For sheer scale of securitizable assets, it’s tough to beat trade finance.
Consisting of very short-term debt used to finance exports or imports, this sector’s size was in the realm of $6.5 trillion to $8 trillion in 2011, according to a rough measure by a study group of the Committee on the Global Finance System, part of the Bank for International Settlements (BIS).
But only a speck of that’s been securitized.
Players say, however, that the economics of the sector are shifting in favor of more securitization, with Basel regulations a compelling catalyst. Recent deals — notably Trade MAPS by Citi and Santander and Lighthouse by BNP Paribas — bear this out.
Yet commoditizing this sector — as has been done, with, say, mortgages — is a long way off.
Given the wide spectrum of jurisdictions and obligors that a single deal would typically contain, the sector’s complexity matches its epic size.
Trade Finance the Basics
The short-term debt used to finance trade can take a number of forms and is originated by banks and nonbanks alike. A fixture of the sector is the letter of credit (L/C), which a bank provides to either make or guarantee payment to an exporter on behalf of an importer upon the delivery of goods.
“Trade finance performs two vital roles: providing working capital tied to and in support of international trade transactions and/or providing means to reduce payment risk,” according to a report from the BIS.
While the dollar is the main currency in global trade, it takes up an even larger percentage of trade finance. Some 80% of L/Cs, for instance, is in greenbacks.
In general, the sector is considered a low risk activity, at least among banks.
Trade finance is essentially a short-term, self-liquidating, low risk business that is generally booked on banks’ balance sheets and often funded by asset liability management with regular deposits, sources said.
Global trade has been expanding at a much faster rate than the global economy in most years during the past several decades (see graph below).
Hand-in-hand with trade itself, trade finance class has grown sharply and with nearly perfect consistency over the past few decades. But when global trade contracted during the 2008 crisis, trade finance shrank even more. Amid the evaporation of liquidity, banks cut back on their short-term lending, causing trade finance volumes to plunge.
The vulnerability of this business to funding shocks has raised concern that the sector can actually exacerbate an economic pullback, particularly if the sources of its funding are concentrated.
All the securitizations that have been done at the global or regional level have had to contend with the far-flung nature of trade finance.
Mirroring the activity they’re funding, these assets are generated by lenders and linked to borrowers operating in countries hosting a spectrum of bankruptcy laws, withholding taxes, and risk levels.
“Trade finance really sits between a number of asset classes,” said Lewis Cohen, a partner at Clifford Chance. He noted that while a trade finance securitization shares characteristics with a traditional collateralized loan obligation (CLO), there are crucial differences. A classic CLO will tend to have debt from senior unsecured corporate credits that have an actual or implied credit rating. In addition, analysts can take a view on a corporate’s entire sector if its particular situation is more opaque. That, Cohen said, helps in modeling the risk.
In contrast, he added that trade finance securitization presents “a range of different types of exposures and a range of credit analyses.” In some cases, a credit may be based significantly or entirely on the collateral posted by an unrated borrower.
In addition, in many trade finance portfolios, a large bank will provide financing to a smaller correspondent bank that, in turn, lends out to, or guarantees a trade by, an exporter or importer. This brings a financial institution counterparty into the mix. Cohen pointed out that trade finance credits can also be directly exposed to the risk of the exporters and importers.
“You can’t do the sort of actuarial analysis of this collateral that you do with mortgages,” he said.
But unlike other asset classes with “bespoke” assets, such as CMBS, there are also a dizzying number of credits in a regional or global trade finance securitization.
And these credits are originated in a range of countries that can have starkly different approaches to taxes and bankruptcies.
“What makes these deals special is that the cash flows can be sourced from multiple countries in the same deal,” said Anna-Liza Harris, a partner at Katten Muchin Rosenman. “That also might be true of a [traditional] CLO, but in that case the countries tend to be EU countries or others where the tax analysis follows a well-worn path. In a trade finance deal, the countries involved may not be party to a U.S. double taxation treaty.”
A deal can be hit with withholding taxes at any stage in which there’s a payment.
Yet another variable is bankruptcy law. An exporter or importer or local correspondent bank linked to a transaction could potentially go under. Each country has a particular way of putting a corporation or bank into bankruptcy.
In addition, trade finance assets can be financing trade into or out of a country that is rated as junk or perhaps even borderline default.
Players say the structure of a securitization can address all these risks — a spectrum of tax policies and bankruptcy legislations as well as the risk of each sovereign itself.
Indeed, dealing with these cross-border issues is something that structured finance is designed to do. And its par for the course among players handling deals backed by asset classes that are either global or connected to emerging markets. But in a trade finance securitization, the number of moving parts can be dizzying. Even with the very low risk associated with these assets, those challenges can’t simply be dismissed.
This is particularly true if a deal wants to hit triple-A or somewhere close.
Fitch Ratings Managing Director Greg Kabance said that country diversification is key to getting there. This would be difficult to achieve for regional or country-specific securitizations of trade finance receivables.
