Article

The new, non-traditional trading environment

by Michael Quinn

Michael Quinn has more than 30 years of experience in banking, with more than half of that time in trade finance. He is a Senior Vice President of JPMorgan Chase Bank in New York and is responsible for product management globally in the trade services business.

DCInsight traditionally provides a forum for discussion of the standard documentation that supports global trade. So it's with a certain irony that I am using this venue to focus on an issue that continues to go unaddressed - either collectively or on a global basis - by the bankers who traditionally service international trade customers.

Customers moving to open account settlement of their international procurement requirements still seek some of the fundamental features of the trade instruments they've forsaken. Risk mitigation, liquidity and settlement are still needed, but in forms substantially different from what the global banking community is familiar or comfortable with.

In an industry that struggled to reach consensus on a five-day versus seven-day notification period standard for acceptance or refusal of documents, many bankers have yet to realize that their customers are moving at ever faster speeds to meet the competitive challenges in their industries. In global sourcing, every movement of goods is now carefully orchestrated by customers to meet time-to-market demands on the other side of the world, while at the same time minimizing their use of their own capital. They are understandably intolerant of delays imposed upon them by one of their service providers.

The demands of just-in-time inventory - assembled by contract manufacturers from components sourced from numerous providers - require perfect synchronization of design, logistics and financing so that the goods that arrive are the right quantity, quality and price. The web of interdependencies in every supply chain makes it imperative that each participant fulfil its role within the parameters prescribed without delay or interruption. Additionally, the ability to change the participants in this intricate network is both problematic and undesirable. Financial viability, crucial to each player's ability to fulfil its role, is as critical a factor as their ability to produce, assemble or deliver parts.

The influence of these customer-driven changes is becoming increasingly evident to banks that have traditionally serviced customers in international trade. The use of documentary credit instruments is declining rapidly in light of the explosive growth. Trade is growing 10-12 per cent annually, yet SWIFT reports flat to declining volumes of 700 series messaging. Of even greater impact is the fact that the dollar value of trade intermediated with traditional instruments fell from 35 per cent in 1990 to less than 20 per cent in 2005.

Paper, please

Yet bankers insist that in order to fulfill their roles in this global economy, key documents - paper only, please! - must be presented to them within the prescribed formats and within their "rules". If a party wishes to be paid for its contribution to the supply chain, it is at the mercy of its bankers, who insist they need time to ascertain that the documentation meets their rigid requirements. If the documents do not meet those standards, then effecting payment will be at the banker's convenience. In order to provide the liquidity necessary to facilitate the roles played by bankers' respective customers in this supply chain, traditional underwriting requirements are invoked with the necessary credit application, acceptable credit history and security interest in the underlying transaction.

Taking a broader view

But if they want to meet the needs of customers and to continue to prosper in light of the international trade revolution, bankers need to greatly expand their view - not only of their customer, but also of the participants in that customer's supply chain. Customers have assumed more risk as their supply chains have globalized. They evaluate the viability of a supply chain partner through analysis of globally available information delivered on the web, by the length of time they have been working together and through assessment of the strategic importance of the supplier's contribution to the overall supply chain. They are deploying tools and working with partners who have the means to increase the visibility of the transactions within the supply chain. Whether this visibility comes from technology solutions or from working with global players who have "feet on the street" where they do not, it results in the mitigation of certain aspects of supply chain risk.

Assessing risks, providing liquidity

To maintain a role - and revenue - in these new supply chains, banks must participate in, and even augment, this risk assessment process. Creditworthiness will vary among participants in the supply chain, and traditional credit underwriting will retain its importance. However, when liquidity is required by non-customers who are direct participants in the customer's supply chain, banks must develop a way to make that liquidity available - with the availability based on their customer's risk profile and without the traditional protections of detailed credit analysis and collateral against the ultimate borrower. They need to rely upon the information available in the supply chain from unrelated third parties who are fulfilling non-financial functions to support their extension of credit.

