The 2020 Trade Fraud Scandals – Have We Learnt The Right Lessons?

The year 2020 changed the world for most of us, but more so for the commodity financing sector.

Rocked by a raft of trade fraud scandals from the start of the year, the industry saw billions of dollars evaporated as a series of traders collapsed, unveiling a hidden world of fictitious trades and multiple financing.

The magnitude of the losses prompted some banks to downsize or withdraw from the commodity financing sector. In response, Singapore, a global commodity trading hub, announced the piloting of a trade finance registry and at the end of last year, a Code of Best of Practices to guide lenders in their lending practices.

With the commodities market booming once again at the start of 2021, the inevitable question that must be asked is whether the sector has learnt the right lessons?

The problem, it appears, starts and ends with liquidity. With price arbitrage opportunities diminished, traders structured their trades to leverage on liquidity – but liquidity, whether to plug an internal loss or as a form of credit to make a trader relevant to counterparts, can be addictive. And that liquidity was all too easy to reach – creating invoices unrelated to trades or pledging the same title document known as a bill of lading (BL) multiple times to various banks, allowed some crafty traders access to staggering sums of money.

To get liquidity, assets went off or on balance sheets when it suited traders, highlighting weaknesses in financial accounting. Swayed by impressive financial statements, banks readily increased limits on traders and in the process inadvertently enticed other lenders, resulting in an over-concentration of liquidity with a few traders. The ease at which a document could be manipulated to create a fictitious trade combined with the difficulty of detection, made this a seductive proposition for companies addicted to liquidity.

Tackling risk

Changing the risk-reward paradigm is where Singapore can lead the way in 2021. A trade finance registry using blockchain technology has been spearheaded by a group of Singapore banks late last year to improve transparency as it would contain data points of the relevant BLs and invoices so they can’t not be used again.

In the fast-moving world of international trade, keeping one eye on the BL and the other on the physical goods is key. A registry achieves part of that objective as the same document (whether a BL or an invoice) cannot be financed twice by participants to that registry. But a registry, even with blockchain technology, does not provide full visibility. This can only be obtained if the physical goods can be digitally tracked from source to end user and the prospects of doing so does not appear imminent given that the majority of commodities are shipped from developing countries without the adequate level of digital sophistication.

BLs are notoriously problematic as they go through numerous hands before they can arrive at a registry in Singapore. Inevitably the issuers of these BLs, whether the carrier itself or freight forwarders, need to be part of this authenticating framework, as well as the many large traders that effectively act as lenders – this poses the biggest challenge to such an initiative.

Despite some of its inherent limitations, the registry will go some way towards changing the risk of detection. The real lesson, however, lies in returning to the fundamentals of the business – financing trade. This is where the Code of Best Practices, launched in November 2020, holds the greatest potential.

The Code, which is not legally binding, comes at a time of introspection for the trade finance community, providing guidance on how liquidity is accessed both in terms of a macro risk analysis of the borrower as well as on a transactional deal level. It highlights non-exhaustive, nonprescriptive examples of good corporate governance and risk management policies on the one hand, and due diligence and transaction transparency on the other. None of these examples should come as groundbreaking practices and in that respect the Code may be in danger of being confined to the volumes of risk manuals already sitting at in the back offices of banks.

The most pressing challenge for commodity finance today is to understand the borrower’s leverage and the specific transaction flow, not just as a one-off process at on-boarding but consistently, across years of the relationship and which is particularly challenging given the velocity of trades conducted by traders in real time. This requires a sustainable system employing both third-party verification of credit exposure and the underlying assets, alongside penal sanctions for false declarations by the borrower.

At the heart of the challenge of understanding leverage lies the paucity of credit information on companies. Banks will tell you of that sinking feeling days or weeks before a company goes into restructuring or insolvency, when they are jolted by with the news that their borrower holds a debt exposure many times larger than what was declared. The implementation of a credit bureau would prevent such sleepless nights for banks – giving them much-needed independent visibility of the leverage and credit history of businesses.

Enhancing transparency

Understanding leverage also requires verification of financial statements and in particularly a company’s receivables which at times can be conveniently used to inflate the company’s financial health to gain access to additional financing. Transparency in financial disclosure needs to be enhanced, auditing made more robust and critically, sanctions imposed by law for those that fail in these duties.

Practices that run the risk of distorting a company’s leverage need to be scrutinised and reassessed. For example, the popular practice of reverse factoring which allows a buyer to record money due as a trade payable rather than as debt is something that can distort leverage assessments and give rise to catastrophic collapses. It allows one large buyer with good credit ratings to extract deferred payments from numerous suppliers, effectively optimising a buyer’s working capital while not accounting for it as a debt.

In simple terms, it gives a big buyer access to more liquidity and as recent cases have shown, addiction to liquidity can spiral out of control. Critically, going back to fundamentals also entails being cognisant of the biasness prevalent in trade finance. Financing trade was traditionally seen as secure because it was premised on the concept of the financed goods being a self-liquidating asset.

An over-reliance on paper documents over the years has challenged that basic concept as banks find themselves holding on to worthless title documents without visibility or control over the physical goods which are long gone. Another inherent bias would be the continuing trend of trade finance banks to move away from SME traders deemed as riskier borrowers, resulting in a concentration of liquidity with a handful of large established traders.

Comfort is taken in the size of balance of sheets which inversely affects the amount of due diligence undertaken for each transaction. And then there is that all too familiar human tendency to relax on compliance as a trader performs without default, year after year.

These are the same factors that resulted in the catastrophe of 2020, and the Code must be deployed with these dangers in mind. With the passage of time and without the force of law underpinning the Code, banks might once again fail to spot that tipping point when a trader moves from financing trades to creating trades for finance.

This article was first published in Singapore Business Times on 11 February 2021




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