Is forfaiting dead?

A provocative suggestion? Margrith Lütschg-Emmenegger says no – just a wake-up call. She argues that the forfaiting industry can survive, provided it’s willing to modernise and reinvent itself.

Prior to answering whether forfaiting is dead, one would first have to answer the question “what is forfaiting?” and market participants would offer many different definitions. Clearly, if one sees forfaiting in its most traditional way, i.e. bills or notes guaranteed by a bank medium-term, there is certainly little business left to discuss. However, I believe most players in the marketplace see the product now in a much wider application and would agree that forfaiting is purchasing and selling, as individual actions, but, more importantly, it is the trading of trade-related transactions. For some, this could be quite structured, taking performance risk through providing pre-shipment financing, followed and combined with receiving post-shipment repayment from the buyer. Documentation could range from LCs, invoices to loan agreements, etc.

Given such wide interpretation, the potential market for forfaiting is almost limitless. While world trade has somewhat slowed during 2001 and 2002 compared to record growth in 2000, when it amounted to US$6.2tn, the numbers are still impressive. Importantly for the forfaiting market, developing countries made an above-average contribution, with a 15% increase in the volume of merchandise exports – three times faster than their GDP growth. Developing countries accounted for 27% of world exports of manufactures in 2000, up from a 17% share in 1990, according to the World Trade Organisation. The market for trade finance has been estimated at US$2.5tn in total assets outstanding in 2000, including US$800bn in new issues. Most of this stays on the balance sheets of originating banks or exporters. Just 3%, or US$75bn, of assets was traded in the secondary market.1

Forfaiting, despite its wide applications, still captures only a small part of this potential market. Why is this? I believe it originates from the fact that we cannot attract sufficient investors, which, in turn, means we cannot offer the best possible pricing and solution to our primary customers, the exporters/manufacturers. As a result, forfaiting still has a reputation as the financing technique of last resort, and of being expensive. Investors ignore our market because it lacks uniformity, relies on physical delivery, has limited information flow/visibility and, as a result, lacks liquidity. All established financial markets except forfaiting, i.e. trading of trade-related transactions, have addressed these problems and grown substantially, benefiting all market participants. If we are to attract new investors, our first priority must be to agree to and adopt standard market practice. If we cannot do this, we will never be able to offer those features required by potential new investors, institutions and funds to enter our market; they are looking for a central custodian, a book-entry settlement procedure and an electronic trading system allowing for transparent pricing and the free flow of information. The potential rewards are staggering – just think for a moment of the business we could all be doing if trade finance became a significant asset class for institutional investors. Likewise, the risks of failing to change are great.

The forfaiting market has been described as “one of the most arcane, illiquid and opaque financial markets in existence”2. It is restricted to commercial bank participants because of the significant barriers to entry. Forfaiting assets should be attractive to institutional investors and funds. The yields are attractive and comparable to other fixed-income emerging markets but clearly carry less risk due to the trade nature of the debt. However, investors stay away because it is a market they simply do not comprehend due to the lack of market standards and basic uniform documentation standards, the need for physical settlement of trades with the associated risks and, more importantly, the heavy costs involved. All this keeps new participants away, as they cannot make an informed investment decision. It also works against us when marketing to exporters, as they have partial access to information via the internet and do not benchmark our pricing accurately. We often appear more expensive. The free communication of information is a central concept of efficient markets. Forfaiters seem to take the opposite view, which is if we give away as little information as possible, we will somehow make more money. I strongly believe that if forfaiting wants to survive, we must make it possible for investors to make informed investment decisions in order to attract them to the forfaiting market.

Our market has proven especially resistant to change and modernisation. Some seem proud of this fact. We have all seen what has happened in our attempt to introduce common market practice. The International Forfaiting Association (IFA) started the process of devising and adopting some rules for market practice at the annual general meeting in 2000; we have since had to narrow the scope to just guidelines on secondary-market transactions between members. We have gone through two serious iterations without agreement and it is now summer 2003. In fact, we have seen some quite heated exchanges of strongly held views on this issue and even some amusement at our inability to make progress. While, in fact, we should all applaud the excellent work and dedication of the Market Practice Committee and the fact that they (the hard-working members) have not yet given up in the process.

Fear, complacency and defeatism

What is holding us back? The usual argument is that our market is somehow special. It’s too complex and our deals involve too many variables, making standardisation and the adoption of new technology impossible. It’s a relationship business and it will not work without that personal touch. Market participants state legal concerns surrounding standardisation and electronic communication and documentation. There is concern that the new technologies are not secure and put our institutions at too great a risk (even though some of our colleagues are happy to risk their own money trading online). All are, no doubt, valid concerns, but none that have not been successfully addressed by other markets. The real reason, I feel, is a mixture of fear, complacency and defeatism. Too many people have their heads buried in the sand, fearing change. They fear that modernising our market will lead to reduced margins and the loss of supposedly “proprietary” relationships, not to mention their jobs. They are complacent, saying: “The demise of the forfaiting market has been predicted for years, but we have survived.” Maybe we have just about survived so far, but the question is for how long and should we be interested in mere survival? They say that standardisation and modernisation is a nice idea, but it will never happen. Well, if we do want to grow (not merely survive) we have to make it happen and it is very much in our own hands.

