I wrote this paper as an internal knowledge sharing document last year to help those members of the Aquifer family without finance/commodity backgrounds understand the WHY behind the WHAT and HOW of our cause. As we found ourselves in a Global Trade War that looks to continue in 2019 and increasingly compressed yields in publicly traded debt & equity investments, I'd like to share this piece with the wider audience on LinkedIn to spark informed debate on addressing the underlying issues choking global trading of physical commodities. "It takes a village" so let's get started...

The Universal Customs and Practice Rules 600 (UCP 600) runs on the documentation-centric "Autonomy Principle" which makes bank's irrevocable undertaking to pay independent from the underlying contract of sale, banks are obliged to pay against documents which are conformant on their face without regard to their accuracy or genuineness. This is a heavy burden for banks whom act both as the financier to traders and guarantor to each other.

The two significant exception from this powerful obligation of irrevocability for a bank are:

1) fraud (UCP 600, Articles 5, 7, 8, 34). and

2) illegality of payment (general obligation on a bank)

Let us explore the issue of fraud from 3 perspectives:

1. Bank

English and Singaporean courts have consistently taken a cautious approach on the basis of public policy in cases where banks decry fraud to set aside their obligations to pay and require a high standard of proof, both as to the fact of the fraud and as to the bank’s knowledge. Unless fraud was established, any claim a bank might have against a beneficiary making a fraudulent demand must be pursued separately following payment, and cannot normally be used as a defence or set-off to avoid payment. ( Solo Industries UK Ltd v Canara Bank [2001] 2 Lloyd’s Rep 578)

UCP 500 left room for challenge when the confirming bank had paid under a letter of credit but it was later discovered that some of the documents presented were fraudulent. The court had upheld the issuing bank’s refusal to pay the confirming bank on the grounds that the confirming bank had no greater rights than the fraudulent beneficiary (Banco Santander SA v Banque Paribas [2000] 1 All ER (Comm) 776). In order to remedy this, article 7(c) of the UCP 600 establishes a definite undertaking by the issuing bank to reimburse the nominated bank when that bank has accepted a draft or incurred a deferred payment obligation. This has been upheld by the English court (Fortis Bank S.A./N.V., Stemcor UK Limited v Indian Overseas Bank [2009] EWHC 2303 (Comm)). It is reiterated by article 12(b) of the UCP 600, which expressly provides an authority from an issuing bank to a nominated bank to discount a draft that has been accepted for deferred payment. Corresponding banks should act with caution before refusing to pay out, even where they suspect fraud. There must be clear evidence of the fraud at the time of payment.

It is insufficient merely to suspect fraud or to prove there was material which would lead a reasonable banker to infer fraud.Whilst the UCP 600 offers consistency, it addresses fraud only to a limited extent. Prevention is the best protection for a bank, due diligence on every agent (traders, banks, logistic partners, other services providers) within the documentation presentation process is therefore vital.

2) Buyer

Payment against documents for goods en route leaves buyers vulnerable. Since if fraud has been committed and proven, there are very few remedies available to a buyer. Injunctive relief is rarely granted and the time and expenses incurred in seeking legal redress make the recovery process commercially unviable. Generally, given the multilateral relationships involved in every bank financed trade deal, the courts are reluctant to intervene for the benefit of the buyer save for the most exceptional cases (Bolivinter Oil SA v Chase Manhattan Bank [1984] 1 Lloyd’s Rep 251).

“If, save in the most exceptional cases, [the applicant] is to be allowed to derogate from the bank’s personal and irrevocable undertaking,.....by obtaining an injunction restraining the bank from honouring that undertaking, he will undermine what is the bank’s greatest asset,.....namely its reputation for financial and contractual probity. Furthermore, if this happens at all frequently, the value of all irrevocable letters of credit and performance bonds and guarantees will be undermined.” Alternatively, a buyer might seek an injunction preventing the seller from relying on falsified documents. However, the court has held that it was not open to a buyer to seek to prevent his seller from drawing on the letter of credit, noting that the “integrity and insulation of banking contracts could be overthrown, simply by the device of injuncting the beneficiary rather than the bank” (Czarnikow-Rionda Sugar Trading Inc v Standard Bank [1999] 2 Lloyd’s Rep 187).

