Understanding Risks in Trade Finance (Updated for COVID-19)

Doing business across borders is riskier than doing business domestically. There are additional elements such as the laws and regulations of foreign jurisdictions, availability of foreign currency and its conversion, and the logistics of exporting and importing, that must all be considered.

Trade finance plays an important role in supporting international trade and mitigating some of these risks for buyers and sellers. The World Trade Organization estimates that 80 to 90 per cent of world trade relies on trade finance in some form.

However, the risks in international trade are not just borne by the importer and exporter. Banks and other finance providers (collectively “finance providers”) provide financing in a variety of ways and are exposed to their own risks while doing so.

This guide will focus on the key risks faced by finance providers. It aims to give you a broad overview of the risks you may face so you are better prepared and can better manage the solutions you offer your clients.
The risks discussed are:

  • Counterparty risks
  • Country risks
  • FX risks
  • Dilution risks
  • Insolvency risks
  • Fraud risks
  • Compliance risks


Counterparty Risk

Counterparty risk refers to risk of default of one or more parties in a transaction. The default could be in relation to payment of monies, or performance of a contractual obligation, resulting in a possible loss for the finance provider.

Every counterparty in a trade finance transaction represents a certain level of risk, and a finance provider needs to assess the risk to decide if it would accept such risk, and on what terms.

A finance provider needs to know who its risk counterparties are. They are typically the source of repayment, reimbursement or payment, for the payment or financing made by the finance provider.

Examples:

  • When a finance provider provides invoice financing to an importer, it takes the counterparty risk of the importer for repayment on due date.
  • When a nominated bank honours or negotiates under a letter of credit (“LC”), it takes the counterparty risk of the issuing bank for reimbursement at maturity.
  • When a bank (guarantor) issues a guarantee against a counter-guarantee from a correspondent bank, the guarantor takes the counterparty risk of the correspondent bank for reimbursement of any payment for a demand.
  • When a finance provider does a receivables purchase, it takes the counterparty risk of the debtor (usually the buyer of goods) for payment of the receivables when due, and the counterparty risk of the seller for any performance issues that reduces the amount payable by the debtor.

The ability and willingness of a counterparty to pay or perform are paramount. Whether a finance provider will be paid, repaid or reimbursed on time will depend on whether the risk counterparty:

  1. Is able to and is willing to;
  2. Is willing to but is unable to;
  3. Is able to but is unwilling to;
  4. Is unwilling to and is unable to.


Counterparty risk overlaps many of the other risks mentioned in this guide, and the different risks often do not exist in isolation from the others.

Mitigation methods for counterparty risk include credit enhancement and collateral. Examples of credit enhancement are:

  • Corporate guarantee (e.g. from the customer’s parent company) where the guarantor is a stronger risk counterparty;
  • Trade credit insurance for receivables purchased or financed;
  • Guarantee from a multilateral development bank for confirmation of, and/or financing under, a letter of credit;
  • Risk participation to distribute the risk of a trade finance transaction or program to participants (typically financial institutions).

COVID-19 has had adverse effects on the revenues, cash flows, debt levels and access to financing of many businesses, which has resulted in increased counterparty risks in certain trade finance transactions.

Political/Country Risk

Political or country risk refers to risk arising from the actions of governments and authorities or regulators which result in detrimental effects to trade with counterparties within their jurisdiction. The causes of the risk are varied, and they include geo-political tensions, economic crises and political instability.

Examples of risk in importing locations include imposition of restrictions on imports, raising of import duties, and restrictions on foreign exchange outflows from the country.

Examples of risk in exporting locations include changes to export licensing requirements, imposition of restrictions on exports of certain goods, and embargoes on selling to certain counterparties or countries. Political risk also includes situations where a country is unable to pay its sovereign debt, or faces a currency crisis.

Some examples of how this risk can impact trade finance:

  • Inability of a letter of credit issuing bank to timely reimburse a confirming bank or nominated bank that has honoured or negotiated a presentation, due to imposition of currency controls in the importing country.
  • Inability of an exporter to fulfil export orders for which pre-shipment finance has been provided, due to imposition of export restrictions or embargoes, which then cuts off the source of repayment for the financing.

Some ways in which this risk may be mitigated are:

  • Credit insurance that covers political risk, where available or feasible.
  • Guarantee of a multilateral development bank (“MDB”, for example, Asian Development Bank, Afreximbank, International Finance Corporation) under the relevant Trade Finance Program (“TFP”, variously named) offered by the MDB.
  • For documentary trade financing, the confirmation or irrevocable reimbursement undertaking from a bank in a lower risk location.
  • Risk distribution to other financial institutions.

COVID-19 has exacerbated the causes of political risk, and thus increased it. Tensions brought about by the global spread of the virus have resulted in imposition of certain protectionist policies, trade embargoes and trade sanctions by nation states. It has also increased the risk of sovereign defaults.

FX Risk

FX (short for foreign exchange) risk refers to risk arising from fluctuations in currency conversion rates. Currency fluctuations occur due to a variety of reasons that include monetary policy, economic conditions, governmental actions, speculation by currency traders, and supply and demand for the currencies bought and sold.