Since a significant portion of trade finance is linked to emerging markets, Kabance said, Fitch approached the asset class with the EM lens. But trade finance is not constrained by a country’s rating — the so-called sovereign ceiling — in the same way other EM asset classes are.
“That’s not necessarily because of the structure on top of a trade-finance securitization, we just don’t think it’s likely the sovereign is going to interfere” with the flows, he added, saying that sovereign crises very rarely lead to defaults in this sector.
Trade MAPS & Lighthouse
Two transactions that each charted their own courses for navigating these challenges were Trade MAPS and Lighthouse, both with senior tranches rated triple-A by Fitch. (See table below).
Closed in early December 2013, Trade MAPS is a $1 billion transaction jointly originated by Citi, Santander and a number of their subsidiaries. Lighthouse is a $100 million deal originated by BNP Paribas. Trade MAPS has a legal maturity date of five years, Lighthouse of four years.
Both transactions are funded deals, distinguishing them from past trade finance transactions that were wholly or partly synthetic. The collateral in Trade MAPS was linked to an array of traded goods, whereas Lighthouse focused on commodities with the offtakers being commodity traders.
Comparing their indicative portfolios, Trade MAPS had 7,336 assets, while Lighthouse had 46, but the gap between the number of obligors was not as pronounced, with 175 in Trade MAPS versus 46 for Lighthouse. Trade MAPS also had exposure to more countries, 25, as compared with Lighthouse’s 19.
This higher diversification helped Trade MAPS senior class achieve triple-A with somewhat lower credit enhancement — 16.01% against 20% for Lighthouse.
This, despite the fact that, given the massive scope of Trade MAPS, the underlying assets are not secured, whereas Lighthouse’s generally are while the goods are in transit.
Kabance said that in the case of Trade MAPS little credit was given to recoveries given the high number of jurisdictions and the complexities related to perfection.
Perfected security interest generally means the asset is fully protected from claims by third parties.
Both Trade MAPs and Lighthouse have concentration limits for obligors based on their actual or implied ratings and on obligors based on the country where they reside, apart from other diversity metrics.
While the concentration limits are near zero for countries with sovereign ratings of B’ or lower, there are ways for the transactions to fund trade to or from these countries in more than negligible amounts, provided the obligor assuming the risk is in a higher-rated country.
Take Argentina as an example. Since Fitch rates the country CC’, obligors domiciled there are not permitted in Trade MAPS. But the deal could potentially fund a loan to an importer in the U.S. that is purchasing soy from an Argentine company.
“Then the risk the bank is taking is the payment risk of the importer in the U.S.,” said Fabio Jose Fagundes, head of trade asset mobilization at Santander Global Banking & Markets. “The U.S. importer has confirmed they’ll pay the full amount on the due date and we don’t have any dilution or performance risk on the Argentine exporter.”
With all these complexities, one might wonder why banks would bother securitizing trade finance assets.
A big incentive, however, has emerged in the form of regulations, most recently, Basel III.
Under Basel III, the new risk weights applied to trade finance assets in order to determine how much capital banks need to hold against them; the treatment of contingent claims under a new leverage ratio, which is designed to keep banks from becoming overextended in their lending as many were before the crisis; and the treatment of trade finance assets and associated funding liabilities under the liquidity coverage ratio; all provide incentives for banks to securitize these assets that have historically been considered of exceedingly low risk and have been treated as such.
“When you look at Trade MAPS, it hits all three aspects of Basel III [i.e. risk-weighted asset ratio; supplemental leverage ratio; and supplemental leverage ratio]” said John Ahearn, managing director and global head of trade at Citi, which received capital relief from the transaction.
He added that banks that had historically held on to these assets because of their high quality may no longer do so because of the regulatory changes.
Basel III was only one of the regulations that motivated BNP Paribas to issue Lighthouse, according to Georges Duponcheele, head of banking solutions in capital markets securitization at the French bank.
But simple growth in the sector was also a factor.
“Commodity trade finance was an increased proportion of the bank’s balance sheet,” Duponcheele said. “We had to look at mechanisms that would enable the activity to continue growing without putting all that growth on the balance sheet.”
While Santander has not yet used Trade MAPs for capital relief, it may do so in the future. “The eligible type of assets are more capital efficient under Basel II and III than under Basel I” said Fagundes. “Because it’s a short-term self-liquidating asset that will be paid in the normal course of our clients’ businesses, that type of asset has a reduced capital impact than other types of loans under Basel II and III as recognized by central banks.”
Regulatory catalysts for trade finance securitization have a longer past, and include synthetic, as well as funded, deals.
Risk management and regulatory capital relief were behind the two securitizations issued by Standard Chartered Bank (StanChart). Known as Sealane and Sealane II, they came out in 2007 and 2011, respectively.
Regarding Sealane, StanChart’s Global Head of Portfolio Management Paul Hare said “going synthetic allowed the underlying trade assets to continue to sit on the bank’s balance sheet while at the same time, opened up the market to provide a way for institutional investors to get exposure to the trade finance portfolio without any impact on the trade nature of the underlying transactions.”
Sized at $330 million, Sealane referenced a portfolio of $3 billion.