It is absolutely essential that we overcome this fear of change and modernisation. This must be a priority for all forfaiters, as we all stand to gain (just as we will all lose out if we fail). It is true that forfaiting deals are non-standardised, can be complex and do not lend themselves well to technological solutions, so it will not be easy. However, exporters cry out for standardised documentation and new investors will not consider entering our market without it. We have not even started discussing it seriously. We are failing to meet the needs of the clients we buy from and the clients we would like to sell to. It’s about time we started the discussion. Likewise, the application of technology solutions is not impossible. There is now a life system/trading platform available for all who are willing to try. A selected number of market participants have tested the system and approved it for launch on May 15, 2003. Surely there will be a need for improvements/amendments and substantial further developments to get where we need to be, but it is a start and, if the market embraces this, it will make a paramount difference. New communications technology should be embraced, not feared. The telegraph, telephone and fax were all new at one time, but once embraced, changed the manner and pace of trading in financial markets (even ours). The internet is simply a more sophisticated communication tool.

There is a tendency in our market to believe that client relationships are proprietary and we jealously guard our contacts from each other and even, I have heard, from colleagues in our own institutions. The truth is the market is small and we all know the same people. Opening up and sharing our contacts via a platform will not kill a relationship. However, it will most likely attract more market participants and increase the total size of the market. Again, it’s a function of providing our clients with more information in order for them to make well-informed decisions.

Lawyers involved in forfaiting argue strongly for the adoption of some UCP-type set of terms and practices. Mike Sullivan of Sullivan & Worcester LLP describes the forfaiting market as a “lawyers’ paradise” and (against his own interests) has often advanced the position that many of the procedural and substantive issues that complicate forfaiting lawsuits could be avoided by slight modifications to the standard-documentation package and market agreement on “terms of art” and “custom and practice”. Regarding e-commerce and e-signatures, it appears that, “as a general proposition, the concept is accepted, although there is a lack of uniformity among domestic authorities. The Uniform Commercial Code certainly contemplates electronic commerce in the form of letters of credit,” he says. The International Chamber of Commerce’s supplement to the UCP, the e-UCP, went into effect on March 31, 2002.

The security of electronic transmissions is one of the most significant operational business considerations facing any market undergoing technological change. However, modern encryption and certificate technology has been demonstrated to be safe and reliable. Doing business on the internet is probably safer now than using traditional methods. However, security is quite rightly a concern and we must balance the goals of promoting the benefits of electronic media with the need to protect participants and the integrity of the markets. The last thing we want to do is provide a new medium for fraud and abuse.

Perhaps the most comfort I can offer reticent parties is that what is being proposed is purely optional. There is no intention to force anyone to adopt standardisation or use new technologies. However, the benefits of doing so should be self-evident.

A matter of priorities

Our first priority must be to agree on a code of standard market practice. The absence of even basic market-practice guidelines is a significant barrier to entry in our market. How can it be so difficult for us when it is possible for traders in more complex markets to agree on standard terms and conditions? It seems that we all agree we need the guidelines, but we disagree over the form and substance.3 There is a lack of urgency, adoption of confrontational positions and even a lack of seriousness about the issue. The IFA has now invested in a lawyer to rewrite the guidelines to address the many concerns of its members and is about to circulate the latest version, which I urge all members to review constructively with a view to approving it and putting it into practice, hopefully during the 30th Annual IFA Conference in September 2003 in Barcelona. This must be a market participant-driven effort – by all participants, not just the big market makers or the 20% who have responded to date. This is one of the important reasons the IFA was established and exists; it is owned by and works for the market participants. The IFA is, in effect, the self-regulatory organisation for the forfaiting market and, as such, should rightly be responsible for establishing, reviewing and enforcing standards of conduct for our members and for fair and orderly operation of trading facilities if and when they are in place.

Second, we must begin the discussion about standardisation of documentation. Hand in hand with this, we must consider a neutral, market-driven and owned central custodian and settlement agent. A start has been made with the trading platform, if subscribed to by the market. A trusted, independent third-party documentary due-diligence agent will make forfaiting assets more accessible, significantly reduce costs (as we will avoid duplication of the due-diligence process each time we buy and sell) and significantly reduce the risk of lost or stolen documents. Delivery by book entry against payment will reduce settlement risk, lower costs and increase liquidity and business volumes. Think of a Euroclear for forfaiting.

Third, we must work towards implementation of a similarly neutral, market-driven and owned trading platform. A trading platform will make our market more efficient and transparent by providing all participants with faster, more effective means of exchanging information. We will also be better able to handle increased trading volume. Data on all completed transactions will be stored and composite information will be available to subscribers. This centralised reporting and dissemination system will produce an extremely transparent forfaiting market. It will allow investors to value investments more accurately and allow exporters to benchmark correctly. A start has been made with the launch on May 15, 2003. Please let’s embrace it and drive it forward together.

Like any business, we must constantly reinvent ourselves in order to find ways to serve our clients’ needs better. I believe we have the extraordinary luxury of knowing exactly what those clients’ needs are. It’s time we listened and started trying to meet those needs. We will attract more investors, which, in turn, will attract more exporters, which means more assets in the market and more business for all of us. If we fail to do so, the title of future articles (if any) will change to: “Forfaiting is dead!”

References

1 “Revolutionising a medieval market”, Trade Finance, June 2001.

2 ibid

3 Tim Everitt, “Forfaiting – Market practice, an insider’s view”, Trade & Forfaiting Review, February 2002.

Margrith Lütschg-Emmenegger is executive vice president of FIMBank in Malta.