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Business News/ Brand Stories / Navigating Credit Risks: Key Considerations for Trade Finance Investors

Navigating Credit Risks: Key Considerations for Trade Finance Investors

For investors, trade finance offers consistent returns, low volatility, and minimal correlation with broader markets, making it an attractive alternative fixed income asset class

According to World Trade Organization, 80-90% of the $17.3 tn trade market relies on trade finance.Premium
According to World Trade Organization, 80-90% of the $17.3 tn trade market relies on trade finance.

Trade finance is a cornerstone of the global movement of goods. It provides the necessary liquidity, risk mitigation and stability to businesses engaged in international & long-distance domestic trade. According to World Trade Organization, 80-90% of the $17.3 tn trade market relies on trade finance. In a simple transaction, when a seller ships the goods, it needs predictability and quicker realization to cash from the Buyer. Buyer on the other hand ideally requires the goods to be sold before paying the seller to maintain an effective working capital cycle. Modern-day trade finance is able to plug this gap for both the buyer and seller by using mechanisms like invoice financing, letters of credit, etc.

Ultimately, like all financial instruments or asset classes, trade finance investment is about understanding risk return. In a trade finance transaction, key risks originate from 

  1. Underlying transaction not being bonafide
  2. Damage to goods during transit 
  3. Buyer and seller disagreeing on quality of goods supplied 
  4. Buyer unable to honour payment and 
  5. Seller unable to honour payment of trade finance received earlier.

These risks were typically compensated by the Seller in either form of collateral, personal guarantees or other security measures which they could provide. However, technology upgrades, improved flow of information, and better understanding of risk have led to more nuanced measures that mitigate risks:.

Transit Insurance: Most sellers now exercise due cover for any transit losses. Given the improved traceability, better transport and significantly improved handling capabilities – insurance firms are able to offer high quality coverage for transit risks.

Confirmation: Technology enables confirmation from both Buyer & Seller quickly and securely. This removes ambiguity related to acceptance of goods and avoids any dispute between the Buyer and Seller

Bank Guarantee: Financial institutions closer to a counterparty are able to do a credit assessment of trade finance and offer products such as bank guarantee which covers any loss in case cash realization on a trade transaction is not on expected lines. e.g. if a Seller is shipping goods to a first-time Buyer, they might insist on a Bank guarantee to ascertain payment. Guarantees are also useful for the Seller to receive upfront cash due to higher certainty. The bank is comfortable with the risk, given they would earn a fee income with capital outflow only in case of an contingent event.

Trade credit insurance:  Given the ability to verify trades along with making credit assessments of counterparties involved, insurance firms can provide trade credit insurance. This implies that in case a Buyer is unable to make the payment for goods, Insurance would cover the same. Trade credit insurance has rapidly become a very commonly used mechanism to improve certainty in the trade finance ecosystem.

From an investment perspective, trade finance is an alternative fixed income asset class with consistent returns, low volatility and very limited correlation with broader markets. Trade finance provides the following key benefits to an investor

  1. Ultra short term duration giving liquidity options
  2. Uncorrelated returns to capital markets
  3. Can be secured through guarantees and insurance 
  4. Complexity premium and 
  5. Diversification. 

Investors can view trade finance as an alternative to traditional credit assets such as debt MFs and short dated bonds or as a strategic cash position offering favorable returns compared to money market instruments.

For an investor, understanding of credit risk associated with counterparties involved and participation in transactions where risk mitigation mechanisms are present would be key for the growth of the asset class. Given the importance of trade, it would not be surprising to see trade finance become a staple in most investor’s portfolios over the next few years.

Disclaimer: This article is a promotional feature and does not have journalistic/editorial involvement of Hindustan Times. The content may be for information and awareness purposes and does not constitute any financial advice.

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Published: 30 May 2024, 08:14 PM IST
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