To make a determination of the role it wishes to play, a trade bank will need to understand the commercial terms of the underlying transaction as well as the responsibilities of each of those parties. Purchase orders, invoices, insurance certificates, warehouse receipts, bills of lading, inspection certificates are, at present, the basis of commerce on which customers rely for settlement in international and domestic trade. However, without the comfort of traditional trade instruments - such as letters of credit and drafts and the protections afforded by the UCP, URDG, ISP and local laws that embrace these global standards - banks need to find ways to "obligate" these non-customers in multiple legal jurisdictions.

New initiatives

There are initiatives underway to assist banks in meeting the needs of customers with sophisticated global supply chains. First, SWIFT, through the Trade Services Utility (TSU), is providing a means for banks to exchange key data elements of the commercial documentation necessary to effect settlement for international transactions. Buyers' banks can communicate "open" purchase order information to the suppliers' banks. Suppliers' banks can respond to that PO with key data elements from the invoice and shipping documents of the supplier. When that information is successfully "matched" by the TSU's matching engine, the buyer can be comfortable that his goods are progressing through the supply chain as originally defined in the purchase contract. The supplier's bank can also be comfortable that "acceptance" of the goods and therefore payment for them is more likely to be forthcoming. There are no guarantees of the validity of the order or shipment information other than an assumption that the participating TSU bank is dealing with reputable customers and that the information provided can be considered legitimate.

Similarly, the International Standards Organization (ISO) is developing standards for "e-invoicing" protocols. In various domestic markets, trading partners exchange purchase order and invoice information through electronic presentation platforms. Some are buyer-centric "closed" networks where the buyer and his suppliers exchange order information and fulfillment information through formatted messaging, and payment is effected by the buyer's bank. JPMorgan Xign, a financial settlement provider, is a leading example of this capability. Others are open networks where data can be exchanged and payment effected with some level of external confirmation. For example, in the European Nordic region, banks have adapted standard formats (Finvoice, UBS) to exchange information and effect payments. The European Commission is pressing for invoice standardization across the EU. The ISO, in response, is attempting to develop globally acceptable standards for invoice exchange and acceptance leading eventually to a means to support requests to finance based upon the e-invoices.

These initiatives will provide a means to effect payment and inject liquidity into supply chains that are not ordinarily visible to potential lenders. Because information is being exchanged through secure means with trusted intermediaries on either side of the transaction, financial players should be more comfortable dealing in this increasingly electronic space.

Role of financial institutions

But how do financial institutions secure their interest in these electronic impulses flying through the ether? How does a party outside the jurisdiction of the borrower know what to do within the local legal regime to evidence that the financing has been provided and the lender has a secured interest in the transaction? Under traditional trade instruments, a draft, bill of exchange, promissory note or other form of debt instrument was part of the paper "trail" supporting every trade transaction. As financial transactions moved with the speed of physical goods, bills of lading could be construed as conveying title to the underlying goods or providing the lender a "second way out" through confiscation and liquidation of the goods to repay the borrower's outstanding obligations.

But in the global sourcing environment, "goods" manifest themselves in multiple ways through the order-to-pay cycle - from raw materials to manufactured components to assembled finished goods - each with a unique intrinsic value to the participants at each level of production and an aggregate value to the end user. Total landed cost of the goods also includes regulatory costs and the cost associated with moving the goods from raw material to finished product, all of which contribute to the ultimate value of bringing the goods to market. How each of these financial obligations is satisfied during the production cycle potentially requires liquidity, depending upon the financial wherewithal of the participants.

Recent initiatives

Similar to the initiatives in the payment and settlement space, there are efforts underway to create uniformity and consistency in securing one's interest in the obligation to pay resulting from the underlying commercial transaction. The United Nations Convention on the Assignment of Receivables in International Trade provides a framework for local governments to conform their laws to ensure consistent rights and obligations between creditors and debtors under these open account transactions. The Convention provides specific rules for determining where an assignor, assignee or account debtor are located. Once applied to a receivable, the same rule will apply to subsequent assignments of that receivable. When it is globally adopted, the Convention can provide protections to financing and borrowing parties that are well understood and consistent anywhere.