3) Seller

Fraudulent letters of credit issued or advised by unreliable banks are a risk for sellers. In addition, genuine letters of credit issued or advised by banks that are unfamiliar to the corresponding bank are often rejected for being perceived as high risk. Where a corresponding bank is unable to seek reimbursement down the chain, one option is to bring a claim against the seller, either for restitution for mistake, or for damages for the production of deceitful documents.

The autonomy principle in letters of credit is powerful and leaves all parties involved vulnerable to fraud, particularly in circumstances where frauds are becoming increasingly sophisticated. It is important to note that although a letter of credit is treated as one transaction, it actually involves multiple parties, multiple individual contracts, and potentially multiple jurisdictions. The difficulty in understanding with a reasonable degree of certainty of the likelihood of successful granting of letters of credits, especially for buyers and sellers of commodities from non-OECD jurisdictions and without established credit ratings significantly hamper the scalability and survivorship of the most important layer of global commodities trading.

Alternative to Letter of Credit?

In reality, Letters of Credit (L/Cs) no longer dominate the global trade financing distribution, Bank of International Settlements reported that LCs make up 17% of the global trade financing market share in the face of rising non-bank intermediated alternatives. LCs under UCP are known to be time-consuming and labour intensive to operate. They still predominate in trade between emerging market (EM) economies, but the number and the complexity of the ‘receivables’ and ‘payables’ involved in many modern-day international global supply chains, increasingly militates against their use.

Let us explore the common alternatives:

(A) Inter-firm trade credit

The major alternative to bank trade finance is inter-firm credit extended between importers and exporters, commonly referred to as ‘trade credit’. This includes ‘open account transactions’, where goods are shipped in advance of payment, and ‘cash-in-advance transactions’, where payment is made before shipment. Inter-firm credit typically entails lower fees and more flexibility than does trade finance, but leaves firms shouldering more payment risk, and a greater requirement for working capital. As a result, trade credit is most common among firms that have a long-established commercial relationship, or are part of the same multinational corporation, and/or operate in jurisdictions that have sound legal frameworks for the collection of receivables. Unfortunately these apriori conditions exclude the bulk of commodities market participants.

A firm’s capacity to extend trade credit can be underpinned by the option, where available, to discount receivables, for example via ‘factoring’, and by access to bank and capital market finance that is not tied directly to trade transactions. Firms can further reduce payment risk by purchasing trade credit insurance. Trade credit insurance is also used by banks to hedge their own payment risks. Insurance companies in the US, find themselves much more beholden to a rules-based environment, where more explicit restrictions are placed on certain asset classes than in Europe. The result is that current trade credit insurance policies tend to be offered as portfolio basis to firms that have long-established operational history, part of large multinational or publicly listed corporations, operate in jurisdictions that have dependable courts and legal framework for recovery of loss. The cost of these policies in addition to the aforementioned underwriting criteria again tend to exclude counterparties from emerging markets, are up-and-coming independent operators or run on lean operational models.

(B) Export credit insurance

Instead of using bank-intermediated trade finance products such as L/Cs, exporters can also mitigate non-payment risk by purchasing export credit insurance from private insurance firms (typically for shorter-term financing) or obtaining guarantees from public export credit agencies (ECAs) (usually for export loans of two years or longer). These instruments typically insure against default by the importing firm and political risk. Banks may also seek ECA guarantees for particular international trade transactions to mitigate risks of non-payment from other banks or customers. Data show that around 9% of global trade has benefited from such support in recent years, with most coming from short-term guarantees. However access to ECAs are typically confined to exporters that are endorsed by the domestic government that supports the public export credit agencies and usually require credit support from a bank.

(C) Securitisation

Synthetic securitisation have to-date proved the most common way to distribute trade finance to non-bank investors. These transactions release capital for reinvestment, but do not provide liquidity relief, as banks continue to provide funding for the loans originated. Essentially, outside investors take a first- or second-loss position against a portion of the bank’s trade finance portfolio in exchange for a stream of payments from the bank. The investor guarantee is provided via cash collateral.

The bank’s purchase of protection allows it to reduce the risk-weighting of the insured loan, and the amount of capital required to be held against it. In contrast, these deals may not make a difference to non-risk-sensitive measures, such as leverage ratios.

Investors receive an equity-like return against a pool of relatively safe assets. Transaction tenors are typically three to five years.

