The distribution game

Feature | 1 October 2015
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As banks face regulatory, capital, and risk management pressures around trade finance, investor participation in the market has never been so crucial. This panel, chaired by TFR advisory board member Suresh Advani, addressed opportunities and barriers at the ICC Banking Commission Annual Meeting in Singapore

Suresh Advani: Let's start from the sell side and hear why the banks, both from a capital and a portfolio management standpoint, individually, as well at industrial level, see the need for greater access to institution investment pools as distinct from the banking secondary market or the credit insurance markets.

Rüdiger Geis: We had noticed that in some regions trade finance demand was particularly high, and this was more than we could fulfil. One solution is to ask for cash cover so you can give additional lines. We have support of multilaterals which you can use to risk mitigate and add capacity to the market. We also have the insurance market and with some
help you can do some leveraging and do more business.

With additional demand there are to solutions how you can deal with it; you can decline it - I'm not sure whether that would be preferable - or you can increase your limits. But with capital constraints (Basel III) you have to raise your equity, which is not so easy. So you need other solutions.

 

John Ahearn: Before the global financial crisis in 2007-08, the trade business for us in Citi was very much a book and hold business. And then it became very, very clear that that strategy wouldn't work; we had to bring the balance sheet of the bank down relatively quickly because of financial distress, which we did. And so we came to the 'originate to distribute' model. The other thing is our supply chain finance business is getting very big. We have large exposures to concentrated names. So we don't want to hold all these assets; from a credit point of view, we can't; so that's also driving our distribution strategy.

Suresh Advani: Portfolio management is something that's become really very important for banks in the last decade.

 

Paul Hare: If you think about banks as regulated institutions, banking is inherently a balance sheet-intensive business; that's what clients come to us for.

There are all sorts of services we offer around that, but balance sheet is a core part of the value proposition. Increasingly, people are starting to accept that the most optimal portfolio management strategy is not to hold everything that your clients bring to you, but rather to create a philosophy at the front end of the business, where you're saying yes to your clients as much as possible, and then finding other people who can more efficiently hold the resulting asset exposure. That, in essence, is the rationale for creating an active credit portfolio management function. I think it's been reasonably well accepted for maybe a couple of decades for long-term assets that banks don't need to hold the whole thing they syndicate.

More recently, banks have started to think about out the same principles applying to short-dated assets like trade finance. Conventionally the view was these assets roll on and roll off relatively quickly. Therefore it's better to hold them. I think the advances in capital and liquidity rules are driving banks to think about the more optimal solution being to create distribution channels, even for the short-dated assets.
 

Suresh Advani: What about the way institution investment participation has evolved over the last few years. Obviously you've got banks creating a structured product in the form of securitisation, which gets packaged and sold out to investors. And then, on the sell side you have funds that either buy risk directly on a portfolio or an individual basis from banks, or actually focus on areas of finance where the banks have no longer been able to service.

Paul Hare: I joined Standard Chartered at the start of 2007 and my role at that stage was to set up the securitisation programme for the trade finance business. We set about looking at what the principal constraint was around the trade business - capital - and set up the Sealane programme, which some of you may be aware of. It's a synthetic securitisation programme. This means the assets stay on our balance sheet, booked in the local country of original booking. My team puts together a notional portfolio.

We use a portfolio credit default swap (CDS) to hedge a certain percentage of the losses on that portfolio. That credit default swap covers the first 6% or 7% of portfolio losses (after any agreed first loss retention). This gives us the majority of our capital back.

So we set about building this structure in 2007. I still remember marketing it to a variety of hedge funds, none of whom had heard of trade finance, and obviously the world was starting to fall apart at the time, so we were very lucky to get the transaction away. The brief for us at the time and the main motivation was to broaden the investor bases and to get genuine scale in terms of capital release. The first transaction we did was a notional portfolio of US$3bn. We had never sold that much corporate trade business in one single transaction before.

This programme is now in its third iteration and we have done a lot of private transactions around it as well. In excess of US$100bn of trade assets would have gone through our programme. It's the largest of its kind in the market and we've probably been distributing to something like 40 or 50 different investors over that period since 2007. But it's important to note that while synthetic transactions are effective at managing capital they don't help manage liquidity because only 6-7% of the notional amount of the portfolio is hedged.
 

John Ahearn: So, we did Trade MAPS . We had become very good at selling launch ticket transactions,US$10m of US$100m to US$100m, but there was no efficient way to get these small transactions off our balance sheet and they were gumming up the bottom of the pool. Trade MAPS was a true securitisation, in that it does give us liquidity, it gives us off balance sheet. But we did not take much capital relief. We brought a partner in because under US securitisation laws had we had done it ourselves, there would have been a round trip on our balance sheets and so could not own 100% of the transaction.

It was significantly oversubscribed. It's got an A tranche, followed by B, C and D. And we thought that we would be able to move the A and B tranches pretty aggressively, and that we would have a hard time getting the Cs and Ds off - but just the opposite happened. Everyone was looking for a yield, so all the institutional investors wanted the Cs and the Ds, and we had sort of linked Cs and Ds to get the As and Bs done, because it was a yield game.

