Third-party risk is inherent of a company’s risk portfolio. On one side, customers are worried that their suppliers will fail to fulfill their obligations and/or repay the advance payment made to them, and on the other side suppliers are worried that their customers will fail to pay them on time (or not at all).
The last financial and debt crisis, together with political instability and difficult economic situations in numerous countries, have increased this sentiment of constant credit and commercial risks, which as a consequence have altered commercial relationships. Unfortunately, the prospects don't foresee any general improvement to that regard.
This graph shows a steep rise in the use of security instruments (letters of credit) in 2008 Q3 (source voxeu.org)
This unstable environment has created the need for many companies to externalize these risks with the help of external providers such as insurance companies, banks and the financial markets who are all providing a wide range of instruments and services helping them secure their operations and mitigate those risks. The use of security instrument quickly became integrated into companies buying & selling processes, sometimes without applying good judgment.
One should remember that outsourcing risk, including that of trade finance activities, always has an explicit and implicit cost which is translated into a spread paid by the contracting parties. This cost will dependent on the instrument type, the provider, the issuance set up, the locations, the complexity, etc. It is very difficult to get an accurate and relevant average cost per instrument. In addition, organizations will have to bear intensive labor cost on top of that due to the time spent by its work force and the increasing need for skilled labor.
Based on the cost accounting methodology used in each company, these costs could not be considered as direct production cost and rather be part of variable overheads instead, therefore not having a meaningful impact on the marginal cost of production which as a result are not monitored accurately. Including security instrument costs into direct production cost would be an incentive for managers to control those costs, renegotiate payment terms with their trade partners and transact more efficiently.
It is worth noticing that while it creates an extensive business for trade finance partners, it also creates huge indirect costs for companies and has significant impacts on their working capital due to the timing difficulties that can arise from those, sometimes even jeopardizing an entire purchase order, altering commercial relationships and impacting a company’s bottom line.
Generally speaking, the use of different security instruments types (letters of credit, bank guarantees, burgschafts, borgtochts, surety bonds, corporate guarantees, etc.) is linked to cultural aspects and is anchored into countries’ DNA. North African and Middle East countries are more inclined to request the use of letters of credit and bank guarantees (e.g. bid bonds), while Asia has been using bank guarantees less often to the credit of surety bonds & accepting additional internal commitments (e.g. corporate guarantees), and the U.S. on their side are using Standby Letters of Credit and Surety Bonds. Europe is traditionally a bank guarantee continent, and difficult to migrate to others types.
Changing culture & habits is a difficult but necessary tasks to alleviate the burden that those instruments can create on the world’s trade activities, and this is now a responsibility more and more assigned to Treasury Departments (linked to the nature of risk management involved) thanks to the centralization strategies and pool of knowledge making it even more an expert function, but very difficult to staff properly. This is why constant training is required to sustain the function over time, including trade finance which is an ever-evolving activity placed at the cross-road of a company’s core business.
All these security instruments are often complex, tedious, expensive, manual intensive, highly reliant on humans, and can create significant financial risks to all stakeholders. One could question the reason why we even think about using any of those; since they also delay many projects and shipments, while increasing tensions in international trade relationships. Undoubtedly, general lack of trust and overall uncertainty surrounding international trade is the reason why and the fundamental basis upon which the banking industry can make a great business out of. In the end, it is all about risk transfer and externalization/mitigation.
But also, if a company has no relevant information about the financial health of one of its business partners, or is a first time partner, or maybe one that has a relatively bad reputation, is that company sufficiently equipped not to externalize this risk and absorb the potential losses? These instruments are just like buying insurance: you pay a premium based on a risk assessment and on its probability to incur losses and damages to your company and others, for which your company would be liable for. All of this will also depend on the risk appetite of the company which you’re transferring the risks to. If on the long term, these instruments are not profitable, not all companies have the capabilities to absorb the losses that will occur on the short term, hence the need to externalize risks. However when taking all aspects described earlier such as cost, complexity, and various hurdles faced while using those products, it is worth considering some alternatives.
On the technology side, there are growing solutions helping companies reduce the human intervention in the manual intensive activity. They usually offer: track and trace solution, connectivity with all financial intermediaries, visibility over all trade finance activities portfolio into one location, more efficient workflow (from submission to cancellation, going through issuance, amendments, extend or pay,… with communication mainly by Swift and less reliant on Emails and paper-based solutions), better reporting (homogeneous format and automated) which translates in time saving for your staff and real-time visibility over credit facilities, automated filling of documents being presented under letters of credit, allowing a drastic reduction in discrepancies and time spent in filling in documents, connectivity with Treasury Management Systems (TMS), etc. Some of these technologies can even help issue surety bonds, corporate guarantees, etc. Robotics solutions also help automate low added value tasks such as filling in application on bank’s portals…
It is a huge market for providers of such technology, as currently very fragmented and the demand is increasing due to the increase in volumes and complexities (and pressure on cost…)