Outright securitisation provides both liquidity and capital relief to originating banks, but has yet to gain much traction. Programmes could entail a true sale of trade assets to a special purpose vehicle, funded by asset-backed securities and commercial paper.

Direct sales of trade loans also release bank capital and liquidity for redeployment. Large banks are increasingly looking to sell syndicated trade loans to investors.

The broadening of the market could lead to shifts in investor demand that in future would introduce greater volatility into the availability of trade finance through the business cycle. The attractiveness of securitisation could deteriorate if margins on trade finance narrow or credit costs rise.

(D) Trade loans

Trade loans are fully revolving credit facilities linked to specific import or export transactions, they are typically granted in conjunction with other trade products (such as documentary credits) and takes on average 4 weeks to establish for an approved customer. These short term flexible arrangements are usually secured by the goods being purchased (presented in the form of drawdown documentation invoices and transport documents), they help fund a business between the time it has to pay for the purchased goods, and the time when the firm receives the funds from the sale of those goods.

The rate of interest charged on trade loans tend to be more expensive given their short dated tenor and flexibility, the administrative cost of opening each facility adds to the other trade products the bank would have already granted to the borrowing entity. This is a product that supplements the suite of banking facilities provided to a customer of good standing, unfortunately this is a status that are very difficult to reach for the independent SME traders, especially from emerging markets.

(E) Direct deals

Direct provision of trade finance by investment funds is generally confined to various boutique operations and largely still conducted through costly and unscalable manual due diligence process. Due to the high cost basis and unpredictability of deal flow that places heavy cash-drag on institutional investor funds, most leading trade finance focused funds seems to be focussed on securing deals that are “bankable” customers rather than those who face constraints in accessing bank-intermediated trade finance, such as small and medium sized firms in emerging market economies.

The most pertinent challenges to expanding the role of non-bank investors include:

1. ‘Agency’ issues

2. Information asymmetries

3. Greater standardisation of the new product base and codification of the commercial practices.

4. Self-regulation, education and joint governance efforts with market participants and regulators for broader acceptance of new industry practice outside of UCP 600.

5. The Agency Issue

The conflict of interest of any “risk-outsourced” direct deal framework is inherent, due to the misalignment of interest among its participants. The low risk profile and narrow spreads on trade finance loans leave banks with limited compensation for originating these assets, while also limiting the margin available for external investors to pay for appropriate due diligence and deal structuring of pools of smaller scale trade finance exposures, which can be expensive. The recent global financial crisis demonstrates how easily underwriting standards and assessments of transaction risks can fall short of best practice, not least when credit evaluations are outsourced to the originator. The net result is that riskier than perceived assets are originated with insufficient risk compensation.

II. Information asymmetry

Familiarity with trade finance assets beyond those who provide it is very limited. Raising awareness with institutional investors is therefore a key need for increasing trade finance appetite, as is an educational programme regarding the nature of the structures and counterparties. One anecdote is that there is currently no such material on the Bloomberg terminals nor does Reuters provide any useful guide, considering that these are the primary source of information for most institutional investors to initiate their entry into another asset class for portfolio diversification.

Trade finance deals require specific knowledge and skills not only for those on the front-line driving deals but also those in the back supporting their execution and risk management. Few institutional investors (hedge funds, family offices, asset managers) are equipped to settle or safe-keep the deals, and there are often limited administrative personnel equipped to handle the necessary documents and accounting requirements. In addition, the major originators of deals (being the up and coming independent traders from emerging markets) have limited experience of working with institutional investors, mounting the difficulty for such investors to independently access the consistent volume of the flow of deals needed to maintain a diversified portfolio.

III. Standardisation and codification of new approach

At present, there is a vacuum in the non-bank led financing model, the observable universe consist of: ad hoc practices of institutional investors, peer-to-peer lending platforms, trade-sale facilitation brokerages and generic project finance-inspired credit provision from alternative bridging credit solution providers. The geographic and sectorial dispersion of these ad hoc practices as well as the lack of a member-driven co-operative social enterprise like benchmark setting, governance and enforcement body render previous attempts of regional standardisation and piece-meal codifications unsuccessful.