Whilst FX risk are primarily risks for the importer and exporter, a finance provider needs to be aware of how it might affect its customers, and be cognisant of how exposure to FX risk might impair a customer’s repayment ability.

An importer may pay in local currency to its bank to convert to the foreign currency that its purchases are denominated in. If the purchase is backed by a letter of credit denominated in a foreign currency, the issuing bank faces an FX risk on the applicant, as any depreciation or devaluation of the local currency will result in an increase in the local currency amount to be reimbursed or repaid to the bank by the applicant.

An exporter that sells in foreign currency may convert to local currency to repay a finance provider that has provided export financing. If the financing is in local currency, a significant appreciation of the local currency may result in a shortfall of the amount converted from foreign currency, to settle the financing.

The usual way of mitigating FX risk is by way of hedging techniques, such as FX forward contracts with banks (to fix the FX rate over a period of time), and FX options. The counterparty may also have exports and imports in the same currency, which could provide a natural hedge for its foreign currency requirements.

COVID-19 has triggered some sharp swings in FX markets, particularly in the currencies of some emerging market economies as a result of a flight to ‘safe-haven’ currencies.

Dilution Risk

Dilution risk refers to risk that the amount that may be payable by the debtor on a trade receivable will be less than the invoiced amount(s). Dilution may arise due to a variety of reasons including return of goods, short-shipment, damaged goods, warranty claims, billing error, rebates and commercial dispute.

The impact of this risk on trade finance is primarily on the financing of exporters’ open account receivables using Supply Chain Finance techniques such as Receivables Discounting, Factoring and Loan or Advance against Receivable. This is because the buyer has time up to the payment due date of the receivables to adjust the amount they would pay on the exporters’ invoices.

Dilution risk may reflect the performance risk of the exporter, as some of the events that give rise to dilution are attributable to the exporter; examples: defective goods, short-shipment, billing error.

Mitigation methods for this risk include:

  • Due diligence on the receivables to be performed prior to financing, to assess the dilution percentage and to set the appropriate advance ratio for the financing. The dilution rate may be monitored on ongoing basis, and adjustments to advance ratios made accordingly on periodic basis.
  • Use of unconditional payment instruments such as bills of exchange and promissory notes, to create a payment obligation separate from the commercial transaction that gave rise to it.
  • Dilution to be included as a recourse event, in the financing agreement with the exporter; i.e. the exporter is to make good to the finance provider any shortfall due to dilution in the collection of the receivables.

COVID-19 has brought disruption to supply chains. FCI, the industry association representing factoring companies, reports that dilution is expected to increase, and to have witnessed amongst its members an increase in dilution in the first few months of 2020.

Insolvency Risk

Insolvency risk refers to risk that a counterparty may be unable to pay its debts and financial obligations. Insolvency could have been the result of losses and cashflow issues arising from inability to collect on debts, inability to sell its inventory, and/or loss of credit facilities.

When a business entity becomes insolvent and it is placed under the management of an insolvency administrator (also variously known as bankruptcy trustee, liquidator, receiver etc., depending on jurisdiction), the debts of the insolvent entity would be ranked in terms of seniority, and as secured or unsecured, to determine priority of creditors for payment.

A finance provider may face competing claims from other creditors for the assets of the insolvent entity; these other creditors could include the government (e.g. for taxes owed), lenders and trade creditors.

A finance provider faces the insolvency risk of counterparties which have bilateral repayment obligations to it (e.g. for trade finance facilities granted), of counterparties with whom it may not have a direct financing relationship (e.g. debtors in a Receivables Purchase), and of other counterparties upon the risk of which the finance provider has provided finance (e.g. an issuing bank of a letter of credit).

Mitigation for insolvency risks includes:

  • Assessment and continuous monitoring of the credit quality of the relevant counterparties
  • Uncommitted financing arrangements
  • Availability of collateral
  • Perfection of security arrangements
  • Trade credit insurance where feasible

Although the full effect of the COVID-19 pandemic on business and the economy is yet to be seen, it has already resulted in an increase in the number of business insolvencies, and its toll is expected to increase.

Fraud Risk

Fraud risk refers to risk arising from intentional deception. Fraud could be perpetrated against one or more of the buyer, the seller and the finance provider. Fraud could be committed by a single party or by two or more parties acting in collusion.

Some common frauds in trade finance are:

  • Duplicative invoice financing, where the same invoices are used to obtain financing from two or more finance providers.
  • Use of forged or fake documents to obtain financing.
  • Collateral fraud involving inventory, such as false valuation and multiple pledges of the same inventory to different finance providers.

As fraud is intentional, the form it takes is myriad and is limited only by the ingenuity of its perpetrators.

There is no assured protection against fraud; however, a finance provider should have in place certain risk management practices such as enforcement of strict internal controls (e.g. segregation of staff duties, use of “four eyes principle”), proper due diligence on its customers, and independent verification of facts on transactions (e.g. vessel checks, price checks).

