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One of the most lasting effects of the COVID pandemic has been the disruption of the global supply chain. Micro, small and medium-sized enterprises (MSMEs) constitute the majority of businesses and employers in the world and contribute significantly to the global gross domestic product. They frequently face more difficulties than other businesses because they have less access to global trade finance systems.
The International Chamber of Commerce (ICC) viewed the pandemic as an opportunity for positive disruption for all players in global financial markets. As a result, in August 2020, he established a Trade Finance Advisory Group (ATF) and tasked it with addressing trade finance challenges that hamper the full participation of MSMEs.
ATF, as part of a joint effort with McKinsey and Fung Business Intelligence, recently released a proposal to restructure global trade finance to better promote financial inclusion and sustainable finance. The report proposes a ten-year, three-phase process to modernize and standardize global trade finance systems through the introduction of an “interoperability layerâ€.
In this article, we will summarize the main recommendations of the report, provide an overview of the structure of the proposed interoperability layer, and discuss the expected effects on MSMEs globally.
The current global trade finance market
In 2020, the financial market hedged transactions totaling $ 5.2 trillion, or about 6% of the world’s gross domestic product. For financial institutions, this translated to 2% of their total revenues, or about $ 40 billion. However, despite the size of the market, a funding availability gap of $ 1.7 trillion still exists, largely affecting MSMEs.
Fintech companies are relatively new participants in the market. However, they are actively working on new product development at every step of the supply chain, and the ICC report seeks to leverage the capabilities of fintechs.
The vast majority (85%) of global trade finance deals with documentation issues associated with cross-border transactions, such as letters of credit, international guarantees and international bills of lading, among other services. Documentation products and services also address regulatory and compliance issues, such as anti-money laundering rules. The remainder is split between buyer-led financing (10%) and supplier-side financing (5%).
What trade finance challenges does the proposal address?
Despite the large and robust market for trade finance, much remains to be done, especially with regard to MSMEs. According to the World Bank, in 2017, around 65 million MSMEs were limited in credit. There are several reasons why MSMEs are not full participants in the global trade finance arena, which the ICC seeks to rectify with its current proposal. Some of the most important issues that MSMEs face are:
Lack of access to liquidity
Traditionally, MSMEs have had more difficulty accessing trade credit than larger firms because they have less collateral available or are unable to meet strict credit requirements established. Credit requirements have not evolved to reflect changes in the global economy and there is a shortage of alternative financing options for international transactions. For this reason, MSMEs often find themselves without credit available for purchases or sales.
Complexity of transactions
The disparate requirements for international transactions and financing around the world place additional challenges on small businesses with more limited resources. Just keeping track of different requirements for each jurisdiction can be an overwhelming task. And when it comes to meeting the documentation requirements for each transaction, the burden only increases.
Limited access to B2B markets
B2B marketplaces create huge efficiencies in the marketplace by bringing together suppliers and buyers quickly and easily. However, MSMEs often lack the knowledge base or resources to access these markets. And for MSME providers, funding, capital and cash flow issues can prevent them from establishing themselves as effective participants in B2B markets.
How does the ICC view global finance?
The ICC proposes a ten-year, three-phase plan for the development of globally accepted standards that serve as a framework for common systems, all brought together in an interoperability layer. The interoperability layer will not be hardware or software, but rather a virtual construct that defines the core standards and best practices supporting the digitalization of trade finance. After all, digitization is increasingly important for MSMEs. According to recent studies, 43% of small businesses now rely entirely on online banking.
Ultimately, the ICC is considering new standardized and shared architectures that are equally accessible to all market players. The interoperability layer would replace the patchwork of standards and protocols that currently exist and fill regulatory gaps by developing a unified and cohesive set of standards and practices. The proposed interoperability layer accomplishes three main missions.
First, it encourages widespread adoption of existing trade finance standards to bring market participants together in a common network. Second, it creates new standards and processes to fill existing gaps, including standards for sustainable finance.
There are two main areas in which the ICC identifies specific needs for additional standards, both focused on relaxation and growing digital transformation of trade finance: uniform data models and API standards. API standards are an immediate need as many banks currently suggest that the absence of such standards is hampering their ability to develop strategies for using APIs in their operations.
Finally, he creates operational playbooks for market players who embody all of the standards. Consolidation of standards and protocols in the interoperability layer will be done with full awareness of the challenges that prevent or hinder the participation of entities with fewer resources or less credit history. With simplified access to the trade finance system, more players at all levels will be able to join.
On the governance front, ICC envisions an industry organization or consortium overseeing the development, implementation, and ongoing management of the interoperability layer. The governing body should include participants from all functions, regions and company sizes.
How does the interoperability layer benefit MSMEs?
The interoperability layer has advantages for all market players, but the impact for MSMEs is particularly noticeable. With new standards and transaction risk assessment processes, MSMEs will gain better access to alternatives for credit and liquidity.
Recent research suggests that traditional bank credit scoring models underperform new technological models for determining creditworthiness. By applying real-time data and highly advanced analytical tools like AI, the new models provide a faster and more accurate assessment of a company’s payment capabilities. In turn, a better credit rating translates into a more efficient allocation of resources, especially for small businesses like MSMEs.
In addition, new document standards and the digitization of documentation requirements will reduce costs for all market players. Since these costs have a disproportionate impact on MSMEs, they will reap the greatest benefits. But as financial processes become more streamlined and more participants enter the market, large financial institutions will see corresponding increases in revenue which, coupled with lower expenses, will lead to increased profits.
Will the interoperability layer promote sustainable finance?
The ICC report recognizes that sustainability is an increasingly important issue for businesses and governments. However, there is currently a lack of standards for sustainable finance, including the absence of a commonly accepted vocabulary. One of the main tasks envisioned by the ICC is the creation of a standard taxonomy for sustainable finance that all market participants can apply in future transactions. Once the market has a common language, it can better develop standards to apply the principles of sustainability in the global trade finance industry.
Time will tell if the ICC proposal gains momentum. Further digitization is inevitable with or without the report. But building a common framework for digitization that enables companies of all sizes to participate effectively in international trade is a valuable goal.
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