As someone engaged in business development for a boutique global trade finance firm, my observations of global trade finance opportunities, as they relate to small and medium size enterprises (SMEs), are as a result of a day to day engagement with SMEs throughout the world. From my hands-on perspective, I view international trade finance as a current-asset balancing act. Because economic realities of the day exclude them from previously accessible credit markets, SMEs need to consider their cash and inventory balance to maximize turnover. The balancing act has become a game that’s played by professionals ranging from global supply chain managers, to local independent importers and first-time entrepreneurs where the importation of goods may not be the core discipline of the business. All of these actors within the realm of international trade, of varying levels of experience and credibility, perform a distinct and well-defined business discipline which is predicated on trust between counterparties.
Too Big To Fail
Large-cap importers have the luxury of dictating terms to suppliers, and can pay on their own schedule with impunity. For most of their suppliers, the financial benefit of a large order outweighs the inconvenience and uncertainty of unfavorable terms. Even some mid-cap importers wield enough influence within their sector that their suppliers are, to a degree, beholden to them. For these businesses, they are ahead of the eight-ball with respect to their suppliers because their size or reputation affords them the luxury. However, it is only a small minority of importers who are able to live by these terms.
For the vast majority of importers–small-caps–there simply isn’t enough of a balance sheet or reputation involved to motivate a supplier to provide open terms on manufactured goods which require significant lead-times. In this most common scenario, the importer is behind the eight-ball and is in effect beholden to the supplier.
In the case of most SME importers conducting international trade, the supplier seeks to hedge against credit risk and the buyer seeks to hedge against QA/QC risk, and delivery risk. The obvious way to protect both buyer and seller is to employ a third party who can guarantee funds to the seller, and opportunity to the buyer. Traditionally, these protections can be found in a letter of credit, whereby a financial institution with a presence in the country of both the buyer and the seller will certify the transaction. However, this business has grown substantially unrewarding for large financial institutions because the margins on these services have tapered.
In an era of quantitative easing where banks can approach the U.S. Federal Reserve and buy money for almost nothing and with near-zero risk involved, it makes little sense to pay an army of staff to secure high-risk transactions for SME client importers when they may only make a percent or two on the deal. For a large bank, returns on letter of credit services simply do not outperform other endeavors with similar cost requirements and risk profiles, so either the products are no longer offered, or they are offered at very high rates. This trend is expected to continue and the industry is adapting accordingly.
As the evolution of capital markets pushes large finance institutions to further exclude SME importers from traditional sources of financing, specialty financial institutions have recognized opportunity and stepped in to fill the gap in the marketplace.
Small, regional banks – particularly ones with a presence in select producing countries (i.e. China, Bangladesh, or India) and satellite offices in consuming countries (i.e. U.S. or E.U.), have differentiated themselves by offering trade finance services to address SME importers with relatively strong balance sheets and acceptable business reputations. Such client businesses may have a decade of operational history, be turning over 25-50 million U.S. dollars per year, and have a somewhat sophisticated approach to importing goods—meaning they require very little consultation from trade finance service providers. This portion of the market makes up the majority of importers in the Western world, and in turn the globe. They are an integral cog in the world’s supply chain, and while they do not process orders in comparable magnitude to their large-cap brethren, collectively they sustain the industry by spreading default risk across many thousands of small-cap businesses, as opposed to centralizing default risk among a hand full of large caps.
The Real Market Makers
Suffice to say the small players in the importing world are critical to the health of the global supply chain, but all too often these players have succumbed to an economy which has proven so favorable to large cap firms. A large portion of import-based businesses underserved by ever-constricting capital markets are either family businesses, or they are being run with a skeletal staff of international traders who may be unsophisticated, meaning they can be susceptible to costly rookie mistakes. For such businesses there may be a great deal of goods they could theoretically sell, but their cash position makes it impossible to capitalize on the opportunity. Many such firms are small retailers who today are coming off of a weak holiday buying season and may be finding it increasingly difficult to finance the inventory they need to grow. Others may have allocated capital poorly in other aspects of the business and now find themselves short of target on inventory financing. It is clear that for SME importers, there are various significant barriers to their growth.
Money Never Sleeps?
