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
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.
Economic recovery likely to prove a ‘stuttering’ affair
By Rupert Thompson, Chief Investment Officer at Kingswood
Equity markets continued their upward trend last week, with global equities gaining 1.2% in local currency terms. Beneath the surface, however, the recovery has been a choppy affair of late. China and the technology sector, the big outperformers year-to-date, retreated last week whereas the UK and Europe, the laggards so far this year, led the gains.
As for US equities, they have re-tested, but so far failed to break above, their post-Covid high in early June and their end-2019 level. The recent choppiness of markets is not that surprising given they are being buffeted by a whole series of conflicting forces.
Developments regarding Covid-19 as ever remain absolutely critical and it is a mixture of bad and good news at the moment. There have been reports of encouraging early trial results for a new treatment and potential vaccine but infection rates continue to climb in the US. Reopening has now been halted or reversed in states accounting for 80% of the population.
We are a long way away from a complete lockdown being re-imposed and these moves are not expected to throw the economy back into reverse. But they do emphasise that the economic recovery, not only in the US but also elsewhere, is likely to prove a ‘stuttering’ affair.
Indeed, the May GDP numbers in the UK undid some of the optimism which had been building recently. Rather than bouncing 5% m/m in May as had been expected, GDP rose a more meagre 1.8% and remains a massive 24.5% below its pre-Covid level in February.
Even in China, where the recovery is now well underway, there is room for some caution. GDP rose a larger than expected 11.5% q/q in the second quarter and regained all of its decline the previous quarter. However, the bounce back is being led by manufacturing and public sector investment, and the recovery in retail sales is proving much more hesitant.
China is not just a focus of attention at the moment because its economy is leading the global upturn but because of the increasing tensions with Hong Kong, the US and UK. UK telecoms companies have now been banned from using Huawei’s 5G equipment in the future and the US is talking of imposing restrictions on Tik Tok, the Chinese social media platform. While this escalation is not as yet a major problem, it is a potential source of market volatility and another, albeit as yet relatively small, unwelcome drag on the global economy.
Government support will be critical over coming months and longer if the global recovery is to be sustained. This week will be crucial in this respect for Europe and the US. The EU, at the time of writing, is still engaged in a marathon four-day summit, trying to reach an agreement on an economic recovery fund. As is almost always the case, a messy compromise will probably end up being hammered out.
An agreement will be positive but the difficulty in reaching it does highlight the underlying tensions in the EU which have far from gone away with the departure of the UK. Meanwhile in the US, the Democrats and Republicans will this week be engaged in their own battle over extending the government support schemes which would otherwise come to an end this month.
Most of these tensions and uncertainties are not going away any time soon. Markets face a choppy period over the summer and autumn with equities remaining at risk of a correction.
European trading firms begin coming to terms with the new normal
By Terry Ewin, Vice President EMEA, IPC
In recent weeks, the phrase ‘never let a good crisis go to waste’ has received a large amount of usage. Management consultancies, industry associations and organisations, including the Organisation for Economic Co-operation and Development (OECD) have all used it in order to discuss how the current crisis, caused by the Coronavirus pandemic, presents an opportunity for new and worthwhile change.
The saying is also commonly used to indicate that the destruction and damage that is caused by a crisis gives organisations the chance to rebuild, and to do things that would not have previously been possible. This has the potential to impact financial trading firms, where projects that this time last year would not have made much sense now appearing to be as clear as day. In Europe, banks and brokers alike are beginning to think about what life will look like post-pandemic, and how their technology strategies may need changing.
We can think of three distinct phases when it comes to a crisis. Firstly, there is the emergency phase. This is followed by the transition period before we come to the post-crisis period.
Starting with the emergency phases, this is when firms are in critical crisis management mode. Plans are activated to ensure business continuity, and banks and brokers work to ensure critical functions can still take place so as to continue servicing their clients. With regards to the current crisis period, both large and small European banks and brokers were able to handle this phase relatively well, partly due to the fact that communications technology has reached the point where productive Work From Home (WFH) strategies are in place. For example, cloud-connectivity, in addition to the use of soft turrets for trading, has enabled traders from across the continent to keep working throughout lockdown. From our work with clients, we know that they were able to make a relatively smooth transition to WFH operations.
In relation to the current coronavirus crisis, we are in the second phase – the transition period. This is the stage when financial companies begin figuring out how best to manage the worst effects of the ongoing crisis, whilst planning longer-term changes for a post-crisis world. One thing to note with this phase, is that no one knows how long it will last. There is still so much we don’t know about this virus. As such, this has an impact on when it will be safe for businesses to operate in a similar way to how they were run in a pre-pandemic world. But with restrictions across Europe starting to be eased, there is an expectation that companies will start to slowly work their way towards more on-site trading. For example, banks are starting to look at hybrid operations, whereby traders come in a couple of times a week, and WFH for the rest of the week. This will result in fewer people in the office building, which makes it easier to practise social distancing. It also means that there is a continued reliance on the technology that enables people to WFH effectively.