In Latin America, the Organization of American States and the National Law Center for Inter-American Free Trade are endeavouring to implement secured transaction law and practice in Latin America that will make credit more readily available and less expensive than what is currently available. Guatemala recently passed model legislation which will support the efforts of its trading partners to create more transparency in the financing of the underlying goods and reduce the cost of credit. This initiative is also consistent with the UN Convention and will help to encourage the passage of similar laws elsewhere in Latin America.

With the achievement of global standards, participants in the supply chain, regardless of where they are located, will know the rules of the game and can make decisions affecting their business processes within a consistent financial framework. When the UN Convention is adopted globally, a secondary market in receivables-backed assets can become a reality, providing increased liquidity and lower costs of funding. Initiatives to reduce the risk and increase the efficiency in the settlement process, such as the TSU and the development of standards around e-invoicing, will be complementary to efforts in receivables financing that improve the reliability and viability of global supply chains.

Now that all of these initiatives are underway, it is the time for the banking community to come together to define our non-traditional future.

Michael F. Quinn's e-mail is michael.f.quinn@jpmchase.com

Needed: modern crossborder payment solutions

by William Cameron

During presentations I recently made regarding the implementation of UCP 600, I was struck by the participants' ease of adoption and understanding of the implemented changes.

Reflecting on this, I believe that this relative ease is in part the result of the good work of the Drafting Group in its attempts to remove problems inherent in UCP 500 and the modest nature of the changes implemented. This brought me back to an earlier question I had asked throughout the UCP revision process: are we focused on relatively minor issues and ignored the massive level of change afoot in the world, to the detriment of our business?

Thomas L. Friedman, in his recent book The World is Flat, addresses the level of change currently taking place in our commercial world and attempts to trace its cause and effect. Friedman argues that the world is "flat" in the sense that the competitive playing fields between industrial and emerging market countries are levelling. He cites many examples in which companies in the emerging economies are becoming part of large, global, complex supply chains through outsourcing of services and manufacturing processes. He describes how these changes were made possible through intersecting technologies, particularly the Internet, fibre-optics and the PC.

His thesis is that there are ten "flatteners". The flatteners include such things as web browsers, search engines, outsourcing, supply chaining and workflow software. He presents the case that up until the year 2000 the ten flatteners were semi-independent from one another. However, around the year 2000, all of the flatteners converged. Each flattener enhanced all of the others; the more one developed, the more the global playing field was levelled.

With the emergence of the ten flatteners, a new platform had to be built in order to do business. Businesses had to begin collaborating horizontally as opposed to vertically. This meant that companies and people had to start collaborating with other departments or companies in order to add value creation or innovation, and the ten flatteners began to reinforce each other. When people began to reorient themselves and their businesses to new technologies, the flattening of the world became more pronounced. As an example, a product was no longer sourced from one entity or place. Supply chains crossed many companies and borders. Friedman believes this convergence is the key element shaping politics and economics in the early twenty-first century. It clearly resulted in a dramatic change in the level of cross-border trade.

Trade growth and L/Cs

We are all aware of the massive growth in cross-border trade since Friedman's convergence date to 2006. The doubling of world merchandise and services trade in that period compares to an approximately 20 per cent growth in crossborder trade between 1995 and 2000. In value terms, this trade was worth around USD 12.5 trillion in 2006 of which USD 10 trillion was merchandise trade. If crossborder trade has doubled since 2000, why hasn't L/C usage gone up significantly with the increased participation of the emerging economies? To me the answer seems to be that the "L/C solution" is built around the old paradigm and doesn't meet the requirements of a flat/supply-chained world.

