastered all over the press in 2020. Except that was not in fact how much the banks actually lost. 

This is where another regulatory concept comes into play – Loss Given Default (LGD). This is the important, yet often misstated, number for calculating those KPIs.  What they mean here is what is the ‘severity of default’ – how much do you actually lose? This is actually a rather harder number on which to access data, outside the bond market (where the ratings agencies are rather more assiduous at collating data), because it takes time to work out/ restructure/ go to court, and by the time recoveries kick in, banks have often moved on (in fact recent regulation seems rather to incentivise banks to sell off defaulted exposures, crystalise their losses and walk away, rather than to put the effort into recovery). Banks usually set bands for LGD for different perceived levels of risk, which are applied upfront. These typically assume quite high levels of loss, especially for emerging markets business and for unsecured exposures (which is what regulators now say these CTF deals are). However, if we look at say the Hinleong case, over the last 5 years since that story broke, banks have steadily been recouping losses through the Singapore courts, both from the remaining physical collateral and from the various commercial counterparties who appear to have colluded with Hinleong to deceive the banks about what was really going on (and for every case that made it to court, several others settled out of court as the direction of travel of the Singapore judges became clear). This experience is not, and has never been, unique to this particular story.  The Singapore banking community has remained stubbornly supportive of commodity trade finance, not least because as it turned out, the severity of the 2020 defaults was nowhere near as bad as broadcast at the time – they’ve steadily been getting their money back, just as, further back in time, lenders got repaid from the Ukrainian CTF restructurings of 2014-17 or before that, the global financial crisis. 

Of course this is not to say the sharks are not still out there. It’s still possible to get things wrong (as in any market), yet the water looks rather more inviting than it did perhaps relatively recently. Regulators still shine a strong light on the vulnerability of Trade Finance to all sorts of financial crime, but these days the guidelines (not least those coming out of bodies in Singapore like ACIP – the ‘AML/CFT Industry Partnership’, which brings together the Monetary Authority of Singapore, the Commercial Affairs Department of the Singapore Police, and the Association of Banks in Singapore in a public-private partnership), or say the Wolfsberg Trade Finance Principles,  are actually very practical.  In a further step in the right direction, the UK’s  Electronic Trade Documents Act 2023 finally lends legal certainty to the use of electronic BLs (e-BLs) as collateral. After some initial hesitation in uptake among practicants, this has now been embraced inter alia by top tier trader Trafigura to launch a very successfully syndicated $2.8 billion facility collateralised by e-BLs already last year, which promises digital monitoring and collateral management to mitigate risks of fraud and fake documents. This is surely the shape of things to come.  

We need to be careful not to overstate the risks in CTF. All banking is a ‘risk’ business, the question should rather be whether the rewards are worth the risk. At my last bank, my CTF team made net money, and target KPIs, every year for 20 years (which not every desk at that address could say). This is not to say we didn’t get bitten from time to time, but the overwhelming preponderance of deals ran to maturity without drama, while on the occasional ‘challenge’ scenario, that severity of default turned out more often than not, not to be that severe.  It’s still worth getting your feet wet.