But it's a very tough environment to get something like this done. Because, as you all know, spreads in the trade business are hitting close to rock bottom and you need to make sure you have a positive arbitrage in doing these transactions. Institutional investors don't care about cross-sell or relationship or any of that.
Rüdiger Geis: We made a core draft, CoTrax, last year, meaning we also were 18 or 20 times oversubscribed so for sure, that's the interest out there in the market. What we notice is that when we to talk to investors, they ask what you are talking about when we talk about trade finance. We had bank risks from 19 countries and that enabled us to get capital relief and free up lines.

Craig Dimmick: As a taker of institutional money, primarily pension funds and insurance companies, there was a market change after 2008 in their investment strategies because they have such long investment durations and horizons.

They switched from chasing yield (which was certainly the case up until the crisis) to looking for non-correlation and low-volatility strategies, of which the trade finance fund format has benefitted from greatly. As Rüediger says, it is an educational process. We see in the due diligence phase, the newcomers to the trade finance investment universe taking anywhere from three to nine months to get a ticket size of US$10m or more into the portfolio. Nonetheless, our current investor base is about 80% institutional. It's dominated by Europe and Japan. The rest of Asia comes in a distant third and, right now, there is nothing from the US.

Suresh Advani: Craig, your business is really about filling the gaps in the trade finance market where the banks have naturally exited. Can you just give us a bit of a feel for that and some perspective around that?
 

Craig Dimmick: Also concurrent with the change in the institutional investor appetite came the experience of the trade finance users in 2008-2009 of the disappearance or combination of providers of trade finance.

Some banks just exited the market; some were bought up by other banks. So typically, at the end of that process, the trade finance borrowers ended up with less dollars in total trade finance facilities. So then they began to look for people like us to provide that incremental amount of what they'd lost during the crisis or for specific trade flows. The banks went through a process driven by risk assessment, by BIS changes, etc. There were pricing adjustments where medium-sized trade finance users found it very difficult and time-consuming to get that next incremental US$5m, US$10m, US$20m trade finance line.

A boutique provider like us reacts much more quickly. We are absolute yield-driven to our investors, so that we have the ability to price more accordingly. We provide specific needs for seasonality swing limits or portions of their trade finance provided by banks that have reached their exposure limit and companies can't find more credit lines. And for those small portions, they are willing to pay us a premium. Their overall trade finance costs are only marginally impacted by our somewhat higher cost lines. So, we are able to satisfy our investors on a yield basis, as well as a risk-weighted basis and have a very good market.

We've grown from one fund of US$80m before the crisis, to three-funds of over US$500m now.

Suresh Advani: At GML, we ran a series of funds for a large US mutual fund shop called Federated Investors. What we had attempted to do there was to allow them to access the asset class, which they felt was very attractive in terms of the duration.

Trade finance is a short duration asset class and with floating interest, which was also very interesting for them, given their view that over time, interest rates were going to rise. The focus of the strategy was really to buy transactions from banks. And between 2008 to the present day we've had a lot of different cycles. At times, there's been a tremendous amount of deal flow when the banks enacted deleveraging; for instance, 2010-11, when the European banks were specifically contracting their balance sheets very rapidly. And the credit spreads are very attractive. And other times, we've seen tremendous scarcity of inventory from banks as they became more focused around the right size of balance sheet. Another facet of our business is that currently we're focusing on the frontier markets of trade finance such as Africa.

Finally, we have a business where we are working with borrowers who don't have access to banking capital, a universe that's getting larger, ironically, and helping them navigate what is a very fragmented and quite difficult institutional investor space to find the capital.

I think we should now discuss the challenges in approaching institutional investors.

Paul Hare: The problem for us in 2007 with almost all the investors that we spoke to was explaining to people what trade finance was and why it was a lower risk financing proposition.

What really got people over the line wasn't actually the data, but understanding the credit decision making and the asset class's inherent self-liquidating nature. When we did the initial roadshow for Sealane. I took one of our credit officers with me for the two-week roadshow. People bought into the credit story at the time rather than the low default data.

We set up our programme with clear asset selection rules. Investors are comfortable that we are selecting assets based on capital efficiency, and not a negative credit view on a client. This is incredibly important with a leveraged transaction like a synthetic securitisation. What the investors in our programme are doing is they are not taking a view on individual credits but taking a view on our credit process and the diversity of the portfolio. A typical US$3bn Sealane portfolio will have 12,000 transactions at a point in time with around 1,200 clients. There is no more than 1% exposure to any client and, depending on credit rating, it can be less than that.
 

John Ahearn: Whatever you do, you have to take the long-term view. We sell a lot of structured and unstructured products to insurance companies and pension funds. It takes six months to get them over the hurdle of what they are buying and get the documentation worked out. And then it is important you keep the flow going.

