The stock market offers endless opportunities and hopes for many investment strategies; short term, speculative or long-term value investing, to name just a few.
Stocks and bonds have an established place in an investment portfolio. Some add precious metals. The most popular are gold and silver, either in physical bars in the vault or as an exchange-traded fund certificate. Trade-finance investments have their place too.
The financial markets have grown to such a substantial size that they have almost taken on the shape of a living, breathing entity, which some might describe as a ‘monster’. Despite the attempts of governments and the financial sector to control it, the market rises and falls of its own accord. The saying remains true, that you can get the market right, but you cannot go against the market. Playing the market can sometimes feel like a gamble, due to its cyclical and sometimes temperamental nature.
Before the 2020 pandemic, the 2008 global financial crisis (GFC) was cited as the most severe economic crisis since the Great Depression, which began in 1929. The early 2000s were again times of loose financial regulations, encouraging some of the wealthiest banks to take what appeared to the outside world to be unwarranted lending risks. This combination burst the housing bubble, tanked mortgages and forced respectable, global investment houses like Lehman Brothers, the fourth-largest US investment bank, founded in 1847, into liquidation.
To prevent a collapse of the worldwide financial system in the face of the housing-market crash of 2008, governments around the world bailed out national financial institutions considered essential for the survival of their financial systems. Those were mainly banks and insurance companies with millions of customers and billions in deposits.
Global trade regulators also responded to the worldwide banking crisis. Prior to 2008, banks lent based on a host of criteria, varying from bank to bank and lender to lender. Then the global regulators decided that all banks needed to abide by the same lending restrictions within the framework of each institution and their product. With Basel II and Basel III regulations put into place, banks began focusing on lending only to SMEs with high credit scores and satisfyingly large capital-reserve requirements.
The financial institutions shifted their focus to larger corporate clients, abandoning lending to their SME customers. The move was to ‘protect’ banks from riskier lending options. This approach has slowed trade rebound and increased the gap between SMEs that needed trade financing and the availability of it. The current $1.6 trillion worldwide trade-funding shortfall is felt the most by SMEs. World trade is in ever-growing need of capital.
The world’s economies needed to prevent another global market crash, and more regulations were the regulators’ way of trying to prevent it. The global financial regulators thought that they were doing the nations a service. The new laws and regulations imparted to banks appeased the public in the face of government bailouts, an act on which citizens worldwide were staunchly divided. With restrictions on trade finance, emerging enterprises struggled to recover from the collapse, due to lack of capital.
The market would again go through turbulent times. In the face of a global lockdown, the world was on the verge of another economic collapse. The 2020 pandemic mercilessly uncovered and reinforced any simmering economic issues of banks and lending institutions. Some banks have greatly restricted their lending to SMEs, while others hardly lend to them at all or only against unrealistic debt coverage.
The unwillingness of big banks to lend affected the SME sector, accounting for over 90 percent of most economies worldwide. With banks still refusing to lend, industries and economies continued to suffer. While trade must rely on the big banks, bank-related regulatory systems will continue to cause economic hardship for SME trade partners around the globe. The nascent world of blockchain-run decentralised finance (DeFi), might bear hope and funding alternatives.
Education about trade and the financial markets in universities appears much less applicable to the trade conditions in today’s world. In response to the most recent economic downturn, many trade-industry participants, experts, traders and manufacturers hoped to see a reduction in trade regulations and a renewed commitment to their interests.
Trade industry leaders have always advocated for a decrease in global trade regulations, even more so now as economies which were barely surviving before the pandemic needed support beyond the traditional lending options.
The governments’ principal claim against deregulation is that investing in trade finance is old-fashioned and risky when data visibly points to the opposite. This may have been true back in the early 1900s when trade financing started gaining popularity among local, wealthy investors. Statistics over decades confirm that financing trade is a low-risk and low-volatility investment.
Sensibly lowering regulatory overkill would provide the SMEs who need trade capital the most with funding and keep the global supply chain functioning. SMEs are a nation’s instrument of economic growth and social development.