When cash is left stagnant and not, at minimum, earning interest, it may be considered a loss of revenue and, in turn, a barrier to growth. One major barrier to growth is that in most cases, SME importers are required by their suppliers to use letters of credit for the protection of the seller (an added benefit is that the buyer is protected as well). A letter of credit works the same way escrow works when buying a house—the buyer must furnish the cash value of the transaction to an independent third party who is trusted by both counterparties. The difference is that when buying a house, ostensibly the buyer receives the benefit of that purchase almost immediately, therefor putting their money to work without delay. When sourcing goods from overseas, one must wait up to 90 days or more before goods are available to be booked as inventory, and only then is it possible to trigger a profit event by selling them on or approaching a factor. When using a letter of credit, money simply does not work hard enough for its owner; any time money is dormant, particularly in the U.S., it is being inflated out of its value. For most SMEs, keeping money dormant for an order fulfillment period (one-quarter of the year or more) represents an incredible loss of profit and is a significant barrier to growth.
This reality has created an opportunity in the trade finance marketplace for an additional layer of differentiation. For instances involving a client importer who understands the time value of money, the market has adapted to provide services whereby SME importers may have their international transactions certified without having to contribute cash as security. This is analogous to a letter of credit with no capital commitment, and it is an up-and-coming tool in the trade finance marketplace. What this means is that for importers who would rather generate a return on their capital instead of laying it dormant behind a letter of credit, inventory may now be acquired and other financial obligations or opportunities may be met in parallel.
It is up-and-coming because the product makes sense for practitioners in this field. Whether a business is credit-worthy is peripheral to the point of the exercise; clients are not debtors and no liens are filed in the event of default. By virtue of this, the application process is streamlined and qualifications are rooted in the nature of the transaction, as opposed to the operational history and financial health of the client which can be costly and time consuming to verify. This reduces operating costs. Under this scenario, the import finance service provider who certifies the transaction uses their own collateral to protect the seller, and mitigates liquidity risk by retaining ownership of the goods until the client pays for them, which is usually immediately following the arrival of goods to port. In the unlikely event the client defaults on payment, the goods can be liquidated.
The Choice is Yours
If the client knows they will not have sufficient cash on hand to pay for the goods as they reach port, the client may seek factoring services, in which case the factor would pay the import finance service provider directly, effectively adding an element of insulation between the importer and the flow of funds which pay for the goods, and in turn providing another layer of security for both trade finance service provider and seller. This benefits the importer by streamlining remittances and reducing operating costs. In either scenario, the SME importer is provided the privilege of ordering goods, and for all intents and purposes, converting a remittance structure which leaves money dormant for months at a time, into a much-preferred COD transaction. Such services have the substantial benefit of accomplishing the import needs of the business, while leaving cash on hand for the importer to fund other profit centers or simply accrue interest.
Of course there is a downside; predictably such services can be pricey. Typically practitioners in this field will add 4% to the cost of the goods. Service fees at or around 4% sound like a lot, but for SME importers who are unable to achieve open terms with suppliers or unwilling to let cash remain stagnant during a lengthy order fulfillment period, the cost of the service must be weighed against the value of foregone business opportunities. The reason this product is able to exist within the trade finance industry is because for much of the time, the ends do a fantastic job justifying the means.
Since the great recession of 2008, global opportunities have changed universally and throughout the world. Capitalizing on financial opportunities in such a complex and evolutionary economic landscape requires an unprecedented level of creativity and entrepreneurialism. Businesses are seeking new support systems. Entrepreneurs—the ones who have created and operate SMEs–have begun to demonstrate that the route to their required financing exists if they are able to separate themselves from the habits and customs of the past lending and credit environment, and open their eyes to the world of opportunity before them in non-traditional structured finance.
Zachary Tatum is vice president of Business Development at CFP International; a firm which specializes in providing bespoke trade finance services direct to SME clients. Prior to this, Mr. Tatum spent several years consulting privately client businesses in the disciplines of business development, strategy and operations. This followed a six year career with an alternative fuels company which, during his tenure, grew from a startup to over $400m in assets. Mr. Tatum studied geology at Arizona State University and is currently an MBA candidate at Middlesex University in London. Zack can be reached at email@example.com.