PROVIDING A VITAL NEW LINK IN THE SUPPLY CHAIN.
Global Finance brings together some of the leading experts in supply-chain finance to discuss developments and opportunities in this fast-growing field.
Moderated by Joseph Giarraputo
Global Finance: What’s happened to supply-chain finance in the past year, and how have supply-chain finance providers reacted to the recent turbulent market conditions?
John Ahearn, global head of trade, Citi: Supply-chain finance has become a much more important product to our corporate customers. Historically, when we talk supply-chain finance, we talk about working capital. Many of our customers thought working capital was interesting, but not a driving force for their business. With the shrinkage of credit availability, commercial paper and so on, many of our clients truly believe that working capital and supply-chain finance are critical. So we have seen over the past 12 to 18 months major awards being made, and those major awards are now creating a new issue. And that’s finding enough funders in the market to fund all the new programs.
Andrew Betts, global head, trade finance & supply chain, global transaction services, RBS: Yes, over the past 18 months supply-chain financing has become very much in vogue. The number of programs now being mandated globally is at an all-time high. At RBS, and in response to the market demand, we’re continually enhancing our SCF program structures. It’s not uncommon for there to be credit lines of up to $1 billion on these programs now, and the challenge is frequently more around actually funding them, leading to necessarily greater collaboration from international banks.
Mike McDonough, managing director, global trade product management, BNY Mellon: The pressure on the banks is even greater because there’s less capacity in the non-bank market to provide funding than there was 18 months ago. That also has prompted a certain movement back towards some of the more traditional instruments such as letters of credit, because financing is inherently easier in many cases to get using the traditional instruments.
Tom Dunn, chairman, Orbian: There are two other aspects. First, for many corporate treasurers, on the procurement side supply-chain finance is now strategic because it’s about business continuity—the management of business continuity risk. They’re concerned that suppliers were being faced with liquidity squeezes that actually were threatening their very corporate existence, so arranging supply-chain finance is now seen as a strategic, not simply a tactical, treasury tool. Second, we’re definitely seeing a movement away from single-bank programs set up for individual corporates in favor of a movement towards multi-bank, multi-lender, multi-financier arranged programs in order to support much bigger deals.
Betts: We agree that working capital optimization has become more critical, but supply protection and business continuity have, for certain corporates, now taken equal weighting in their considerations. In addition, providers are looking to standardize program structures more and more, which is breaking new ground.
Dunn: Particularly on the buyer side, the modeling and analysis is becoming increasingly sophisticated. They’re now able to extract a very high degree of specificity about the risks and the returns—the gains that are being made by the suppliers from the availability of the lower-cost financing. And they’re seeking to claw back most of that through term extension.
Betts: The working capital focus by corporates has also led to increased demand on the receivables side, too, so we’re seeing real end-to-end supply-chain solutions to address both sides of the corporate’s relationships.
McDonough: A lot of these solutions are directed towards the most creditworthy borrowers in the market, though—the largest corporates. It is questionable whether the smaller corporates that need working capital optimization will have access to it in the current environment because of constraints in credit and liquidity.
GF: What solutions are banks or providers devising for these issues?
Ahearn: Partly because of accounting regulation changes in the US, we can’t be super-innovative so we’re pretty heavily utilizing the balance sheet if we get into these big receivables deals. We are doing them, but only for selected clients at the right price. But the secondary market, where banks are willing to buy some of this paper, is beginning to come back; it disappeared at the height of the crisis. However, the pricing in the secondary market is inverted: Banks used to pay you for origination, but today banks are charging you for their liquidity. The secondary market is priced higher than the primary market, which is causing some pain in the distribution side for paper.
Betts: Banks are focusing very much on core client relationships, and in our case we’re very strong on the breadth of supply-chain financing solutions, which we continue to engage with clients on across our international network. Interestingly, it’s the supplier finance side that is proving more attractive at the moment. For example, we’ve been approached by a group of suppliers wanting to redress the balance of power on payment terms with large retail buyers. The challenge there, however, is that undisclosed programs are difficult to structure given today’s credit risk environment, so we’re looking for ways to mediate the relationship to the benefit of both sides.
McDonough: It’s supply and demand. Not many banks globally are participating in this activity. If the benefits of these programs are going to flow to the companies that probably need it the most, more banks are going to have to become engaged. We just don’t have the depth of the market at this point on the supply side.
Dunn: At the height of the crisis, participants were so concerned about the counterparty and transactional risks they were taking on through other organizations involved in the origination or the syndication that the market seized up. Now there is a real focus on creating instruments and funding mechanisms that provide a very clear path through to the underlying credit of the buyer. That is taking a lot of time and attention from all participants in the marketplace at the moment.
