Roundtable: Back to the future

Members of GTR’s editorial board evaluate their respective businesses, document key emerging themes and take a guess at what they future may bring.

Roundtable participants:

• John MacNamara, global head of structured commodity trade finance, global transaction banking, Deutsche Bank
• James Willcock, senior associate, DLA Piper
• Nick Shaw, head of global trade finance, BBVA
• Peter Jones, secretary general, Berne Union
• Adnan Ghani, head of transaction services origination, UK (international), RBS
• Martin Knott, head of trade, global transaction services Emea, Bank of America Merrill Lynch
• Ralph Lerch, head of export finance, Commerzbank
• Suresh Advani, head of trade finance, GML Capital

GTR: What are your predictions for the year ahead, and even further into the future?

Ghani: I am going to have a bit of fun now, if you will allow me. I was thinking about Star Trek – the world beyond. What is trade going to look like in 2050?

This is the world I see: a completely dematerialised trade finance world. Everything on the net, globally linked. You have your bills of exchange, you have your trade, you have invoices, everything on the net and no need for paper. That is maybe one scenario. I see, again, a globally linked world in trade. No tariffs, free trade across the globe, so anything which is good for people, good for countries, is traded freely without tariffs.

What about a world where trade finance is provided directly from the investor to the customer, without the need for intermediation? Again, you can have net, cloud, whatever it is; the technology that allows the investor to finance directly a customer in need of trade finance.

Willcock: I think one of the things that we will be watching very closely is the participation of alternative credit providers (ACPs) in the market in whatever form that takes, and particularly how that will impact documentation. Earlier this year we worked on a trader arranged oil pre-export finance (PXF), in which at day one the trader fulfilled all the roles of facility agent, security agent, etc, which impacts the documentation in particular ways but with an eye for syndicating down the track, so that all needs to be looked at quite carefully.

Then, as a related point, whether that type of participation by ACPs in the market will be typical or whether you will rather expect to see, for example, insurers coming in as participants in syndicated financings or as funded or risk participants and, again, how their requirements will impact the documentation. From a bank perspective, we have been hearing increased interest in ownership structures, where the bank is taking ownership of the underlying commodity, either by way of repurchase arrangements or a purchase and sale on deferred payment terms. It will be interesting to see how that develops over the coming year as well. At the moment, several banks seem to be at the stage of getting comfortable with the structures. It will be interesting to see how this translates into deal flow during the coming year.

MacNamara: I think we face a double whammy, certainly on the commodity front – one: there is a capital markets recovery coming our way. You can see it in America, in Asia – and I see it in Russia, in a number of clients I lined up in the front-end of this year. They have said: ‘We did a PXF in 2008 and 2009, and it’s coming to the end. Do we do another PXF or do we do a bond?’ And approximately 85% of them have done a bond – and local Russian bonds at that, so there is a lot of local money available. So a capital markets recovery after five years of global financial crisis hits everybody in trade and export finance, because if clients can get their money easily without conditions, then they are hardly likely to come knocking on our door.

But then, a factor specific to commodities is that the market is, I think, beginning to sense a ‘loss of comfort’ in credit departments with respect to commodities. There is a concern that the commodity super cycle is over and commodity pricing is coming down. Sure, we did have a bit of a shock in the second half of 2008, but it lasted a maximum of six months – in fact only three months in most commodities. So there is a whole generation of people out there, including credit departments, who have only really seen it go one way, including these tremendous developments and consolidations. There was a theory – which I think has just been blown out of the water by a certain steel trader – that all commodity traders will eventually end up looking like Glencore. There has been a lot of enthusiasm – people who have come in over the last 10 years saying: ‘Oh yes! I must join this sector. I must be right on top of this,’ – but I think recent events have reminded us that there is risk in commodity trading. There is risk in the commodity sector, and a lower commodity price environment also starts to hit the high-cost producers. How many high-cost producers are there? Well, how long have we had high commodity prices? The market has had 10 years of stuff coming out of multiples; I have been going down mines in Australia that were shut down in 1991, and have been brought back in in the last three or four years, because now it is worth doing. How many of those are going to shut down again if the price goes back down? Probably quite a lot, actually, so it will hit the producers.