IV. Self-regulation

The trade finance industry benefits from the stability of other segments of the financial system, and it is vulnerable to contagion. Appropriate regulations that span the three pillars − capital, leverage, and liquidity − are therefore clearly essential to control incentives to accumulate high-risk, highly-leveraged financial assets.

The regulatory framework for finance, in Europe, the US, and beyond, is not yet fully settled. Much of the regulatory duties are shared between governmental legislative instruments, administrative decrees and practices with industry self-governing bodies. The rise of the former two branches and shrinking of the latter branch due to rapid de-mutualisation of co-operative exchanges and other industry self-governing bodies in the past 30 years have contributed to the growing global funding gap that stands at $1.5 trillion in 2016 (The 2017 Asia Development Bank Trade Finance Gaps, Growth, and Jobs Survey). There is widespread recognition across the financial sector and beyond that low-risk, highly collateralized trade finance assets, such as L/Cs and other self-liquidating commitments with a very small loss record, do not warrant being primary targets of regulation; and that the profitability of trade finance ought not to be undermined by (any unintended consequences of) the new regulatory framework. It is important, as this architecture continues to evolve iteratively across numerous dimensions, and navigates new challenges (from, for example, technological innovation, new business models etc.) that the issue of finance supply be given its due priority, including importantly a dependable, robust, and cost effective mechanism for trade.

The need for inclusion in new trade finance benchmarks: disproportionate importance for SMEs and emerging markets

SMEs are a key component of today’s fragmented supply chains, they account for some 95% of all firms and around 60% of all jobs. While they propose ~50% of trade finance applications, up to 75% of these applications are turned down: perceived risks around their businesses remain high (Trade finance and regulation: The risk of unintended consequences). International trade is the driving force sustaining emerging economies, with many companies largely dependent on banks for finance. The risks from an unduly constrained market for (especially dollar-denominated) trade finance would likely be felt acutely in the emerging markets. As barriers to global trade continue to erect, the need for a new benchmark practice that disproportionately benefits those with the highest need of financing and investment access in global trade is paramount to sustain the global economy through the current cycle.

The inclusive alternative solution by Aquifer

Aquifer Institute Ltd is a cooperative self-governing not-for-profit enterprise dedicated to propagate a new standard of trade finance for institutions to access dependable flow of commodities deals with built-in counterparty and market risk management.

Aquifer’s core value lies in the codification of a “Prepayment With Guarantee” model of financing with legal contracts (under English and Singapore law) enforceable in the courts of most common law jurisdictions as well as smart contracts (on a public blockchain) that automates the self-liquidation and audit-able discharge of predefined obligations offers an effective alternative to supplement the UCP600 framework. The implicit traceability and transparency affords users of the model additional options of deploying sustainability goal tracking and Shariah compliant financing modules.

Rigorous quantitative risk management techniques are embedded in the Aquifer proprietary technologies and liquidity facilitation methodologies to further enhance the timeliness of intervention and evidentiary support as basis of technology enabled self-governance.

Incorporated in Singapore as a Public Company Limited by Guarantee, its members contribute to and benefit from the self-governing ecosystem that allows end to end service of trade finance transactions in a virtual “Terminal Market” model. Aquifer Institute Ltd is currently supported by Enterprise Singapore Board (the regulator of commodities industry in Singapore) and contributes to International Standards Organisation as part of the technical committee for ISO/TC 307 Blockchain and distributed ledger technologies and ISO200022 Universal Financial Messaging. Members of the Aquifer Institute Ltd include a Singapore Global Trader Programme endorsed metals trading house; leading blockchain based marketplace that is present in Hong Kong, Korea, USA; licensed foreign currency remittance service provider backed by a leading Korean commercial bank that’s also a top trade finance bank and a next-generation infrastructure and technology hybrid venture builder.

The alpha-version of on-chain the Aquifer programmatic auction platform conducted its first test trade in September 2017 on the Ethereum public blockchain. In March 2018, Aquifer Institute published its quantitative risk management models (“Commodity Trade Finance Platform Using Distributed Ledger Technology: Token Economics in a Closed Ecosystem Using Agent-Based Modeling”) for academic peer review on the Social Science Research Network and Centre for Open Science. The full platform is built and operated by Aquifer Pte Ltd, while the Aquifer Institute Ltd will remain dedicated to the research, development and public education of advanced risk management practices enabled by cutting edge open-sourced technology and proprietary data sciences