In most OECD countries, SMEs contribute more than 50 percent of GDP. Some global estimates put this figure as high as 70 percent. Thus, funding trade in times of economic uncertainty helps stabilise the global market and encourage worldwide economic growth.
Indeed, trade financing ties into the overall economy, though the trades themselves are not tied to the stock market. Trade-finance investments do not shift with global market fluctuations; trade revolves around the need for specific goods and services imported or exported, making trade financing recession-proof and uncorrelated with the world’s stock markets.
Even in times of downwardly spiralling global economies, trade- finance investments remained safe in times of economic distress. This phenomenon was proven over centuries by the thriving league of British merchant banks.
The British Merchant Banks
The ‘Central European Panic’ was the name given to the declining state of European banking in the spring of 1931. The summer that followed was marked by significant difficulties for banks throughout Central Europe. First, banks in Austria declared insolvency, promptly followed by those in Hungary and Germany. Central to the crisis were the London merchant banks.
Before the panic began, a credit boom spread throughout Central Europe. Banks with dwindling amounts of capital were guaranteeing the bills of sale of foreign merchants – funding European merchants did not require any extra financial resources and allowed the banks to earn considerable returns on their investments.
Capital issues began arising across the globe a few months into 1931 when the Great Depression swept through Central Europe. As currencies depreciated, local governments introduced more capital controls on banking institutions. The action was meant to reduce fallouts associated with the banking panic; in truth, it only pushed local economies deeper into depression. These controls were known as the standstill agreements.
The balance sheets of several British merchant banks suggest that the banks’ exposure to Central Europe debt accounted for a mere six percent of their direct portfolio holdings. However, the banks were additionally exposed through the bankers’ acceptance (BA), an offer almost exclusive to merchant banks.
This financial instrument was a specific type of bill of exchange used by international merchants to finance their trade activities. The principle was simple; a bank in London guaranteed a company’s debt by accepting a commission in exchange.
For example, if a Colombian exporter sold goods to a German importer, they would normally be paid between 30-90 days later. Most exporters were paid upon receipt of the goods by the buyer. If the exporter wanted to be paid prior to the goods’ arrival, the seller could opt to draw a bill of exchange on the importer (the debtor), ordering the buyer to pay the bill holder the amount of the transaction at an agreed-upon date in the future. The merchant would then try to discount the bill on the London market.
In May of 1931, the largest Austrian bank, Creditanstalt, declared insolvency, triggering a regional banking collapse in the two months that followed. With newly implemented bans, all payments abroad were frozen, and Central European banks were forced to create arrangements with their foreign creditors to settle the payments of their debts.
Lenders in London would not have paid a discounted bill from a foreign merchant without a guarantee of some kind that they would receive payment from the importer. The BA solved this problem as it allowed the exporter to draw the bill on the accepting London bank with whom the importer/debtor had an arrangement rather than directly on the importer/debtor.
To be accepted by a merchant bank, an exporter was required to prove that they had shipped the goods to the importer and that the importer would pay the balance soon. Upon successful examination of the evidence, the bank accepted the bill. They stamped the bill with their emblem for a fee.
With the signature of a reputable London house on it, the bill was turned into a saleable security which could easily be discounted on the London market by the seller at the prevailing interest rate. By doing this, the bank committed to pay the bill at maturity regardless of whether payment had been remitted by the importer/debtor. Acceptance was an attractive line of business for British merchant banks and in the nineteenth century the merchant bankers had a near-monopoly on the acceptance business.
During the Great Depression brought on by the First World War, merchant banks faced the difficulty of the standstill agreements. The limitations imposed by the Federal Reserve meant that the struggling countries of Austria, Hungary and Germany could not convert their local currencies into sterling to pay the debts owed to British banks. Even a flourishing bank could not transfer funds to the UK unless they had claims in foreign currency.
The standstill and liquidity freezes resulted in months of missed payments that greatly contributed to the downfall of the British merchant banks. Even though bills could not be paid due to the standstill, federal legislation did not include any relief provisions for banks who were still legally responsible for paying for goods at their agreed maturity date.