Something else people forget is that there is a direct correlation between low commodity prices and the risk of fraud. Anybody who spends time in commodities will tell you that. In a low price environment people start pulling out all the stops to survive – and I think if you put all that together then what you are looking at is a potential loss of comfort in the credit departments, who then start to get much more antsy about the next ask. We see this already in the unsecured revolving credit facilities for traders. That is perhaps not such a bad thing, that they become less popular. But we can also see it on refineries. After Petroplus, it is currently very difficult to get a refinery deal through, and I think this phase is rippling outwards – so what do you do?

This year, as I’ve said, I am not too worried about the budget. It is next year I am much more concerned about. My tip to anybody who is looking at the commodities side is: watch commodity prices. Watch them like a hawk, and work out the price at which you need to start worrying for every deal in play. When oil goes down to US$75/bbl, do you worry? When it goes to US$65/bbl, do you worry? We are doing deals at the moment where we are trying to say the tipping point is below 50. But watch your commodity prices. That is something people have not had to do for a while.

Advani: I think that the biggest challenge for all providers, be they banks, insurers or non-bank financial institutions such as the funds, is going to be that we are entering a period of potentially very low credit spreads, without a commensurate reduction in the underlying risk in the environment that we are dealing with on a global macro basis. This means that the risk-adjusted returns for our businesses are going to fall. At the end of the day the assumption of risk for our clients is the key proposition, whether you are a bank, an insurer or an investment fund. This is going to be difficult and it is going to be challenging. Mac has talked about the metal situation.

Overall, I think you have got a lot of distortion in terms of risk-adjusted return occurring as a result of quantitative easing, which is much more systemic. For instance if you look at spreads in the emerging market bond space, they are at historically low levels. There is so much money going into the EM bond space, because investors are chasing yield. What that has done is compress returns that borrowers can expect, which makes no economic sense. So I think that it is the big challenge that we have as trade financiers which is also facing other players within the financing industry in a broader sense, and I do not know where it will go.

Knott: Regulation. I think that it’s an important aspect of what we do on two levels: firstly, the perspective that we need to drive from at an industry level is having the right regulation, not more regulation, and I think we have a part to play in that. Secondly, regulation has to be consistent across markets, so we need to ensure that as an industry, we maintain a level playing field.

Jones: I was at the recent WTO trade finance experts group, and the two key issues that were identified, having sort of resolved Basel III, at least as far as the European Union was concerned, which were regulation and over-regulation, both in banking and insurance sectors, and the know your customer (KYC) rules, which are not consistent within countries or across countries. They are not even consistent within banks themselves, depending on where you are. That has actually gone up to the top of the agenda, to start dealing with FATT, to try and get some standardisation and uniformity in there so banks know what they are doing, clients know what they are doing, and transactions can actually continue and not have compliance officers on a power grab of stopping everything that comes across their desk.

From the members’ point of view, it is to continue this development of products that do release liquidity, and the obvious one is the 100% guarantee, so it goes back out into the insurance company and the pension fund markets. But bear in mind, of course, it does have a political dimension in as much as governments are telling their ECAs: ‘You need to do this, this, this and this,’ and of course that could change again. But the private market continues to develop at pace, and obviously they are not subject to those constraints.

Lerch: ECA has done well as a counter-cyclical measure during the crisis, and so the volume has elevated to record heights. I would not expect this to easily continue, because we have seen that liquidity was a driver for ECA finance, because there were nearly no alternatives in long-term finance. That has changed. My expectation for ECA business in the next couple of years is, that it will be seen again as a measure to mitigate risk in emerging markets, mainly because the last couple of years we have financed, and more or less substituted lending in various areas including OECD countries. From my perspective that was never the intention of ECAs, so it is always some sort of answer to a crisis scenario.

Despite the fact that nobody knows whether the crisis is over, I would say that in the meantime a mechanism is known how to source funding again, also on a long-term basis, and to a certain extent, of course, the ECAs have done well to support those initiatives, to create an ECA as some asset layer, which was never the case before.