Ahearn: Until we banks get our heads around the fact that pricing has to be higher, it’s going to be very difficult to get that liquidity back into the market.
McDonough: Getting the market to move that pricing higher requires a fair bit of consensus, and there are inevitably a few outliers that make it more difficult for everybody else to do that. Certainly Basel II—the accounting changes—will have a natural effect of pushing pricing upward. But if we can’t get that pricing to be where it needs to be, we’re going to hit a point where it’s going to be difficult to continue expanding at the rates to which we’ve become accustomed.
GF: What impact is the convergence of supply-chain and working capital management having on providers of each service?
Betts: There’s much closer cooperation between different parties in the supply chain now. You see that very much in this drive to sharpen working capital optimization. And clients are now actively requesting joined-up cash-management, liquidity and payables solutions that can be rolled out on a country, region and multi-region basis.
McDonough: The market is split between providers of open-account processing services and providers of open-account financing services. Very few have combined them to provide the one-stop shopping solution that the market’s going to ultimately demand. Those who can provide that one-stop solution will be the most successful in the long run.
Ahearn: There really is no such thing as supply-chain finance. It’s a nice buzzword, but when we’re talking to our clients, it’s all about working capital. What drives the client to select a provider or to do a program is the working capital release they’re going to get. How you release that working capital is by financing various parts of your supply chain.
Dunn: Exactly right. This is all about the release of working capital and the most efficient mechanisms for doing that by combining technology and access to liquidity.
GF: What’s been the impact of deleveraging on companies engaged in cross-border trade and on the providers of trade finance? Some claim that Basel II capital rules discourage banks from offering trade finance. How will this play out?
McDonough: Basel II could potentially discourage banks from offering trade finance. It’s up to the banks to make sure that the returns they earn on the services they provide are adequate, not only for Basel II measurement but for all other profitability and capital adequacy measures. The impact of deleveraging has been reduced availability in financing and pressure on pricing.
Betts: Basel II standards penalize lower-rated counterparties, particularly in emerging markets. One way we are approaching this potential risk is to work with other banks in how we can lobby the regulatory bodies in the interest of our clients around the world. Additionally, we look to mitigate those negative impacts using some guarantees and other structural elements that allow us to continue providing finance into these markets.
Ahearn: Basel II really only affects the bank-to-bank market, so Basel II is not the real issue. The real issue in trade finance is threefold. At the height of the crisis, it was completely unclear what banks were going to survive, so you saw a massive deleveraging of counterparty risk. Second, banks are going back to their core businesses. For many of the super-regionals and regionals, trade’s not a core business so we’re losing capacity there. Thirdly, it’s about relationships. We’re going to be putting our assets against companies that pay us back for those assets. If our returns on a company have been very, very low for a long period of time, that asset level commitment will go down.
Dunn: Our business model is more narrowly focused around working capital and supply-chain finance, and one of the things we’re seeing is the growth of global programs. Instead of just having domestic, in-country supply-chain finance and working capital solutions, large companies are looking for global solutions—built off a single program that can enable supplies to be brought in from jurisdictions and countries all around the world.
Ahearn: The industry on the cross-border supply chain is just catching up with our clients. Ten or 15 years ago our clients started globalizing their supply chains, but most of the supply-chain finance programs that existed prior to the crisis were domestic programs. Now the mandates we’re winning are much more global. One thing that concerns me about that is that some of the providers are taking the cross-border aspect way too lightly.
McDonough: Those questions are just starting to be addressed. Industry groups need to present the case with one voice to the market, but achieving the necessary consensus has taken longer than was expected.
Betts: We’re seeing larger programs now covering more countries. It’s not uncommon to have multi-country programs with multiple currencies across multiple jurisdictions. There is a complexity to these programs that global banks are well placed to advise clients on, but there is an expertise required to work through the detail, and these shouldn’t be considered lightly.
GF: Why has it taken so long for supply-chain finance to go global?
Dunn: There haven’t been the global solutions—the single global platforms—enabling people to do that, so they’ve been required to patchwork things together, which is a disincentive to do it. Also, we shouldn’t underestimate the extent to which the crisis really has brought working capital optimization, supply-chain finance, to the top of the agenda.
Betts: Although the solution set for working capital optimization is relatively new, we have over 200 active international cross-border programs. As with most innovations, the market follows the client demand. One driver of the increase in client demand for regional/global solutions has been the centralization of purchasing for many major corporates, whether that is regionally or globally. Centralized procurement leads to multi-country programs, which has forced the SCF providers to provide more consistency and transferability across different jurisdictions.