With all their assets tied up, British merchant banks had no choice but to liquidate their assets to meet their committed financial obligations. To recover from these losses, they were advised by the Bank of England to continue restricting credit. Thus, the banks hit hardest by losses were not the least capitalised but the most exposed to Central European acceptances.
The Bank of England considered merchant banks to be crucial in preserving the position of the London market. As a result, it bailed out 20 of the 22 merchant banks struggling as a by-product of the standstill agreement. As a result, most were able to stay in business.
The Bank of England knew that acceptances were never going to go away entirely and decided to reopen the London market. Instead of requiring only minimal information from exporters looking to sell their discounted bills, the Bank began to integrate a careful peer-review business analysis before providing international and domestic acceptances to unverified merchants. This allowed for a massive step forward in bank recovery and resulted in a new industry standard.
The Kuwait Market Crash
The Souk Al-Manakh, better known as the Kuwait stock-market crash of 1982, is a prime example of trade financing remaining solid in the face of a local economic downturn.
At its peak, its market capitalisation was the third highest in the world, behind the United States and Japan, but shares were purchased using post-dated cheques. This created a completely unregulated expansion of credit in Kuwait that inevitably came to a grinding halt when post-dated cheques were not honoured, creating an unprecedented chain reaction of cheques bouncing like balloons. These bounced cheques, from 6,000 different investors reached nearly US$94 billion (the equivalent of US$260.5 billion in 2021).
A recession began on a national scale that disrupted investments and impacted stocks across the country. All the banks in Kuwait collapsed except for one, held up by trade financing and the central bank. The crash set off a recession that rippled through the global markets. The National Bank of Kuwait worked with importers and exporters to finance trade throughout the region, which had yet to be repaid.
With a small bailout from the government, the bank was able to keep its doors open with each delayed payment that it received, immediately reinvesting it back into financing more trade.
We see this same trend in any market we investigate; even during crashing stock markets and global economic depression, trade financing has always remained a source of investing and profitability. One of the reasons it has remained such a constant is because trade itself is a constant. Most industries are working across the global markets, which means the international transport of goods and services. Trade financing has withstood the test of time, war and economic depression.
Before the GFC, trade financing used to rely mainly on bank financing. During the post-financial-crisis era, due to strict regulations, banks started to back off from providing this support, especially to SMEs, which opened the door for alternative financing opportunities to fill the trade-finance gap.
The first record of an entity other than a bank facilitating a trade-finance arrangement points to the sōgō shōshas in Japan. These general-trading firms exemplify the longevity and sturdiness of trade finance. They not only withstood multiple market crashes and global regulation setbacks, but they have been able to grow into a global powerhouse today.
The Sōgō Shōshas of Japan
Sōgō shōsha is the name of a group of several trading companies that the Japanese organised to meet their internal needs for business capital in 1955. A group of wealthy Japanese businessmen created a small, single entity that served to finance emerging businesses, to propel them into the global market.
What started as a single entity quickly decentralised after the Second World War, when the sōgō shōshas switched their lending model to acquire 10 different companies quickly.
The sōgō shōsha framework was formalised in 1960, at the start of the Japanese post-war economic boom. With trade moving from strictly regulated to the free market, Japan focused on low- technology and non-differentiated exports to increase trade volume. It also diversified the products it marketed internationally, from vending-machine snacks to the automobile industry.
Japan was a developing economy growing fast after opening its ports to foreign vessels and encouraging new industry. As Japanese trading evolved in the 1970s and ’80s, traders refined their processes. They managed business during a time of war, enhanced their risk- management systems, strengthened their corporate governance and started taking inventory of their unprofitable assets. As time went on, private trade was gradually permitted and accelerated the free trade market as the sōgō shōshas were being formed.
The sōgō shōshas were the organisers for various industries providing products and market development. They acted as Japan’s wholesalers/suppliers and optimised the supply chains of the Japanese industry, helping to provide capital for the raw material, energy and technology needs of Japanese SMEs while aiding businesses to coordinate the manufacturing and retail sectors.
Simultaneously, they marketed the products of Japanese companies overseas. Using this operational system, the economy and businesses skyrocketed.