Technology could be an enabler in fraud detection, such as use of data in information systems to detect anomalies and red flags, e.g. the reuse of the same data for different financing transactions within the same finance provider or across different finance providers.

COVID-19 has brought heightened fraud risks, and the pandemic’s disruptions to business (on commodity prices, availability of financing etc.) have also served to uncover some frauds previously undetected in trade and commodity finance.

Compliance Risk

Compliance risk refers to risks of legal or regulatory sanctions, financial loss and reputational damage that a finance provider may suffer as a result of its failure to comply with applicable laws and regulations.

The Financial Action Task Force (“FATF”) refers to ‘trade-based money laundering’ as the process of disguising the proceeds of crime and moving value through the use of trade transactions, which can be carried out through misrepresentation of the price, quantity or quality of imports of exports, and fictitious trade activities.

Besides money laundering, financial crime compliance includes countering terrorist financing (“CFT”), anti-bribery and corruption, non-proliferation of weapons of mass destruction, and complying with economic, financial and trade sanctions imposed by states and the United Nations.

A finance provider could also face the risk of being unable to collect on a repayment or reimbursement, for example, if it has provided financing to an exporter under a documentary credit but the issuing bank withholds payment due to detection of a violation of applicable sanctions.

Mitigation methods for this risk include the following:

  • Education and training of the finance provider’s staff on compliance requirements and to instill a compliance culture, based on guidelines or guidance from its regulators.
  • Effective Know-Your-Customer (“KYC”) practice to verify the customer and its owners prior to onboarding (and periodic reviews subsequent to onboarding) and Customer Due Diligence (“CDD”) to assess their level of AML/CFT risk.
  • Transaction screening, reviewing and monitoring, to verify that the underlying trade transactions are genuine and do not violate applicable regulation.

Effective management of compliance ought to have the benefit of reducing friction for customers and helping governments with their objective of financial inclusion.

The FATF reports that criminals are taking advantage of the COVID-19 pandemic to carry out financial fraud and exploitation scams, and that terrorists may also exploit similar opportunities to raise funds, and recommends that financial institutions and other businesses should remain vigilant to emerging money laundering and terrorist financing risks in mitigation, detection and reporting

COVID-19 Considerations

The COVID-19 pandemic has elevated all the risk types discussed. It is a Black Swan event for many businesses.

Increase in counterparty risk brings with it an increase in insolvency, dilution, fraud and compliance risks. Increase in political risk brings with it an increase in counterparty, FX and insolvency risks. There is inter-relation between the different risks, and one feeds another.

Trade finance is vulnerable to the increased risks, and some finance providers have responded by limiting or curtailing trade finance.

The ICC has in September 2020 launched the “Advisory Group on Trade Finance” (“ATF”), that aims to inform policy reforms and interventions by governments and multilateral institutions to prime the trade credit ecosystem for a rapid economic recovery from COVID-19. Trade finance is seen as the critical enabler of international trade and as key to the revival of the global economy and job creation post-COVID-19.

Effective management of various risks relevant to trade finance would benefit finance providers and the customers they serve, national economies, international trade and the global economy. The first step toward effective risk management is to understand the nature of the different risks involved.

The present challenges in managing trade finance risks could be a catalyst for new risk management tools to be adopted, which ought to include digitalisation of processes to make them more efficient, secure, auditable and cost-effective.

About the author

Tat Yeen Yap is a consultant trainer for ICC Academy. He has held positions as head of trade finance at banks including Société Générale and ABN AMRO. He has also been a contributor to ICC rules and the Global Supply Chain Finance Forum.

Contact details:
yty2020@outlook.sg
https://www.linkedin.com/in/tat-yeen-yap/

Further Learning

If you would like to enhance your understanding of trade finance further, we recommend taking our one of our internationally recognised, professional trade finance certificate programmes.

Global Trade Certificate (GTC):
The GTC is our introductory trade finance certification programme which will give you a thorough and broad understanding of the various trade finance techniques and settlement methods available.

GTC Students get access to 14 individual courses covering documentary credits, guarantees, standby letters of credit, supply chain finance and much more. Once you have completed nine of the courses you will be eligible to take the final exam. If you pass you will receive an internationally recognized ICC Academy certificate, which you can use to improve your career prospects and work towards more advanced qualifications such as the CTFP.

Certified Trade Finance Professional (CTFP):
The CTFP is our advanced trade finance programme intended for those with five or more years’ experience working in trade finance or those with an existing trade finance qualification from the ICC Academy or LIBF. It is designed to give you the tools to confidently sell, deliver and process global trade finance solutions and is fast becoming an industry standard for senior trade finance positions.

CTFP Students get access to 11 individual courses covering documentary credits, guarantees, standby letters of credit, supply chain finance, supply chain finance, fintechs, trade operations and much more. Once you have completed nine of the courses you will be eligible to take the final exam. If you pass you will receive an internationally recognized ICC Academy certificate, which will qualify you for more senior trade finance positions and help to fast-track your career.