Trade — Not So Risky Business

Risk distribution and client technology capabilities can raise the profile of Trade in your company

By Bruce Proctor

Risk management is a constant theme in global business, as corporate and financial institutions around the world struggle with an increasing range of operational, financial, political and regulatory risk factors. Whether firms are present in 50 countries or two, they face a growing challenge in navigating through these cross currents, which can have a major influence on their business success.

2007 will be remembered as a year in which the global economy was buffeted by the negative impact of sub-prime and subordinated debt defaults, with the fallout affecting investors everywhere. While these events have shaved billions of dollars from portfolio valuations and triggered the resignations of several high-profile financial executives, the day-to-day economic activity of world commerce continues largely unaffected. Why is this the case, and what role does Trade finance play in allowing buyers and sellers to transact with relative assurance that their goods will be delivered and paid for?

Over the years, Trade practitioners have developed numerous mechanisms to provide for the financing and settlement of commercial transactions. Tools as traditional as the Letter of Credit, as well as sophisticated hedging and risk distribution capabilities, are designed to address the key risk aspects of cross-border transactions. While many primary regulatory authorities have designated Trade as a "high risk" business in terms of money laundering and potential dealings with sanctioned parties, the actual risk of financial loss to participants (including investors in Trade paper) remains quite low by historical standards.

As a generally short-term, self-liquidating form of debt, Trade risk provides a predictable underpinning to the global capital programs that allocate funds flows among various investment options. While changing market conditions and volatilities will certainly drive the Trade community to explore new and different options for improving risk management techniques in the business, Trade debt should continue to be looked upon as a relatively attractive investment opportunity.

As both financial institutions and non-traditional providers continue to expand the boundaries of what is encompassed by the definition of "Trade," we see a widening range of market instruments being generated from commercial transactions. This is an expected outgrowth of the business wherein risk sharing and risk mitigation have been primary themes underlying Trade activity for hundreds of years. Creative thinking has helped to devise more innovative and marketable forms of risk transference, while an increasing level of sophistication has been evidenced by an ability to structure risk instruments for specific investors (by currency, geography, industry, tenor, etc.). As a result of these developments, market acceptance and absorption capacity have greatly increased, and Trade risk can now be spread across an ever-expanding universe of participants.

The ongoing growth of global commerce generates trillions of dollars of activity on an annual basis — the large majority of which can be bundled into some form of tradeable obligation. Investors can design model portfolios and source the necessary assets (or liabilities) from a number of sources around the world. Risk can be bought, sold and traded through privately-arranged transactions or consolidated into collateral packages that support publicly traded instruments. Whether originated from traditional Trade instruments, open account transactions, structured Trade facilities or other sources, a distinct advantage of the Trade market is its massive liquidity. Cross-border flows continue to grow strongly (as do "in-market" transactions), thereby generating an almost never-ending flow of new commercial activity which will support additional risk distribution opportunities for investors.

As with any asset class, there are obvious differences in perceived quality among specific Trade instruments, depending upon the counterparties involved, the nature of the underlying transactions and other risk factors. And, of course, not all Trade activities involve the exchange of physical goods, since the financing of professional services contracts (for example) falls under the Trade umbrella as well. In general, however, Trade-based transactions are viewed as a more stable form of risk and are documented, priced and (where applicable) rated more favorably than other forms of non-government financial investments. Empirical evidence is still difficult to obtain across all markets and risk parameters, but the recent history of debt reschedulings and moratoria strongly suggest that critical-need merchandise trade facilities will be accorded preferential treatment in terms of repayment and renewal.

It would appear, therefore, that Trade offers an increasingly attractive profile relative to other forms of risk as world markets continue to experience turmoil and uncertainty. In order to support this differentiation in the eyes of investors, major industry participants should focus their efforts on ensuring the efficient distribution of risk and the provision of client technology capabilities, which can assist with the monitoring and reporting of changes in market conditions.

Opportunities to expand the universe of potential buyers of Trade risk should be actively pursued, as this type of paper should be of interest to asset managers in insurance companies, investment funds, pension schemes and other non-traditional placement sources. Of equal importance is the current and future risk profiling of Trade activity, and the leading players in this business will need to be actively engaged with regulatory bodies, credit rating agencies, market analysts and others to explain Trade's advantages and applications.

2008 and subsequent years should be an exciting time to be involved in the Trade business as it expands into new market spaces and continues to reinvent itself. A clear appreciation of the risks and benefits available in the market should yield some tremendous opportunities for those who view Trade as a critical component of global transactional and investment activity.

About the Author: Bruce Proctor is managing director, JPMorgan Global Trade Services.