So the major way banks did business was conclude the deals and then book and hold, and now I guess it has changed, so there is a diverse landscape all over Europe, but also in the banking community. Some banks are desperately trying to distribute these assets, and therefore insurance companies and pension funds know that ECA transactions are in the market; they understand the mechanism and so they are keen to spend money on that. This is good for the product, and of course that will also help for the next cycle. But there is still some competition with commercial facilities and commercial products, with bonds and so on, and therefore, from my perspective, you have to be strong in terms of advice, origination and being close to the investors, and on the other hand have some strong structuring execution and funding base. Then for the banks it will be important to explore and pursue those measures further, because if you look at the different countries, what the ECAs have invented, for example securitisation guarantees, and how the legislation for covered bonds has changed, that is still work in progress, and has to be further pursued.

Shaw: We have been reorganising ourselves significantly in terms of where it is that we as a bank, with the problems of being a Spanish bank, have to concentrate our efforts. Clearly the move has been from the structured and big ticket transactions to much smaller ticket transactional trade. ECA remains for us a very important element, albeit that we want to move much more into capitalising on our presence in Latin America, which offers us great potential in this product. We have made the most of the export markets and not necessarily the import markets on the ECA side, and that is something where we think there is a lot of mileage. Smaller ticket size reduces operational risk, but the margins on medium-size company transactions are much more attractive. Our Latin America positioning continues to be a very big powerhouse for us in terms of opportunity, and it is on this that we are developing and gearing ourselves up.

I agree with you in terms of your vision. I do not know if we will ever get to totally paperless, but certainly tendencies are going towards that, and, again, I think the importance, especially from a bank of our sort, where you are well-represented around the globe, you have to make the most of it, and you have to implement systems which are going to be seeing this and where you are going to be operating as one bank. That is the way we have geared ourselves up. We have increased our capacity through the way that we organise ourselves, so that there really is one product unit transversal throughout the whole bank, and that is a novelty for us, because in the past although we had lots of teams talking to each other, they were not one team. That is a big difference.

GTR: What changes can we expect in the commodities sector? How has the crisis affected the sector, and how has this translated in terms of deal flow?

MacNamara: I think the starting point – one that we have acknowledged previously – is that the crisis has been very good for structured commodity trade finance. It has reduced competition from capital markets, pushed pricing up and made people much more risk-averse on the one hand, and much more keen on risk-mitigated solutions on the other. But this can only last so long, and the macro analysis we are getting at the moment on the metals side is doom and gloom, particularly for steel and aluminium. This does not mean you cannot do deals in that sector, but the macro outlook does seem to be negative. There have been some fairly high profile failures on the steel trading side in particular, as well as other issues on aluminium. The moment somebody whispers ‘Chinese downturn’, people start to get increasing degrees of angst.

Then you have the whole overhang of shale gas on the energy complex, and when is that going to go off? If I was a gambling man, my money would be on some sort of downturn in the commodities space. That said, we are seeing a recovery in Japan and perhaps also in America and other some economies too – which is probably also not so good for my business and means my five-year plan is possibly looking a little more vulnerable than my 12-month plan.

Advani: In the funds space, what I think we are definitely seeing is particularly in the metals sectors, as Mac has stated, as well as coal, a deterioration in underlying credit quality and a higher level of risk in that sector. At the same time, across the entire trade finance market, we are seeing reductions in credit spreads. So arguably, in terms of relative value on a risk-adjusted basis, we are going to be dealing with a much more difficult environment. Whenever sector risk rises but effectively returns across the board are falling is never a very nice place to be. I think we have been relatively spoiled over the last few years because with the credit shortages and the dislocations that have been created, we had a very generous credit spread environment across many sectors and across many products, and I think actually those good old days are probably beginning to go away. I think banks such as Deutsche Bank that have, for instance, improved their capital positions – having raised a lot of capital earlier on this year – and other members of the banking industry have got significantly stronger balance sheets and that has probably created a more balanced and focused level of lending capacity which means you are going to see spread compression continue.