The sōgō shōshas act as the corporate middlemen or as a special niche of trade financers. They do not own the resources or have the means to mass-produce products, yet they have maintained their Fortune 500 status since 1996. In this model, there are two ways the firm could increase its earnings. One was to handle goods they traded on a larger scale, meaning millions of tons of coal, grain, paper or pulp or hundreds of thousands of computers.
The other way to increase profits was to apply their trading expertise to other items, including higher-value items such as motor vehicles, aeroplanes and medical equipment. This is what is called a scope, increasing the kinds of goods they trade. A single sōgō shōsha handles around 30,000 different products on average − everything from noodles to aeroplanes or from chopsticks to satellites as the saying goes. The handling of such a wide variety of items in such huge volumes is a unique characteristic of the sōgō shōsha and has allowed them to flourish despite economic challenges.
When the 2008 GFC hit, the sōgō shōshas seemed unfazed. Shoei Utsuda, the president of Mitsui, believed the sōgō shōshas were safe in the economic downturn. In The Economist of December 2008, he said: “We have diversity in our industries and our geographies, so we are protected.” And he was undeniably correct. The sōgō shōshas were able to navigate their way out of the turmoil of the surrounding financial landscape by increasing their trade investments and continuing to market their products internationally.
In 2021, there were seven sōgō shōshas in Japan, including Mitsubishi, a name known worldwide. The average sales volume of one of the big five sōgō shōshas is about $123 billion, net profits exceed $3 billion and assets average around $80 billion per company.
Mitsubishi, known most widely as a car manufacturer, also owns the processed and distributed food that it sells in convenience stores in which it holds a stake. An essential partner-selection process negates overseas investment risks. By using commercial rights in existing business areas, Mitsubishi extended its earnings models at every stage of the value chain.
To quote the Jefferies Japan senior vice president Thanh Ha Pham, speaking to the Financial Times: “The trading houses were written down as dinosaurs, but they are still around and making money here. They tend to evolve as businesses, and they do it well”. The prolonged success of the sōgō shōshas caught the attention of Berkshire Hathaway’s Warren Buffett in 2019, and his revelation of this historic tool served to increase public awareness of the lending and investing options that exist and remain underused. What does this investment in sōgō shōsha mean for the future of trade investing?
Berkshire Hathaway
Warren Buffett and Charlie Munger’s investment miracle began in the mid-1900s. After noticing a pattern in Berkshire Hathaway’s stock price, Buffett watched the market and waited for the right time to purchase stock in a company. Whenever the company was forced to temporarily shut down a production mill, the stock price would initially drop. Once productivity resumed, the shares would soar again.
The next time a Berkshire Hathaway mill closed, Buffett requested to buy shares in the company. Seabury Stanton, running Berkshire Hathaway at the time, approached him to buy back his shares. but the agreement Stanton sent to Buffett undercut the deal so deeply that Buffett was furious. Instead of selling his stock to Stanton, he bought more, just to be petty. Nearly overnight, Buffett became the company’s majority owner and fired Stanton. When Buffett made the purchase, Berkshire Hathaway was a failing textile business. By sheer determination and resourcefulness, the Buffett/Munger duo transformed it into a globally recognised, multibillion-dollar conglomerate.
Warren Buffett’s preferred advice to investors is to watch everyone else in the marketplace and do the opposite. Wall Street calls this the contrarian approach. He didn’t build a $652 billion company by following standard or even practical investment advice. Instead, Buffett looked for something different, something new or something previously undiscovered. When the Covid-19 pandemic hit, Buffett’s Berkshire Hathaway was looking for new opportunities, not mulling over the past.
In August 2020, Berkshire Hathaway placed a $6 billion investment in Japan’s five biggest sōgō shōsha trading houses. This investment was preceded by a dwindling number of foreign investments into SMEs, but Buffett’s decision to invest in the sōgō shōshas marked a changing of the tide.