Finally, we have the post-crisis period. In terms of the current crisis, this stage is very unlikely to occur until a vaccine has been developed and distributed to the masses. Although COVID-19 has caused mass economic disruption, many analysts are predicting a strong rebound once the medical pieces of the puzzles are put into place. It may not be entirely V-shaped, but the resiliency displayed by the financial markets thus far suggests that it will be healthy.
Currently, many European trading firms are taking what could be described as a two-pronged approach.
The first part of this consists of planning for the possibility of an extension to phase two. Medical experts have suggested that there could be some seasonality to the virus, with the threat of a second wave of COVID-19 cases in the Autumn meaning that the risk of new restrictions remains. If this comes to fruition, there would be a need for organisations to fine-tune their current WFH strategies and measures, and for them to take greater advantage of the cloud so as to power communications apps.
The second component consists of firms starting to think about the long-term needs of their trading systems. Simply put, they are preparing themselves for the third phase.
It is in this last sense, that the idea of never letting ‘a good crisis go to waste’ resonates most clearly.
Currency movements and more: How Covid-19 has affected the financial markets
The COVID-19 pandemic has been more than a health crisis. With people forced to stay indoors and all but the most essential services stopped for multiple weeks, economies have suffered and financial markets have crashed. Perhaps the most public and spectacular fall from grace during the early stages of the pandemic was oil. With travel bans in place around the world and no one filling up at the pumps, the price of oil plummeted.
Prior to global lockdowns, US oil prices were trading at $18 per barrel. By mid-April, the value had dropped to -$38. The crash was not only a shocking demonstrating of COVID-19’s impact but the first time crude oil’s price had fallen below zero. A rebound was inevitable, and many traders were quick to take long positions, which meant futures prices remained high. However, with stocks piling up and demand sinking, trading prices suffered. Unsurprisingly, it’s not the only market that’s taken a knock since COVID-19 struck.
Financial Markets Fluctuate During Pandemic
Shares in major companies have dipped. The Institute for Fiscal Studies compiled a round-up of price movements for industries listed by the London Stock Exchange. Tourism and Leisure have seen share prices drop by more than 20%. Major airlines, including BA, EasyJet and Ryanair have all been forced to make redundancies in the wake of falling share prices. The automotive industry has also taken a knock, as have retailers, mining and the media. However, in among the dark, there have been some patches of light.
The forex market has been a mixed bag. As it always is, the US dollar has remained a strong investment option. With emerging markets feeling the strain, traders have poured their money into traditionally strong currency pairs like EUR/USD. Looking at the data, IG’s EUR/USD price charts show a sharp drop in mid-March from 1.14 to 1.07. However, after the initial shock of COVID-19 lockdowns, the currency pair has steadily increased in value back up to 1.12 (June 25, 2020). The dominance of the dollar has been seen as a cause for concern among some financial experts. In essence, the crisis has highlighted the world’s reliance on it.
Currency Movements Divide Economies
In any walk of life, a single point of authority is dangerous. Indeed, if reliance turns into overreliance, it can cause a supply issue (not enough dollars to go around. More significantly, it could cause a power shift that gives the US too much control over economic policies in other countries. Fortunately, other currencies have performed well during the pandemic. Alongside USD and EUR, the GBP has also shown a degree of strength throughout the crisis. However, these positive movements haven’t been shared by all currencies.
The South African rand took a 32% hit during the early stages of the pandemic, while the Mexican peso and Brazilian real dropped 24% and 23%, respectively. Like the forex market, other sectors have experienced contrasting fortunes. Yes, shares in airlines and automotive manufacturers have fallen, but food and drug retailers have seen stocks rise. In fact, at one point, orange juice was the top performer across multiple indices. With the health benefits of vitamin C a hot topic, futures prices for orange juice jump up by 30%. The sudden surge had analysts predicting 60% gains as we move into a post-COVID-19 world.
Looking Towards the Future through Financial Markets
The future is always unknown and, due to COVID-19, it’s more uncertain than ever. However, the financial markets do provide an indication of how things may change. The performance of USD and EUR in the forex markets suggest there could be a lot more trade deals negotiated between the US and Europe. The surge in orange juice futures suggest that health and wellness will become a much more important part of our lives. Even though it was already a multi-billion-dollar industry, the realisation that a virus can alter the face of humanity has given more people pause for thought.
Then, of course, there’s the move towards remote working and socially distance entertainment. From Zoom to Slack, more people will be working and playing from home in the coming years. The world is always changing, but recent have events have made us appreciate this fact more than ever. The financial markets aren’t a crystal ball, but they can offer a glimpse into what we can expect in a post-COVID-19 world.
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