MacNamara: There are some nice big deals washing through the commodity market. And the other theme of the business is consolidation – so the largest oil company, by oil reserves, just got even larger. You have got Glencore/Xstrata on one side looking like a huge monster of a business, and you also have Rosneft-TNK, another monster of a business. Both are all still doing trade finance and structured trade finance. This year, I cannot complain; there is plenty of good business. The medium-term outlook, however, is a concern.

GTR: What key themes are emerging from the Global Trade Industry Council?

Ghani: There has been a lot of debate about what we really work on. For most of last year, what consumed most of our time was advocacy or lobbying around Basel III, and the unintended consequences of Basel III on trade finance. That took a lot of time. To some extent I think that advocacy has paid off, because the regulators have understood and are very sympathetic towards trade finance in particular, and they are quite keen not to impact trade in a negative way. So, some of the harsh impacts that we were expecting of Basel III have actually gone to the back burner. There is still some work to be done, but by and large the message is that we have achieved some significant leeway in terms of trade finance in particular.

What is now going to consume most of our time and effort is going to be around core streams, or themes that industry participants think are important. There is an acknowledgement across the industry that when we talk about trade finance we end up confusing our investors and the market in particular, because we may have different terminologies for the same thing or vice versa, so one of the key things that we want to do is to standardise the definitions of trade. What do we mean by a side letter of credit, a deferred letter of credit? Some basic definitions, what we really mean when we call an instrument by a certain name, and define it as crisply as possible so that it becomes a standard that gets adopted in the industry. A set of definitions have been drafted and sent to International Chamber of Commerce (ICC) for ratification. Once we get ICC’s ratification, because they are such a big monster and go through national committees, we feel that the rate of adoption is going to be high. That is step number one.

Step number two is standardising documentation for trade finance, so once we have standardised the definitions, the next logical step is to try and standardise documentation.

MacNamara: The Loan Market Association (LMA) introduced a template for PXF in September last year, which I think was perceived as a good thing – at least the principle if not some of the finer details. I wondered; have you two talked at all about this? They are standardising documentation and so are you.

Ghani: It is a very good point, and it has been highlighted in the London Group. I will talk about the London Group in a second, but it is a very relevant point. The honest answer is we have not, butwe should, so one of the action items is to reach out to somebody in LMA.

MacNamara: And when you say standardising the definitions of trade finance, does that include the PXF end of the market?

Ghani: The first document that we have taken is the bank to bank loan, because that is a significant volume of business in the classical trade world. The idea is once we standardise that we will take the next big chunk of portfolio standardising and move forward.

The third element that we are looking at is something called the ICC Register. A very simple background: while we were trying to advocate for getting the right treatment for trade finance, we realised none of the banks had data to substantiate low capital treatment, so the Asian Development Bank (ADB) is the one which started off this initiative by seed capital, and then there were eight banks, including ourselves, which provided more capital to start a project where – anonymously – we sent our loss data to ICC. That was collected. Then we hired Oliver Wyman, I believe, who are now doing some analysis and several reports have been published.

The fourth element is how we is really looking at how we get trade to be a distributable asset class, which means how do we get other investors, especially from the capital markets, interested in this asset and hopefully close the gap between their expectation on pricing versus what the portfolio actually offers. That is codenamed the London Group. This really is about bringing more investors into trade. We have had two meetings so far. We hold monthly meetings.

We have heard a lot from the panel members in terms of what it would really take to get other investors interested in this asset class; we are now trying to distil it into some concrete actions in terms of what do we do, who does it and how do we measure whether we are moving in the right direction.

Willcock: Picking up on Mac’s point on the LMA PXF and the extent to which we have seen it used in the market or expect to see it used in the market, we have been hearing different views from clients. The starting point of some 215 pages is, according to one school of thought, too extensive for a lot of the market that it might be aimed at, so for a range of PXF transactions it might not be a suitable starting point, outside the much larger transactions.

The other view of the LMA document which, in my view, is more prevalent based on discussions with clients, is that it may be used as a way of standardising particular clauses in the market, which have had a wide degree of variation amongst them to date. So rather than being used as a starting point for a transaction document in smaller deals, it could have the effect of standardising particular clauses and wording across the market.