Ahearn: There are some companies that have working capital in their DNA. Others talked about working capital, but as long as there were cheap alternatives out there, they were more than happy to take advantage of those cheap alternatives.
Betts: With the sharper focus on working capital, we’re seeing much more interest at the CFO and group treasury level. As a result, we’re seeing requests for larger limits per program, more suppliers to be involved and greater overall reach of the programs. This clearly presents a challenge as to how banks can respond to make sure sufficient credit lines are available, which takes us into more innovative solutions around attracting non-traditional investors to the programs. In order to do that, we need to convert trade finance into trade paper, which is a tradable instrument, and have a liquid market for others to participate in.
McDonough: We still have to be able to provide a solution to the corporates that’s cheaper than what they currently use and that provides more value than what they currently use. Otherwise, there’s very little chance of making that sale. So there’s still going to be downward pressure on bank revenues, compounded by the fact that you now have balance sheet constraints, which limit the amount of this paper you can put on the books. It’s going to be a very delicate balancing act to manage this in a way that remains profitable for the banks and offers the corporates the cost-effective solution they need.
Ahearn: You also have to make sure that as we start bringing this paper to the capital markets, we don’t start competing with our own customers’ commercial paper programs. If we’re putting assets out there with the same look and feel and risk, but with a yield of 40 or 50 basis points higher than what their commercial paper programs are, that’s going to be a real problem, because we’re going to be arbitraging our own clients.
GF: This seems to be a time in which export credit agencies could provide a great service. How are they performing?
Ahearn: In general, they’ve been slow off the mark, and there have been a lot more political statements than actions. Some of the export credit agencies [ECAs]—especially in Japan and China—have been very proactive to protect their industries. In general, though, ECAs are not really set up for short-term trade, so as we’ve gone through the crisis, the ECAs have been playing catch-up. To be honest, they have not been all that effective.
Betts: We have seen some movement into the more short-term space, with Japan and China and, in a more modest way, Sweden, Canada and Korea, but typically not so much.
Dunn: The crisis was all about liquidity. Where could people find liquidity? Not where could people find the enhancements to their credit. The need for liquidity was not one that ECAs were naturally set up to pursue.
McDonough: It’s true that by the time the ECAs come out with meaningful programs, very often the market no longer needs them. But I do think that their participation—and the visibility of their participation—lent a certain amount of confidence to the markets. The help they ultimately provided to the recovery may have been indirect, but it was still meaningful.
GF: Do you expect that the role credit insurers play has fundamentally changed going forward?
Dunn: This crisis has shown pretty clearly that the role for credit insurers is going to be extremely marginal going forward. Liquidity became of paramount importance, and credit insurers provide nothing in the way of liquidity. We don’t see much of a role for credit insurers in the working capital optimization or supply-chain finance programs that we’re running or putting together, mandating or organizing. The ability for investors to be able to look clearly through to the buyer credit is of paramount importance, and the role for a trade insurer is not there.
Ahearn: When you look at the receivables side, credit terms are going to play a much more important role. If you believe that banks are deleveraging, and banks are shrinking their balance sheets, there’s going to have to be a way to offload credit from some of your larger clients. Credit insurance is a natural way for you to continue to serve your client but also start offloading some of the exposure. Credit insurance can also help banks extend their reach into unbanked clients.
Betts: I agree. On the payables side, there’s a limited role for credit insurers, as the programs will likely continue to focus on well-rated buyers. On the receivables side of the supply chain, I think there’s an extensive role. We’ve seen credit insurers become more important to structuring transactions, particularly as the asset securitization market continues to suffer. Now, you have large portfolios of receivables coming into the market for trade financing solutions. Therefore, there’s greater scrutiny on the debtors. Typically, banks will be inclined to work with debtors who are banked by the institution, and we’ll look to credit insurers to cover some of the other names.
McDonough: If the issue for the bank is risk mitigation, insurance provides perfectly good alternatives, assuming it’s priced correctly and has the correct terms and conditions. But if your problem is balance sheet inflation or balance sheet creep, insurance won’t help because you’re simply shifting the risk from one asset class to another, and probably keeping it on your balance sheet unless there’s a secondary offer or capability on the insurance side that for some reason would be greater than it is on the trade side.
GF: Trade activity can provide an early indicator of future economic prospects for various regions and countries. What are current trade levels telling us?
McDonough: Trade activity is telling us that China and some of the major Asian economies are looking to play a very significant role in driving the economic recovery, from increasing their foreign investment to increasing domestic economic activity, to increasing their export activity through increasing their domestic demand. The question is, do those engines of growth have the horsepower to sustain a global economic recovery?