We are in the distribution game; we are going to continue to distribute the assets whether or not pricing is high or low, and we have developed this investor community, which is important. We have got good at transferring some of the spread compression. When spreads are high our investors get better returns. When spreads are low we say, "spreads have come down, this is the new price, what do you want to do?" And building it is expensive (legal costs, ratings agencies, etc). Our systems were not set up for Trade MAPS.

One of the problems we have with a short term asset, is that the average duration on the portfolio is 84 days and you have long-term three-year money. You have to constantly refill the bucket on a regular basis and you need strict selection criteria.

And institutional investors look at the world in a different way. It took six to nine months to get a major insurance company to understand supply chain finance and they told us that if we could not write a US$500m or US$1bn ticket they were not interested. We did not have those tickets to sell. It took eight years to get there with Trade MAPS.

Suresh Advani: Yes, your point about the minimum scale for the buy side is absolutely right. If you go to an institutional investor and say 'I have got this great deal of US$2m to US$5m', they are not interested, but at US$100m to US$500m lights start flashing. What we are seeing with quantitative easing and low interest rates there has been a search for yield. There is a need to analyse things differently and create diversity in the purchase position. This means thinking about transactions in large numbers.

Rüdiger Geis: If you do a three-year deal and average lifetime of 90 days, that means it needs replenishing 12 times and usually you have to do it with the same asset class. You tell your sales guys 'Get me US$xm from that country from a bank that has got AA rating.' You might say single A is OK for the right deal, but don't bring B+.

Craig Dimmick: We changed our strategy post-crisis to target a different segment of the institutional investor market - focusing on those with larger total portfolios and those who were looking to supplement a well-balanced portfolio with a low volatility, low correlation strategy.

We have to explain what was involved with trade finance assets and how you look for risk points, the structure, the quality of the administrator, the track record of the fund, etc. We then take them through the portfolio construction, and what kinds of borrowers we on-board. Once they understand this, we take them through the operational risk control processes at the fund manager and administrator level. It is a generally a 6 to 9 month process. However, we have a good success rate when we have convinced these institutions that properly managed and controlled trade finance transactions show lower default ratios than many other types of assets.

Suresh Advani: There is a lot of awareness to do with the crisis in 2008 and the realisation of trade finance as a systematically important form of finance, as well as efforts by the ICC and the banking industry to sell more assets to that community. And, investors need to identify new yield opportunities at a time of QE, and low interest rates.

While I do think there have been both supply and buy side efforts to make process easier, it still remains a challenge. Within the institutional investor initiative at the ICC Banking Commission to identify enablers and building blocks that could be put in place to make things easier. We are looking at the areas of indexation to see how possible it is to create relative return framework - within the investor world many products have an absolute return as well as a relative return index. This is all still a work in progress.

Paul Hare: Standardisation and data are absolutely critical. The long-term future is to see industry-wide platforms with independent managers able to aggregate less diverse portfolios from individual banks who may not have the scale or sophistication to manage their own issuance. That is where the trade securitisation market ultimately needs to go if we were to see broad, scalable platforms across the industry.

John Ahearn: I agree - while I don't know where it will all end up this is strategically important for our industry. Banks and bankers are a kind of herd. We get into trouble and out of trouble at the same time. While we trade assets between ourselves it is not sustainable. There is going to be something in our future where if we don't have access to other investors other than ourselves - banks - it is going to be problematical. Data is key. Investors want to know what they are buying. Unless we get the data together and sort the jargon out we won't get over these hurdles and we need to get over them.

The Capital Attraction panel was moderated by Suresh Advani and took place on 22 April 2015 at the ICC Banking Commission Annual Meeting in Singapore

Box-out 1

Suresh Advani, head of trade finance, GML Capital. Also on the ICC Expert Committee with a remit to share findings from the the institutional investment trade finance working group (moderator)

Craig Dimmick, executive director, EFA Group in Singapore. The fund manages over US$500m of its assets in trade finance strategies

John Ahearn, managing director, global head of trade, global transaction services, treasury and trade solutions group, Citibank. Distribution is a huge part of Citi's business, with around US$55bn assets traded.

Paul Hare, global head portfolio management, Standard Chartered. A former lawyer, his team is responsible for managing front-end origination strategy and asset distribution - including the securitisation platform - for the bank

Rüdiger Geis, head, product management trade services and issues, Commerzbank. He has built the trade risk distribution team at the bank from two to ten people since 2008

"Spreads in the trade business are hitting close to rock bottom and you need to make sure you have a positive arbitrage in doing these transactions"

John Ahearn, Citi

"What really got people over the line wasn't actually the data, but understanding the credit decision making and the asset class's inherent self-liquidating natures"

PAUL HARE, STANDARD CHARTERED

"If you do a three-year deal and average lifetime of 90 days, that means it needs replenishing 12 times and usually you have to do it with the same asset class"

RÜDIGER GEIS, COMMERZBANK

References: 

References

  1. The landmark securisation programmes including Sealane are explained by Dentons Ed Hickman at
    www.tfreview.com/node/10195

  2. A TFR Deal of the Year winner. See www.tfreview.com/node/10120

opinion: capital attraction

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