It leads on to a related point, on standardisation of documentation generally. Another area where we are being asked to look quite closely at language is in the FI market and incorporation of sanctions language into FI documentation, as well as how that can be applied to trade instruments themselves. We are seeing a lot of enquiries surrounding how sanctions requirements might be addressed in trade instruments or LC refinancing documentation, for example.

At the moment there is a wide range of approaches to that, and it will be interesting to see over the next year whether the market arrives at a more standardised position.

MacNamara: Many of us are just grateful that PXF was recognised. 10 years ago, the man in the street wouldn’t have known what PXF was. And to a lot of trade finance bankers, PXF was a bank ringing up and saying: ‘Lend me US$100mn. If you really want to know what it’s for, it’s for PXF, and if you insist, I’ll give you a list of exporters,’ which is a bank-to-bank loan. So PXF in the sense of the major CIS and African commodity-backed deals, has become quite a big part of the market thanks to the commodities super cycle, but still we were not on any of the maps. As a result, some of us were sitting there thinking ‘The LMA template for PXF may not be the most perfect document at this stage, but it does get us on the map and it will evolve.’ That is worth having. The irony, of course, is that literally three months later the biggest deal for years – Rosneft – hit the market. Was it PXF? Not quite. Actually it was pre-payment, and because it was a particular type of pre-payment, there was absolutely no precedent in the norms of that market – the Russian market – so we ended up writing it from scratch, meaning there is very little of the LMA template in it. With that precedent now set, there are pre payments left, right and centre in the CIS. And I think you will see even more given the slowdown in the commodities super cycle, because people like the idea that pre-payments may show up on the balance sheet as trade credit rather than debt.

Knott: There is one important word James mentioned which was ‘clients’. To Adnan’s point, I absolutely agree on document standardisation, but not solely towards alignment with the regulators to recognise trade as a relatively low risk asset class. It is also important from a client perspective – and this is one of the things we are particularly focused on. Having industry standard definitions of trade solutions is also critical in making client interaction easier. If we get to a point where clients are meeting with banks and the banks are talking about supply chain finance, the client will know exactly what we are talking about, and not the 12 different iterations that we could potentially discuss. For me, that is another important driver from a market perspective.

Again, from a client perspective – and one of the things we have seen is more diverse sources of funding and multi-bank transactions – if you are there as a client and you are negotiating six different sets of documentation with the banks, it can be a problem when some banks want to change aspects and others may not. Standard definitions and a level of standardisation of documentation are important from a positioning perspective with the regulators, but also, equally as important if not more so, with clients.

Jones: Berne Union members are aware of the move toward trying to standardise documentation because it comes back on to the insurers. However, there is not a great deal of appetite from our members’ side to seek to standardise their documentation inasmuch as they feel it could risk just turning it into financial guarantees, which as insurers they do not provide. So there is a tension there, and a gap. Apart from that, it really is business as usual at the moment.

GTR: How has the insurance market fared? How can it better meet banks’ needs?

Jones: I would say the capacity levels are up to where they were pre-crisis. Claims are up again in 2012, which is to the banks’ benefit as these are potential losses they may otherwise have sustained. Premium rates are still flat or decreasing. So the insurers had a good crisis from the point of view of business, but there is concern that they are under pricing going forward, based on just sheer volumes of capacity in the marketplace for public and private.

We are seeking to expand our membership, which will be primarily into the private market, both in North America and within the Lloyd’s market, because there is obviously a gap in what we are reporting. The objective is to maintain the Berne Union’s status as being the pre-eminent source of trade finance – short, medium and long term – from the insurance market. We are already supporting over 10% of global world trade, and for all we know that figure could be as high as 15% or 20% if you actually had everybody reporting in to a central association, so we are looking to correct that.

We are also undergoing a strategic review as to what we do, how we collect information and how we share that information among members, and also how we interact with external parties, whether they be in the banking sector, international financial institutions or with governments themselves. One of the ideas is a trade ready index that basically says: ‘Look, if you as a country are able to meet these criteria then our members will support business into and out of your country.’ Those are the kinds of approaches we are looking at going forward, and hopefully this will help not only our members but also the rest of the financial sector who we support and who are very clearly important clients, quite often indirectly, of our members.