“The objective was to enable the bank to seek credit protection over a wide spread of credit risks for risk and regulatory capital management purposes,” Hare said.
Issued for similar reasons, Sealane II was a credit default swap referencing $3 billion and issued with a funded securitization of $180 million. Both Sealane pools were highly granular, with more than 1,000 entities in each.
Fagundes said that a funded trade-finance securitization can provide capital, credit and liquidity relief at a cost-efficient level. “It’s a more comprehensive solution than the reg-cap synthetic CLO’s we have seen some banks issuing in the past” he added. “In addition, by distributing, you can enhance the origination and relationship with your clients.”
Banks aren’t the only ones moving into trade finance securitization. Non-banks are too.
As they aren’t subject to the same capital requirements and other regulations as banks, other lenders might grab more market share in the sector if banks retreat. More activity from non-banks could spur them to securitize their portfolios as they seek alternative funding sources.
Certain corporate segments are particularly vulnerable to a withdrawal of bank funding.
“Increasingly there is a dearth of capital dedicated to global trade finance in support of SMEs. This trend is a result of numerous factors including regulatory constraints such as Basel III,” said Martin Silver, managing partner and chief operating officer at IIG Trade Finance, a nonbank finance company that issued a $220-million trade-finance securitization last November. “Traditionally, banks have always served as the primary lenders for global exports, but they have been pulling back sharply.”
Silver said that SMEs were already an underserved market to begin with. IIG’s deal — its first securitization — is backed by loans to small-to-medium-sized producers based in Latin America, primarily in the agriculture and commodities sectors. The five-year deal is unrated though IIG may eventually seek a rating, said Jason Bross, executive director in charge of strategic projects at the firm.
Citi’s Ahearn said regulations will lead to consolidation in the trade finance business, with smaller players pulling out.
Already the top 10 banks in the sector roughly have a global market share of trade of nearly 30%, while some 1,500-2,000 banks have the other 70%.
The banks that stay in the sector will have more of a need than ever to get this off their balance sheets, Ahearn said. He believes the sector might go the way of the U.S. credit card business. “In the early 90s, every bank issued a credit card, and then larger issuers came in and became aggregators,” Ahearn said.
Currently in the U.S. roughly 30% of outstanding credit card receivables are in securitization vehicles.
Even with the regulatory incentive in place, banks and nonbanks looking into securitizing trade finance assets need the economics to make sense in terms of what they can reasonably offer capital market investors.
“Trade financing has very tight margins” and it can be tricky to provide a yield that will be attractive to investors, said Mahesh Kotecha, the president of Structured Credit International Corp. He said that recent market talk indicates that an investor could garner a return in the mid 20s for an equity tranche in a traditional CLO. “I don’t think you’d get more than the mid teens for that tranche in a trade finance deal.”
“The bond bucket that’s used to juice returns in a [traditional] CLO — there’s no real equivalent in a trade finance securitization,” said Clifford Chance’s Cohen. “Those are the challenges for getting the capital structure while still getting third-party investors into the mix.”
On the other hand, these are widely perceived as exceedingly low-risk assets to which capital market investors can’t get easy exposure.
Also, in terms of higher returns, nonbank regional deals such as the one issued by IIG might offer a route to yield by tapping into higher-risk, smaller obligors. The $110-million senior tranche on the deal is priced at 500 basis points over three-month Libor, while a $77 million B piece is priced to yield 10.75%. The transaction has a duration of five years.
For lenders there is also the simple appeal of tapping new funding sources for these assets at longer terms.
“A lot of banks have woken up to opportunities to diversify their funding sources and we’re using various ways of obtaining funding using high quality assets,” said Shaun Baddeley, executive director at Santander Global Banking & Markets. “And here’s an opportunity to do that, to access the U.S. dollar market and to fund out to three years.”
While initially a securitization of assets from Santander and Citi and some of their units, Trade MAPS was set up as a platform for any major bank to use.
“We’ve already been approached by a variety of banks,” said Citi’s Ahearn. “I think there are a variety of originators that would like to be in our series.”
Baddeley added that Trade MAPS is basically a master trust program. With the “plumbing in place” other banks can now join in. Both Baddeley and Ahearn said they expected Trade MAPS to float a sophomore deal but as of press-time it was unclear whether additional banks would contribute assets. “We may want to launch our second issue before they’re ready,” said Ahearn.
Kabance said Fitch was fielding calls for new platforms out of different jurisdictions.
While not open to other banks, Lighthouse may launch new securitizations from BNP Paribas, said the bank’s Senior Securitization Structurer Thierry Daeschner. But he added that there is interest from other banks in potentially doing their own deals.
Kotecha said he was talking to a client about a deal that could have reference collateral for as much as $1 billion.
“We’re pitching it as both funded and synthetic,” said Kotecha, saying that the potential deal might resemble Sealane II, with its mix of both. “It’s up to the issuer,” he added, saying that regulatory capital relief can come from either synthetic or funded deals. It can often boil down to whether the issuer is seeking actual funding or not.