Buffett always looks past the present moment and peers into the future. Although the Japanese trading houses faced pandemic- related challenges like any other lending institution, Berkshire Hathaway’s hundreds of subsidiaries and affiliates across all essential industries lowered the long-term risk:
“The five major trading companies have many joint ventures throughout the world and are likely to have more of these partnerships. I hope that there may be opportunities for mutual benefit,” Buffett said in a press interview to celebrate his 90th birthday in August 2020. Investors looking to diversify their portfolio with a low-risk asset in trade financing would do well to follow his advice.
The ability of the sōgō shōsha shows how long-standing these investments can be and for how long they can continue to pay dividends. The relationship between SMEs and financiers is mutually beneficial. It helps both parties grow in a positive direction no matter what the financial market is doing, since trade financing today remains uncorrelated from the volatile stock market.
Generation Fintech
When trade finance began, exporters could not be sure when they would be paid for their goods by importers, and importers struggled to work out how to securely pay their exporters. Paying for the goods before their shipments arrived was risky; what if the goods never came?
Paying for the goods after delivery meant that exporters might not receive their payments for sometimes months at a time if at all, although letters of credit were partial answers to this problem. Modern technology reduced risk, but it remained a time-consuming process. The implementation of fintech will change trade finance as we know it.
No trade or investment is entirely risk-free. Current technology improves the efficiency and safety of trades and for all parties. In the last century, trade finance traditionally relied on paper trails, telexes, emails and fax machines which, after effectively pushing the telex out of use are now more or less obsolete themselves. After decades of unrevised, lengthy trade-financing processes, the trade-finance industry was ripe for an innovative leap, to handle trade in a more modern way. Fintech was born out of three quantum leaps which took place around the same time: technological advancements, the computing power of data analysis and financial overregulation. It can be summarised as a combination of AI, blockchain and machine learning, which make trade financing more straightforward and reliable.
The integration of fintech into trade finance was meant to provide a flexible and transparent resource to overcome the complexities of the past. Fintech is the financial terminology for describing innovative, technology-based financial products. Applications for consumer and SME-focused e-payment money-transfer systems, peer-to- peer (P2P) lending platforms and alternative currency-exchange providers are all variations of fintech. With the invention of the blockchain and its cryptocurrencies travelling on it, global financial transactions could now be condensed into a single, decentralised platform, making trade financing easier even for SMEs to access.
By 2022, AI will be found in most industries worldwide. Its application extends from industrial robots to self-driving cars and automated soda machines, as well as aeroplanes and rockets. In our context, it refers to machine learning. Fintech has unique AI qualities. These are just a few examples of the most important uses of AI and machine-learning algorithms in finance: improved financial decision making; security and fraud detection; asset management; customer support; insurance; loans; forecasts; and personalisation.
As the platforms learn how to use financial-technology software, every transaction becomes increasingly quick and efficient. AI-powered scanners constantly learn what properties to look for, at the same time weeding out possibly fraudulent ones.
AI provides statistical predictions on buyer activities, customer trends and seller needs. This helps companies achieve their growth objectives and make them more relevant to their clients all while reducing operational costs and increasing internal efficiency.
The best-known cryptocurrency has become a household name: bitcoin. Crypto is yet another fundamental driver of fintech. Platforms like PayPal, Square or Stripe are all considered fintech and are essentially the computer software that hosts the virtual delivery of web-based money for services. The value of the global fintech market is already valued at a few hundred billion pounds.
Crypto wallets are themselves encrypted and not associated with names or bank accounts. But many fraud cases have shown that encryption alone is no guarantee against hacking and theft. Wallets should therefore be handled with the same care as cash in your pocket.
Blockchains are the business-delivery device of fintech. With the addition of blockchains to AI and crypto, fintech took off in the trade- finance industry. Transactions between lenders, buyers and sellers were streamlined, transaction costs were reduced, transaction timeframes were quicker, and it introduced greater transparency and security for contracting parties through so-called smart contracts.
Blockchains store information on a redundant basis. Information can be transferred but never altered, deleted or retracted. In trade financing, it is common to exchange high quantities of documents and contracts per transaction. With fintech, instead of scanning and emailing 200 individual records, it is possible to transfer everything without multiple signatures and wait time.
