By Hans Krohn, Head of Trade Products at Commerzbank
Until recently, the trade finance securitization market’s success was hindered by a marked lack of demand from institutional investors.This was partly due to the fact that it was difficult in the past for non-bank investors to access trade finance assets, which are generated almost exclusively by banks and historically traded only in the interbank market. But more’s the point, not all institutional investors have always understood the appeal of this asset class in terms of its stability and returns profile.
Yet, we have recently seen a surge in issuance of securitization deals prompting healthy demand from institutional investors. In September last year, Commerzbank clinched its own deal and successfully placed a US$22 million mezzanine tranche of a US $500 million portfolio of bank-to-bank trade financing transactions with institutional investors. The recent wave of deals – including the Trade Maps 1 and Lighthouse deals – shows that demand for well-structured trade finance securitizations is growing. However, if the market is to succeed long-term, the onus is on banks to structure such deals so as to appeal to a wider range of institutional investors – providing yield, security, and granularity in the asset reference pool – while at the same time increasing standardization of the underlying trade finance assets. If successful, 2014 may be a boom year for trade finance securitizations.
The appeal of trade finance assets
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Behind the recent increase in trade finance securitizations is partly Basel regulation, forcing banks to hold more capital against trade finance loans, thus making structures that help to reduce risk-weighted assets appealing.
At the same time, trade finance business is booming with both global GDP and international trade on the up. However, this increase in demand is not being balanced by the introduction of new financial institution players and, when combined with capital constraints, the result is pressure on banks’ lending capacities. The solution to meeting this demand, therefore, is securitization of trade finance assets, allowing banks to sell the associated risk to institutional investors and freeing up capital for new lending activities.
After 2008, the idea of banks turning to CLO-type structures could, on first impression, seem worryingly like history repeating itself. Yet it is important to remember that the sub-prime crisis was brought about by the lack of quality of the underlying assets, not the structures of the securitizations.
The stability of trade finance assets is therefore key to its appeal. The International Chamber of Commerce Trade Register recently reported that trade finance transactions are far less likely to default in comparison to corporate loans. The data shows that across nearly 8.1 million short-term trade finance transactions, fewer than 1,800 (or 0.02%) defaulted between 2008 and 2011.Certainly, this fact seems to have caught investors’ attention, particularly in the current low-rate interest environment, with appetite for alternative assets classes now larger than before.
What is required for the market to succeed?
Although investors are attracted by the low-risk nature of trade finance assets, in order to firmly establish their interest, they need to be sure of granularity and diversity in the underlying reference pools.
Portfolio diversity is important in trade finance securitizations in order to get investors comfortable with the risk. Commerzbank’s Co-Trax Finance II-1 deal is a case in point: investors demanded that deals from all over the world be included in the reference pool so it was made up of around 160 transactions (around 80 debtors) with an average probability of default of 0.99% at the outset. This consisted exclusively of short-term trade-related financings with other banks, from a wide range of domiciles (23% of the deals came from Brazil, 22% from China, 12% Panama and 7% Russia, and the remaining came from 12 different countries).
As things stand, there are only a handful of banks globally with portfolios diverse enough to cope with investors’ requirements for granularity. Therefore, in order for trade finance securitizations to take place on a much larger scale, an idea proposed by the London Group and implemented by Citi and Santander in 2013 could provide food for thought. The concept centres on the creation of a much larger inter–bank securitization pool– larger than any single bank can possibly provide – which, as a result, significantly increases diversity and hence lowers concentration risk for investors. Certainly, this structure has the potential to be complicated and costly but it is something that needs testing and discussing in order to draw investment.
Of course, portfolio diversity is not investors’ only requirement – there is also the important matter of yield. Institutional investors seek much higher yields than traditional trade finance business can normally offer. This makes the slicing of the CLO into tranches – allowing a ‘high yield’ piece – important. With the CoTrax deal, for example, the pool of assets was sliced into a senior tranche and a first loss piece, which Commerzbank kept, and a US$27 million mezzanine tranche; US$22 million of which was successfully placed via a private auction, drumming up a great deal of interest from investors.
Although we are witnessing an increase in the number and size of securitization deals, suggesting that trade finance assets are likely to take off in the near future, some obstacles still stand in the way of the market continuing on the road to success. The most significant one is the lack of uniformity in trade finance. Indeed, documentation can vary enormously from deal to deal and investors frequently scrutinize the standards adhered to. To respond to these concerns, banks should aim to implement master agreements for trade finance deals – something which Commerzbank has been working on for a number of years.
Certainly, with improved document standardization and increased investor awareness of the extraordinarily low default rate of trade finance assets, securitizations look set to help solve banks’ capital requirements and, at the same time, offer investors access to an emerging asset class. Let’s see what 2014 will hold for the market.