MacNamara: Are you aware of the whole debate that has been going on in Germany about whether insurance qualifies under Basel II and III because of the prompt payment business?

Ghani: It is a good point. One of the things that I think the industry needs to square, or at least communicate well, is what exactly is the capital benefit now of private insurance? Is there a capital benefit for non Prudential Regulation Authority (PRA) insurance policies? PRA has come out with certain guidelines which make insurance policies literally like irrevocable guarantees, and if you do not have a PRA approved insurance policy then what is the capital benefit? Is that kind of clear for other members, because for me it is completely opaque?

MacNamara: Well, Basel II was a great force for good in the insurance business. It finally did away with 300 years of history resting in the hands of the guy holding the pen writing the Lloyds’ policies. As a result, banks were able to say: ‘Look, it is not us; it is the regulators. Either your policy qualifies for Basel II or it doesn’t, and if it doesn’t, I can’t buy it.’ So that was good, but there has been a somewhat bizarre twist in the tale lately, with a number of German auditors saying ‘Well, Basel II says “prompt payment”, but you are going to wait 180 days for this.’

Now, the response from the export credit side (stating that political risk policies always have a waiting period, and this is to be expected) is even more bizarre, as I don’t buy political risk policies – I buy cover for ‘all risks leading to non payment by the borrower’. This is a ‘lender’s policy’. The response to this is: ‘Well, if political risk is covered, you can have a waiting period.’ And this, surely, is a triumph of form over substance – following the rules off the end of a cliff. After all, they either pay on time or they don’t. If a 180-day waiting period is agreed – and the prompt date includes that 180 days – do they pay prompt? Yes, they do, – but to hang it on the political risk component is a little bizarre, I think.

Jones: Obviously members all have different documentation, which is part of the problem. They all deal with this differently, but generally if it is comprehensive cover including commercial and political risk it does not make any difference. If there is a non payment, whatever the cause, it gets paid within the period which is stated in the policy, but it is normally only with investment insurance where you get waiting periods of 180 days or longer.

MacNamara: For a lot of PXF, 180 days is all the insurance you get.

Advani: The other issue is that in fact 180-day waiting periods are not always the norm. Sometimes you get policies with 270-day or 360-day waiting periods.So what are you going to do with those policies?

Ghani: I think the key challenge, at least from a bank’s perspective, is that it is no longer just good enough to have credit risk mitigation. Banks really need capital and risk-weighted assets reduction also. Its lower risks should equate into capital. It is not clear within the PRA guidelines whether insurance policies that do not tick all the six boxes, including prompt payment, get the lower capital treatment, and even lawyers do not know which ones are PRA acceptable or not, so there is an extreme amount of confusion in a lot of banks about which types of insurance policy should we now accept, and do they meet all the six criteria to get capital reduction also? We all know that it mitigates risk; where we are completely confused is whether we get a lower capital treatment, because in essence what PRA has said is if it is a guarantee, or if it looks like a guarantee, then you get capital reduction. If it does not look like a guarantee, then frankly your insurance policy is only a risk mitigant, not a capital mitigant, and to be honest that is not good enough for banks any more, and not good enough for clients, because the
price does not go down for them.

MacNamara: Let us face it – as a bank, when you book a loan and take insurance or any other type of cover, whether it’s CDS or anything else, you have only two possibilities of booking: as cash or as a guarantee. The question is then: ‘Can you book an insurance policy as a guarantee?’ Now, the insurers say it is not a guarantee, but they’re not the ones doing the accounting. This is bank accounting, and the Basel II door-opener for insurance was on the basis that conditionality lies within the control of the insured. This means loans can be booked as guarantees. But it does not address your capital point.

Jones: I think it is fair to say that our members, particularly the public ECAs, are very aware of the issue. They know that they can mitigate risk but that does not solve the problems in today’s world, which is all about liquidity; and our members do not normally provide liquidity. So there is a continuing move all the time to see how close the insurers can get to meeting the banks’ needs in order to ensure that the liquidity is released and therefore the transaction does occur.