The digitisation of trade finance had been slow but not due to a lack of demand. Cross-border trade involves much complex information, resulting in an overflow of documents, product details, transaction reports and point-of-sale paperwork.
Initially, the trade-finance industry worried that due to the complex nature of the workflow, the use of fintech was uneconomical for most trade deals. The first company to delve into the world of fintech for trade financing was Ornua, an Irish dairy company, in the form of a letter of credit (LC) transaction, using a digital fintech platform called Wave.
Wave was one of 11 fintech start-ups propelling trade financing into the twenty-first century with paperless dealings. Ornua was able to use the platform with ease on bulk milk deliveries. For Ornua to qualify for trade financing, it used Wave to have its LC approved by the bank and seamlessly received the money. Once the due date (the tenor) of the agreement was reached, Ornua repaid the investment received on the Wave platform and received the next round of funding for the following dairy shipment.
Ornua and Wave concluded that the differences between analogue documentation processing and fintech were remarkable. Before fintech, it took Ornua 10 business days to receive an LC from the bank compared with just one day with Wave. Once the LC was approved, Wave automatically flagged the account for investors, triggering a payment directly to Ornua’s business account.
Less than four hours later, $100,000 worth of cheese and butter was being transported from Ornua to an Irish-based food company. Along the way, Ornua investors could see the phases that the shipment was going through, including real-time approvals by the exporters and importers. They were also electronically notified when the shipment arrived.
The transparency that Wave provided to the investors was one of many unprecedented advantages of fintech. The benefits of using the technology in the trade-finance sector speak for themselves. It is not the only place blockchain systems have been shown to streamline trade deals effectively.
Fintech was also used to facilitate a trade-financing transaction between Australia and Japan in 2017 with the Marubeni Corporation. The agreement went through all the typical risk analysis and regulator checks using the new technology with great ease, exclusively using IBM’s Hyperledger Fabric platform, with blockchain distributed ledger technology (DLT).
The new technology provided by IBM was built explicitly with DLT in mind. The infrastructure and protocols could be simultaneously accessed, validated and recorded across a network spread across multiple entities and locations. It effectively decentralised the process to allow for numerous moving parts occurring in tandem across the globe.
Both parties using the technology noticed faster document creation, transmission and delivery which cut both costs and time. Again, transparency for both parties was increased, since the technology constantly gives a status update regarding shipments, deliveries and payment.
Meanwhile, Maersk, the Danish container-shipping giant, tested its blockchain solution to digitise its cargo inventories in Scandinavia. IBM ran a proof of concept (a test-run of the software) to ensure that this fintech application could handle demand. In September of 2016, Maersk, together with IBM, began tracking a container of flowers shipped from Kenya to the Netherlands.
The pilot programme ran on a blockchain network that the Marubeni Corporation had used. The technology was designed to support multiple parties across the global transportation system. It was hosted on the IBM ‘cloud’ and was an immediate success for both Maersk and IBM.
The introduction to this technology significantly reduced the delivery time for trade documents, cargo and related work tasks. Documents that had once taken several days or weeks to share and approve now only took a few hours, a breath-taking reduction in time to create and transmit documents and reduced costs through document digitisation. Importers, exporters and financiers saw transaction details in real time and could instantly share them with all parties involved.
Fintech in this application reduced errors in shipping manifestos and minimised, if not eliminated, the possibility of fraud. The blockchain system reduced product transit time and the shipping process; improved inventory management; reduced waste and the associated costs; and mitigated investor risk. The fintech system appeared to be working at multiple levels and for various industries, leaving the door open for other enterprises to follow suit.
These preliminary tests have proven largely beneficial and point towards a bright opportunity for fintech and blockchain in the trade-finance industry. The goals of this invention make trade more accessible for more investors. With the new forms of transparency and accountability from blockchain contracts, trade financing will attract a new generation of investors.
Trade financing has always been a reliable and profitable practice when managed with care. With heightened risk-management protocols in place and the adaptation of fintech for trade-financing enterprises, even a non-bankable trade has a chance. Trade financing has been slowly crawling its way into the financial spotlight.
