The Technological Transformation of Trade Finance: Closing the SME Funding Gap

The landscape of international trade and finance is undergoing a profound transformation. The pre-existing challenges of complexity and cost in international trade have been further exacerbated by events like the Covid-19 pandemic and geopolitical tensions such as the conflict in Ukraine. However, as we look to the future, it is not just economic and geopolitical factors that will impact trade; tighter regulatory compliance is poised to add significant cost pressures. While the need for stringent regulation is unquestionable, it must be accompanied by a fundamental transformation of trade finance practices. Fortunately, this transformation is already underway, driven by cutting-edge trade technology (tradetech), which is ushering in new players and fresh liquidity to the sector. This trend is expected to gain momentum in the years to come.

The Regulatory Landscape

In the wake of the 2008 global financial crisis, the Bank for International Settlements introduced a set of capital requirements for international lenders known as Basel III. The next iteration of these regulations, Basel IV, is set to be adopted by lenders in the near future. In essence, Basel III and IV mandate that banks increase regulatory capital and reduce free capital, leading to higher balance sheet costs as larger capital reserves are required.

These regulations, combined with other factors, have led to increased complexity and higher costs for onboarding clients, mainly due to more rigorous anti-money laundering checks. As a result, some banks have withdrawn from certain markets and geographic regions, making it increasingly challenging for small and medium-sized enterprises (SMEs) to secure trade financing from traditional banks. This situation has created a growing SME funding gap.

The Rise of Non-Bank Lenders

In response to this funding gap, new funders, often referred to as non-bank lenders, have emerged on the scene. These non-bank lenders are stepping in to provide much-needed liquidity to SMEs through services like invoice financing, effectively filling the void left by banks that have shifted their focus towards core client groups.

The concept of non-bank financial institutions is not entirely new; SMEs have been using factoring companies for decades when traditional banks could not meet their funding needs. Factoring companies purchase a business's unpaid invoices in exchange for a fee, which is deducted once the full payment is collected from the customer. This injects liquidity into SMEs by allowing them to access funds based on their receivables at a discount.

Recent years have seen the emergence of many alternative lenders that leverage tradetech to automate the process of funding invoices. These lenders extend liquidity to SMEs by providing loans based on invoices approved by the buyers. These innovative non-bank lenders aim to bridge the SME funding gap and bring much-needed financial support to this crucial sector.

Banks Adopt the Originate-and-Distribute Model

In addition to non-bank lenders, traditional banks are adapting to the changing landscape. Many are shifting toward what's known as the "originate-and-distribute" model. This model allows banks to focus on servicing transactions while relying on third-party, non-bank liquidity from asset managers and institutional investors. Today, advancements in tradetech are making it feasible to implement this model on a much broader and more automated scale. Banks are increasingly collaborating with capital market players, offering them access to transactions they service, which expands capacity in the trade finance market.

The Originate-and-Distribute Model in Action

The originate-and-distribute model is a brilliant solution to address capital constraints without restricting trade finance availability for clients worldwide. It's at this juncture that the Trade Finance Distribution Initiative (TFD Initiative) plays a crucial and expanding role by adding liquidity through its growing network, which currently consists of 80 members, including some of the world's largest financial institutions.

The TFD Initiative recognizes a common need among incumbent banks, factoring companies, and alternative lenders: the need for third-party liquidity. This new source of liquidity can be found in institutional investors, including family offices, pension funds, and credit insurers. The mission of the TFD Initiative is to transform trade finance into a liquid asset class that can be traded globally, with transaction-level automation and standardization, leading to significant cost efficiencies and real-time processing.

Overcoming Barriers for Institutional Investors

One of the significant barriers for institutional investors looking to enter the trade finance market is the specialized skill set required to source and originate trade finance deals and understand complex legal documentation. The TFD Initiative is providing the key to improving market access by making trade receivables investable to capital market players.

Perfect Conditions for Closing the SME Funding Gap

The growing body of research on the benefits of the originate-and-distribute model, coupled with the increasing interest in trade finance as an asset class for non-bank investors and the rise of the tradetech sector, has created the ideal conditions for closing the SME funding gap. As technology continues to shape the trade finance landscape, it is clear that a new era of trade financing is dawning, one where traditional and non-traditional players work together to meet the evolving needs of businesses in a rapidly changing world. The future of trade finance is not only more efficient and cost-effective but also more inclusive, ensuring that SMEs continue to have access to the funding they need to thrive in the global marketplace.

Read More on The Technological Transformation of Trade Finance