Expert opinion: Taking stock of trade finance funds regulation

The UK Bank of England Prudential Regulatory Authority (PRA) and the Financial Conduct Authority (FCA) have finally turned their attention to trade finance funds via their 9 September letter to CEOs. Should we be surprised? Not really. Should we be concerned? Well, yes – on the one hand, the regulators haven’t exactly shown themselves to be understanding of the nuances of trade finance and have all but killed the sector for many by a perceived over-regulation and heavy-handedness. After all, if it weren’t for the mainstream banks being so bogged down by regulation there wouldn’t be such a growing funds business anyway! But on the other hand, the regulators do have a point.

Feeding off the pickings

Many trade finance funds exist and thrive by feeding off the pickings left behind by the mainstream banks, either ignored because carrying out KYC/due diligence is just too time-consuming and cumbersome (in the case of SMEs) or the deal ticket size and client is too small to get excited about (again those unwanted SMEs). Of course, there are a handful of more established funds who paved the way for this recent emergence and whose mission was more about going where the mainstream dare not venture (typically the emerging markets) irrespective of the size but, where are they now? Redeemed. Dismantled. Refocused perhaps. 

You see, although 2020 was a bad year for the trade and commodity finance banks, the trade funds have been suffering too. Where doing SME KYC/due diligence was too much for the banks, it shouldn’t mean it simply gets ignored by the funds so as to win business. Neither should thorough and relevant risk assessments be side-lined in favour of more relaxed judgements in the clamour to achieve a higher yield. The high-profile failure of one trade finance fund is going to have an impact on how all other trade finance funds are viewed – in effect it already has (Greensill) – so, as a community, responsible trade finance funds should look to ensure their risk management won’t be found wanting.

Leave an audit trail

The FCA/PRA letter refers to “several high-profile failures of commodity and trade finance firms with significant financial loss” and goes on to list some best practice procedures it expects lenders to address in terms of risk assessment, counterparty analysis, transaction approval and any transaction payments. It also mentions “our recent assessments of individual firms have highlighted several significant issues relating to both credit risk analysis and financial crime controls” especially around the risk of dual-use goods or the potential for fraud, noting that “firms have either failed fully to assess these risks, are unable to evidence the checks they have undertaken, or in some cases discounted them inappropriately”. The message is clear, whatever judgements are made, leave an audit trail. 

Execution failures – problems regulating what you can’t see

However, the high-profile failures in the sector (Hin Leong, Phoenix, Greensill to name but a few) haven’t been down just to the areas the FCA/PRA have identified. It seems the key problem was execution: failure to do the post-approval due diligence checks, like confirming with buyers where receivable assignments were taken, or screening against subsequent parties identified in a transaction (for example, vessels and ship owners), or in some cases relying on collateral instruments (for example, pledges and trust receipts) without fulfilling the conditionality that gives effect to the charge. The Greensill revelations in particular have been viewed by the industry as ‘laughable’ that they even thought they might have a claim on receivables that didn’t yet exist. 

And therein lies a problem with regulation: you can put rules around what you like to see checked so that a box gets ticked, but what will bite you is what you can’t always see. That includes the external influences and manipulations which change an ‘acceptable’ status quo into something less palatable. What would be interesting to know is whether all these pre-engagement due diligence checks would have made any difference to granting approval in any of the high-profile cases the FCA/PRA refer to. 

More than likely, a risk assessment would not have picked up the changes to arise later in the external environment, a counterparty analysis would not have picked up anything untoward on the buyers/sellers (especially where genuine counterparties were fraudulently used), transaction approval would therefore have been more or less automatic and transaction payments would follow the approved flow and should anyway be screened at engagement by the paying bank. Execution and ongoing monitoring and control is typically where things go wrong in trade and commodity finance, so having the right individuals with an appropriate level of experience is key to mitigating for what a tick-box approach will miss.

Investment in appropriate risk systems

Then there are the AI/IT system solutions, which are many and varied, especially in terms of effectiveness and cost. We don’t want to see a situation where the costs of compliance outweigh the benefits of engagement, but neither do we want an environment where effective risk management is left to chance. Some investment in appropriate risk systems is inevitable and there is a wealth of providers to choose from. However, the fee structures and absolute cost can be a deterrent for all but the established firms, so some providers need to get real about the economic cost versus benefit to their target clients. Trade finance funds don’t all have the same capacity as the banks to meet these costs, especially when they’re still building a book, and it’s often the case that more than one system is needed to address the multiple issues to be covered. This needs to be simplified.

Good risk management, though, is undeniably an enabler of sound revenues – and can be a real differentiator when competing for investor capital. Those firms who recognise this and invest in the resources to do more than pay mere lip service will benefit tremendously from a risk sensitive approach. Of course, trade finance funds come in various shapes and sizes: from the boutique fund managing family office capital through to the private fund managing professional investor capital to the listed funds managing the public consumer’s capital, each having its own requirements and expectations. A ‘one-size-fits-all’ regulation may be inappropriate in that respect, but ‘one-size-fits-all’ is invariably what we will get. 

Welcome scrutiny – take stock

Notwithstanding, we should welcome that trade finance funds come under the scrutiny of the regulators as that will begin to level the playing field, enabling those funds with a sound risk management framework to positively differentiate themselves. However, where screening for AML/sanctions/financial crime is mandatory and should anyway be addressed, trying to regulate credit risk assessment is perhaps a step too far. That is because it all depends on judgements based on the available data and judgements made with experience may put a different bias on the results: not to have considered a material aspect would be negligent, but to have considered it and made the wrong judgement is simply a mistake. 

All trade finance funds should anyway now take stock: dust off those policy papers (if they exist), tidy up the audit trails and make sure that what the FCA/PRA wants to see addressed is effectively covered. You know it makes sense – mostly.