Liliana Slavova, a senior trade finance underwriter in AIG’s Trade Finance Portfolio team, provides an overview of the pivotal role that credit insurance plays in the growth of trade finance funds.
The last decade marked the creation of specialist trade finance funds and establishment of trade finance as a distinct institutional asset class. As the demand for trade finance funding increased and banks retreated due to regulatory capital requirements, institutional investors stepped in to fill the gap, seeking enhanced returns on short duration assets. To address the single most significant risk for institutional investors in trade finance funds – capital preservation – credit insurance was introduced.
Drivers for institutional participation in specialist trade finance funds
The recent institutional investment push into trade finance funds has been driven by a prevailing negative and low yield credit environment and imbalance between the increasing demand for trade finance and the limited supply available from banks. The attractiveness of trade finance in a fund format for institutional investors is underpinned by positive mid-single digit yields, liquidity via a fund structure with stable quarterly or semi-annual NAV, low correlation with global bonds and equity, active asset management and fiduciary undertaking. The opening of the trade finance market for institutional investors has been supported by the banks’ constrained trade finance capacity, imposed by stringent regulatory capital requirements and the heightened compliance issues of KYC and AML.
Trade finance funds structures
The most popular trade finance funds are usually structured as specialist investment funds (SIF), being Luxembourg-domiciled open-ended vehicles, benefitting from less stringent requirements than those applicable to the institutional mutual money market funds in UCITS format, in terms of quality and liquidity of funds’ assets and frequency of NAV reporting. The investment vehicle is established for an indefinite period, although the board of directors of the investment company can liquidate, merge or reposition at any time. A fund can issue different share classes depending on the institutional risk appetite and return requirements.
Key benefits from the use of credit insurance
The benefits of credit insurance for trade finance funds are well recognised, namely: insulating credit risk from a granular portfolio with significant SME and emerging markets exposures (thus ensuring capital preservation for investors), the risk attaching nature of the policy (assets compliant with policy eligibility criteria are covered even if the insurer removes credit limits on future purchases), aiding the management of the fund’s liquidity risk, contributing to stable fund net asset value (thereby reducing volatility), as well as ensuring dynamic portfolio monitoring and reporting via best-in-class third-party technology platforms (thereby enhancing portfolio management services).
Key risk management considerations:
Termination risk
Credit insurance covers the credit risk of buyers failing to make a payment for goods and services they have received from suppliers for any reason (subject to certain exclusions), including corporate bankruptcy. Credit insurance is usually provided on a risk-attaching basis, meaning that all assets acquired by a trade finance fund in accordance with the policy eligibility criteria remain covered under the policy even if the insurer removes credit limits on future purchases. Timing mismatches between a buyer’s default, policy claim and insurance pay-outs may present a liquidity risk for trade finance funds especially if redemptions increase dramatically.1 Funds redemptions usually spike when insurance claims are submitted although the insurer’s financial strength (and therefore its willingness and ability to indemnify claims) may remain unchanged. This liquidity risk can be mitigated by an increase of cash holdings, prudent risk management practices (daily liquidity stresses, VaR stresses) and, as a last resort, suspending redemptions.
Non-marketable asset risk
Traditional trade finance structures do not provide for easily transferable and tradeable securities, which makes their purchase, valuation and sale more complicated for the fund. Trade finance funds are presumed to reference esoteric collateral and have lower liquidity, hence the SIF format they utilise. In this context, they are only suitable for well-informed investors, qualified institutional investors, or professional investors even when credit insurance is in place. Credit insurance does not override the complexity of the underlying asset class but adds a layer of monitoring and credit risk management.
Product suitability
Credit insurance is not a substitute for comprehensive asset due diligence. Product suitability due diligence should identify certain practices (such as unusually long payment terms, programme size more than working capital needs, costs assumed by the buyer obligor not supplier as customary, etc) promptly and risk manage those in a timely way. While trade finance has low default risk due to the short duration of the assets and its collateralisation and self-liquidating nature, financial engineering and imprudent origination practices can disguise higher risk products as trade finance assets. For example, advances on future receivables can conceal working capital facilities and, in extreme cases, can alter the nature of a trade finance transaction from a facility secured on a specific asset for a specific purpose to an unsecured general-purpose facility, thus changing the risk profile of the trade finance fund.
Liquidity risk
In a benign credit environment, sizing liquidity is a function of the assets’ credit risk, insurance claims and pay-out terms, the fund’s liquidity requirements and forecast redemptions. Cash positions vary but can be revised upwards in periods of significant market volatility or credit crisis. Often the nature of a trade finance fund’s investor base can expose the fund to a sudden investor run off, prompted by asset deterioration, insurance claims or stale pricing, combined with negative headlines. Freezing redemptions is subject to regulatory oversight and can seriously damage the investment manager’s franchise but can be justified as an extraordinary measure in exceptional circumstances to preserve capital value for investors. Credit insurance is only a tool in enhancing a fund’s liquidity and has to be considered in conjunction with policy termination provisions, expected redemptions and the overall credit environment.
Contagion
It is a common practice to have trade finance funds included in credit funds from the same asset management platform. Such cross holdings can have serious implications, as in a scenario where the trade finance fund with less liquid holdings freezes redemptions, the other credit funds which hold share classes of the illiquid trade finance fund may suffer redemptions and sharp NAV decline in anticipation of losses stemming from the illiquid trade finance fund. While credit insurance can provide some comfort to funds’ investors, the contagion impact can also be cushioned by adequate and timely liquidity measures.
Transparency
All concentrations must be easily identifiable and regularly reported. Real-time granular data on exposures and transactions is required at the invoice/payable level. In that context, credit insurance is not a replacement for transparency and underlying assets disclosure but imposes a requirement for implementation of the highest transparency standards. Full transparency should facilitate prompt identification of any adverse credit trends, like large risk concentrations, recycling of the same risk as different facilities to disguise long-term borrowing, and related party transactions. Comprehensive and transparent reporting can ensure the trade finance fund and its regulators can identify any extraordinary lending terms or relationships which breach investment rules, ie fund investors or related entities acting as obligor buyers or sellers.
Granularity
While granularity combined with strong credit quality is easily achievable by large commercial banks, it can be a challenge for trade finance funds as it requires a complex origination process based on extensive relationship management, repetitive and sizable volumes, and competitive terms. Trade finance funds are more likely to succeed in niche geographic markets or with specialist products. Credit insurance terms can be influenced by the fund’s granularity but in all cases those terms will aim to capture cumulative and specific credit risks.
The path forward
Trade finance as a separate asset class is already included in the institutional investment universe. Credit insurance plays a pivotal role in the growth of trade finance funds. Prudent application of credit insurance in these funds can ensure the success of the asset class. Flexibility and tailor-made policies will be key for a successful credit insurance implementation. It is important to understand credit insurance is not a replacement for transparency and underlying assets disclosure, but imposes a requirement for the implementation of the highest transparency standards. Termination risk presented by credit insurance should not be viewed as a deterrent for the fund industry, but a partnership opportunity underpinned by the risk attaching nature of credit insurance policies and the additional layer of monitoring, risk management and reporting. In that sense, credit insurance is not meant to impair a trade finance fund’s liquidity but rather risk manage it to a sustainable level.
For more information about the wider team and AIG’s capabilities in this area please contact Benjamin Toledano, Head of Trade Finance Portfolio at benjamin.toledano@aig.com
Reference:
- Fitch Special Report 29 April 2021: “Uncertain Future for Supply Chain Finance Funds”
