$9 trillion market not many institutions know about

Pending Basel III regulations could move trade finance and its $9 trillion market into the sights of institutional investors.

Money managers and banking executives say trade finance fits right into the non-traditional credit arena in which investors are seeking yield.

But it's a tough sell, particularly in the U.S., where banks have not been big players in trade finance and many investors don't know what it is.

“Nobody knows anything about it,” said Robert Kowit, New York-based senior vice president at Federated Investors Inc., which runs a $500 million trade financing strategy. “The educational effort required is enormous.”

Basel III regulations would raise the amount of capital banks would have to have on their balance sheets to cover their loans, such as for trade finance, making it more costly for those seeking loans and making banks more likely to limit how much could be offered.

Trade finance can be provided through lending, letters of credit or insurance. It has been “providing absolute return since 1796 B.C.,” said Mr. Kowit, when lenders provided the bread-making monopoly in Babylonia with financing.

Researchers at Greenwich Associates think there is a market for institutional investors. In a report last month, the research firm said Basel III will “accelerate the development of alternative sources of credit — including trade finance funded by non-bank investors.” The report sees one potential source as institutional funds or structured products. “In the current era of historically low interest rates, investors hungry for sources of attractive returns could be enticed by the incremental yield, low volatility, low duration and diversification benefits of trade finance,” said Markus Ohlig, a Greenwich Associates consultant in Stamford, Conn.

It's a good time for investors to look at trade finance “because of Basel III and how that has caused (investors) to look at how it fits into their overall asset allocation,” said Adam Dener, managing director and head of trade finance at Conning, Hartford, Conn. Conning has $91 billion in assets under management, mostly for insurance companies. “Banks are no longer a sufficient capital resource, and the same holds true with trade finance.”

The market for trade finance hovers around $9 trillion, Mr. Dener said. “It's the largest form of credit worldwide.

“Low interest rates are forcing investors to look at new things in search for yield,” Mr. Dener said. “Non-traditional credit like trade receivables has sparked broad interest among institutional investors. Sophisticated participants are looking into non-traditional investments like this.” He would not name those investors.

The $320.9 million Claude Worthington Benedum Foundation, Pittsburgh, has been investing in trade finance for the past three years as a portion of its 10% fixed-income allocation, said Dwight Keating, vice president and chief investment officer. The allocation to trade finance stands at $4 million and is managed by Federated.

Mr. Keating has direct knowledge of trade financing, having used it to pay for coal exports to Japan in his previous position as president of Grafton Coal Co. Inc., a Bridgeport, W.Va., mining firm that has since closed. “(Federated) mentioned it to me, and because I was familiar with it from a practical standpoint, it made sense to me,” Mr. Keating said.

The investment was for made for return reasons rather than as a hedge, Mr. Keating said. He couldn't provide specific returns, but said performance has been better than bank loans over the course of the three years. “It pays more with less risk,” he said.

James Prusky, partner and head of business development at Crecera Finance Management Co., called trade finance “a pure alpha generator” because unlike securities, collateral is controlled better and direct investment in trade is not subject to market swings on a microeconomic level.

Crecera, a San Francisco-based money manager established to support small and midsize commodity exporters in Latin America, has about $400 million in assets managed in trade finance strategies.

But since worldwide banking regulators through the Basel rule restrictions will limit how much banks can lend for trade finance, that investing opportunity now shifts to investors, Mr. Dener said.

That shift has piqued the interest of investment consultant Aksia.

“We're in an exploratory phase,” said Patrick Adelsbach, partner at Aksia, New York. “What grabs us is that it's very much on the short end, 30 to 120 days, generally. It's uncorrelated, primarily contract risk, not market risk. … It's more execution than market risk. Therein lies the rub. Whoever executes this, investors must be comfortable with their operational capabilities.”

Trade finance investing ranges from short term to long term, and direct to securitized investments. Short term involves 60- to 90-day paper sponsored by large corporations; long-term examples are 10- to 12-year paper that finances large-scale trade among firms like Airbus SAS, Boeing Co. and General Electric Co., said John Ahearn, global head of trade at Citigroup Global Transaction Services, New York.

Short term, “as an asset class, it's a differentiated form of credit, a short-duration form of credit,” Mr. Dener said. “It's generally no longer than one-year duration … it's similar to commercial paper.”

Long-term lending brings in a country's export/import bank, either as direct lender to a borrower or by serving as a third-party guarantor, said Bruce Proctor, head of trade and supply chain finance at Bank of America Merrill Lynch, New York.

Money managers could possibly access these securities in a secondary market, Mr. Proctor said, and over time the idea would be to have more market-tradable products.

Still, a lot of work remains to be done before that will happen.

Mr. Prusky added that money managers “are just now getting into this. Money management units of big banks are working on ways to securitize trade financing to sell to institutional investors.”

Limits on bank credit offerings “have trade industry groups talking with regulators about trade as an asset class and how great it is, and institutional investors who are chasing yield are attracted to this,” Mr. Ahearn said. “A lot of institutional investors have expressed interest in this,” although he would not identify those investors.

Mr. Proctor envisions pension funds and sovereign wealth funds joining in post-deal syndicates for long-term investment — with banks selling loans off their balance sheets to pension funds and wealth funds, among others.

“The opportunity for institutional investors could well be there with U.S. pension funds,” Mr. Proctor said. “Larger banks will look at how they can work with non-traditional investors to change the scope of what we're selling” by putting trade finance into more common investor terms.

“We need to do more to package this to make it look more like a fixed-income instrument. It makes it more understandable,” Mr. Proctor said. We have to make it an interesting offering. We need to present it in a way that investors can understand. The trade financing product we provide has been traditionally focused on the origination side of the business. Now we're looking at investment opportunities to balance with the origination side.”

Despite the size of the market for investors and its long history, most institutional interest in trade finance has come from non-U.S. investors, particularly in Europe and Asia, Mr. Prusky said. “Very few institutional investors have gone into trade finance because it's been done mostly by non-U.S. banks.”