Ahearn: Trade activities by themselves don’t really project where we’re going. You need to look also at inventory levels, commodity prices, GDP and so on. Currently, trade activities are actually a lagging rather than a leading indicator.
Betts: Trade is just one part of the story, one indicator. Having said that, one thing that’s become quite clear is that even though we’ve seen increased activity in Asia, the consumer demand provided by North America is critical to a recovery. So trade is as global or even more global than we’ve considered it in the past.
GF: What best practices in supply chains should practitioners concentrate on?
Dunn: First is the technology and service side. The key emphasis is on security, ease of implementation, robustness and just the absolute confidence that the system works flawlessly for every participant—the buyer, the supplier, the financers, everybody. The other side is the financing side—providing liquidity, ensuring programs have access to the broadest, deepest and most secure pools of liquidity that they possibly can. The crisis tested to destruction the notion of single-bank programs for all except the smallest. A number of major players—big banks—just decided to get out of the business, and that had significant disruptive consequences for buyers and their supply chains.
Betts: Throughout the recent economic turmoil we’ve seen that tight relationships between corporates and their banks—particularly the well-established, global transaction banks—has paid dividends. In some cases there has been a very clear focus to work with a single bank in order to take out the risk of having second-tier financing participants. I think the programs themselves have grown in strength and stature during these difficult times. The major trade finance banks now face the challenge of maintaining those key relationships in a time of reduced credit appetite, hence the drives for standardization and increased distribution capabilities to bring in additional liquidity to meet these core clients’ needs.
Ahearn: The technology is becoming commoditized so the competitive edge in this business is becoming the ability to deal with the cross-border aspects, to manage multi-bank solutions, how to run risk mitigation off the back of one of these systems, being able to segment asset pools, and so on. And in the long term, the banking community has to find a way to get this to the capital markets because that’s the most efficient way of funding these things. It’s not apparent yet how we’re going to get there, but that’s where the intellectual property comes.
Dunn: I agree. Supply-chain finance as an application is not where the value-add lies. It is the detail—cross border, tax, financing, the service level that goes with the entire system and delivery of that application to what is, in every situation, a mission-critical piece of the puzzle.
McDonough: Not so many have left the market, but the events of the past year have given a lot of potential participants reason to think twice about coming into the market. From the perspective of the user, the challenge is to right-size the solution they buy for their needs. If you over-sell to a client, it’s not going to be a good relationship for long; the client not only has to right-size the solution, they also have to be willing to pay a fair price for that solution.
GF: Will trade paper develop as an asset class?
Betts: Yes, but probably as an unrated asset class. To fit a true capital market model, it would require structural enhancements, which takes it into a completely different space. For single debtor programs, there is progress, but a fully-fledged capital markets model where it becomes a freely tradable liquid asset is a step into the future.
Dunn: We need to separate between whether the paper itself is rated or whether the underlying buyer is rated. With unrated buyers, it’s going to be tough. But it is not in our interests to have that paper rated because, firstly, the agencies will probably rate it as debt, and, secondly, it will compete with commercial paper. If we can just set up a standard model for the way these things work, then we can just explain it once to investors how the model works.
McDonough: Rating individual trade instruments runs the risk of becoming extraordinarily unwieldy, especially when you’re dealing in 30-, 60- or 90-day paper. Folding trade paper into some sort of a class like enhanced CP may be a better way to go about it. The questions are, who are you selling it to, and what are their return expectations? Those questions are fundamental to whether we can sell trade paper as a stand-alone instrument, or if it has to become another quasi-enhanced commercial paper instrument.
Ahearn: I think that’s the way it’ll end up. It’s going to have to be some sort of pool. You take obligors from 10 or 15 of your programs, commingle it, maybe you take an equity strip and get it rated. It’ll have to be rated because the amount of money investors can put in unrated paper is tiny compared to what they put into rated paper. The yield is going to drive the price. If the investor wants 150 basis points providing this type of paper, then guess what? We need to price it 200 or better.
McDonough: The efforts currently under way to set up pools of trade assets include a certain amount of reality checking to make sure hedge funds can invest in them. The question to which I keep returning is, even as a safer asset, does trade paper yield enough for them, or does it have to be enhanced, potentially in ways that just aren’t possible?
Betts: We’re all well down the path on specific solutions for certain clients. Whether this develops into a fully-fledged market is another matter.
Ahearn: The big providers need to make a decision. Do we continue to create our own solutions for moving the paper to the capital markets, or do we collaborate, standardize and maybe get there quicker? Collaboration between a few key supply-chain finance banks could enable us to get to the capital markets.