International trade has suffered during this pandemic due to rising trade barriers, protectionism and administrative and procedural inefficiencies across borders. This has led to a fall in global trade. A solution must be adopted that increases transparency and traceability whilst also reducing bureaucracy.
A solution would have wide benefits, especially for SME’s access to wider financial markets as they currently face higher regulatory and administrative burdens. SMEs are the largest employers and the backbone of any economy; their recovery is the key to the recovery of the whole economy.
Trade finance is a mechanism to reduce risk in international trade. It could be as simple as a credit note from a bank to guarantee payment to a supplier without having to pay them before the goods are delivered. Essentially it reduces the risk to both parties.
World trade and global foreign direct investment has taken a hit during this pandemic. The key to recovering will be, in part, due to the number of insolvencies that can be prevented. This can be done by offering firms reliable ways to enhance their efficiency and productivity.
Global Value Chains have also been highlighted during the pandemic for the sheer disruptions that have been caused to them. This not only has an economic impact but a long-term impact on society.
It is easy to see then, how access to trade finance is the perfect tool for policy intervention that will aid economic growth and foster international trade. These are the insights gleamed from a report titled: “Trade Finance, a flywheel effect to boost the economic recovery post COVID-19 pandemic” and co-written by Business at OECD, IOE and B20 Italy.
According to the report:
The typical cost-to-income ratio in traditional trade finance is 50-60%, meaning that more than half of the price charged to clients for trade is used to cover operational expenses, even before covering the costs of risk, liquidity and capital. From an operating cost perspective (e.g. document wait times), Bain & Co. estimates that enhancing process efficiency could reduce such costs by 50‐70% and turnaround times could be improved three to four fold, depending on the trade finance product involved [Bain&Co, 2018b].
A major stopper for SMEs is the high number of late payments. For an SME, not accessing finance could put a business in jeopardy. 3 obstacles to accessing trade finance are mentioned in the report.
Anti-money laundering (AML) and Know You Customer (KYC) requirements are absolutely vital but resource heavy burden for an SME. KYC compliance accounts for about a third of rejected trade finance with “missing information” and “knowledge of the process” as common reasons for rejection.
In additional, banks are shrinking their balance sheets to meet the key ratios segment of Basel III due to a rise in the cost of capital. One of the unintended consequences has been crowding out of trade financing products in favour of invoice financing, bank-to-bank financing and subsidiary-to-subsidiary financing. Trade financing, therefore, shifted to shadow banks who are unregulated and pose higher risks to the financial stability of the economic system.
Today’s processes are still in favour of paper-based workflows and manual processing which poses an additional obstacle during a pandemic. Inefficient processes including manual contracts, multiple checks, duplicate bills etc lead to complexity and delays.
Multiple platforms used by various players in the market lead to confusion and open the door to increased miscommunication and fraud. Another point of miscommunication is data field interactions. One trade financing transaction is thought to average hundreds of data fields with only 1-2% estimated to add real value.
There is also a gap in understanding trade finance and access to digital skills for SMEs.
Innovation can be fostered by governments who improve the regulatory framework by adapting existing rules to new technologies. Compliance can be made more consistent, less costly and less complex, thus improving its transparency and traceability.
An important driver of this is globally recognised and consistent use of digital technologies. One of these recommended technologies set out by the report is Legal Entity Identifiers. The article states:
“the LEI is part of the Financial Stability Board’s proposed enhancements to make cross-border payments more transparent, efficient and inclusive for all users (ensuring to avoid any unintended discrimination). Being an open and non-proprietary standard, it can facilitate more effective counterparty identification and verification on a global scale by providing a universally recognized identifier paired with essential entity data, rigorous verification processes and high data quality, which helps increase transparency and traceability.
Both the Asian Development Bank and the African Development Bank confirmed the usefulness of the LEI for creating a standardised, reliable, global identity to:
- Mitigate the risk for the correspondent bank – customer relationships being de-risked;
- Increase SMEs’ access to finance in emerging markets by easing the flow of reliable information; and
- Promote development of financial technologies, blockchains and similar platforms to reduce costs.
Importantly, the LEI, a global open data standard, does not contain confidential (private) information; therefore, it does not pose confidentiality threats in respect of information exchange. On the contrary, by providing a unique identifier, the LEI can help create an open and transparent ecosystem (e.g. for KYC purposes), where relevant financial institutions benefit from swift identification of new clients, while reducing duplicative work involved in having to gather themselves the information already captured by the LEI.”
The report also outlines 4 benefits if LEIs were used by all financial institutions at the time of onboarding new clients. The burden of identity validation, KYC and AML could be reduced by:
Another notable benefit of the LEI is the reduction of time spent on data corrections and reconciliation. With a single global standard for taking company information, approximately 35% of total trade processing costs can be streamlined through use of LEIs with a potential to maximise 10% of the costs.
The LEI could also be used in legally recognised digital documents as we predicted would be useful in August 2019.
The next step for governments is to push forward some innovative legislation that would recognise the use of LEIs in trade and in digital documents enabling more seamless cross-border transactions and stimulating trade post-pandemic.
In the meantime, businesses can register for an LEI and start trading today. Many legislations already require the use of LEIs to trade but any business-to-business transactions would benefit from LEI used in KYC and AML procedures.
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