Trading partners are now much more integrated with one another. The pace and extent of activity, communication and movement of goods has accelerated. L/Cs are slow, dependent on documents, open to discrepancies and inefficient as well as far too expensive. In point of fact, without the Asia banker's requirement for L/Cs to facilitate supplier credit (packing loans), the L/C business would be significantly smaller than it now is. Thus the L/C seems to be largely a banker's solution to a banker's problem. We need a banker's solution for the client's problem if we are to remain relevant.

It seems to me that the characteristics of the emerging trade paradigm are sufficiently different from those in the past to require new means of trade facilitation in almost all respects. My contention is that traditional banking payment and risk mitigation products are no longer adding sufficient value, and furthermore that the banking community is not responding to the emerging needs of the new economy. There are a number of reasons that banks are not meeting these emerging requirements, including (i) a focus on domestic payment mechanisms (which are not suited to cross-border payments, particularly in the area of common standards), (ii) under-used payment infrastructures, (iii) regulatory barriers and requirements and (iv) a lack of a sense of urgency and a complacency with the status quo.

Our customers have been asked in numerous surveys what they need, and their responses tend to be relatively uniform. They want (i) risk reduction from fraud, security lapses and misdirected payments, (ii) liquidity (faster more precise payments), (iii) processing efficiencies that reduce the time and number of steps required to complete a process, (iv) explicit cost reduction (i.e., out-of-pocket expense and investment cost in payment mechanisms) and (v) a trusted governance and infrastructure within which to accomplish all of this, including eliminating the inefficiencies in the current cross-border infrastructure.

For these solutions to evolve from the banking industry and provide tangible benefits, a long-term vision and spirit of horizontal collaboration is required. True collaborative efforts between banks and corporations could give rise to improved cross-border payment systems using newly defined standards. These initiatives will continue to diminish the importance of physical borders and support the continuing rise in global trade.

While many banks have already invested in cross-border payments and trade finance, these efforts have tended to be narrowly focused, and the banking industry does not fully appreciate the extent of the threat to its hegemony in the payments business. In my view, the banking community is still living in a vertical world, while our clients are increasingly living in a flat world.

New solutions

Technology to create a modern crossborder payments solution will be developed either by banks or other trade facilitators. Banks will have to offer such a service, or it will be offered by others with the banks relegated to a lowmargin, bulk-settlements business. In an excellent companion article in this edition of DCInsight, Michael Quinn refers to some of the emerging technologies which will underpin the financial solutions of the future. Over time, the availability and features of emerging payment solutions will, like all other solutions, become commoditized, and the payment process itself will lack competitive differentiation. Competitive advantage for financial institutions will come in the form of all-encompassing electronic financial supply chain solutions. However, new solutions will require common building blocks on which differentiation and competition are based. While this will limit the window of opportunity for the value-added end of these new solutions, it also means that we will be active participants as opposed to being bystanders.

In summary, it is my belief that we have spent a great deal of time focused on correcting issues that are important to select aspects of the payments facilitation of world trade. However, these issues are not material to the major forces at play in the emerging world of trade. The really big changes taking place require solutions that our existing products do not address. It's nice to have all the deck chairs on our ship in perfect alignment, but the icebergs threatening that ship are real and we need to correct our course. Course correction is where we now need to focus attention. I no longer believe that banks can continue to be relevant by merely moving existing products into the context of a flat world. We need to invent products that respond to the emerging world, and those products can't be evolved by one bank alone. Collaboration is the key to success in the flat world. I don't mean that we should collaborate to reduce competition, just the opposite; we should collaborate horizontally to create real competition.

The Banking Commission

Should the ICC Banking Commission have a role here? Do its members have a shared view that there is a problem? I believe the Commission is uniquely positioned to add value in this discussion; however, exactly how it moves forward on such an initiative is an article for another day. The intent of this piece is to provoke thought and discussion. If the interest and response is forthcoming from the members of the Commission, they can work together to address potential solutions. Perhaps they can begin with a panel discussion on the nature of the emerging world of trade and its requirements.

William Cameron is a partner in Owen Consulting in Toronto, Canada. His e-mail is bill_cameron@attglobal.net