ETHE SAME DAY of the week, thousands of visitors pass through Istanbul’s fragrant spice bazaar. It’s a diverse collection, with local shoppers mingling with camera-wielding tourists. The products offered too. While many of the specialties on display are grown in Turkey, one trader gets his berries from Iran, his nuts from Chile and his almonds from California. Another, who was asked if she had gone all the way to China to buy her jasmine tea, replies wryly: “Of course not. Importers ship it here.

Most of the goods traded in the world still travel on merchant ships. From the hills of Istanbul, you can see them placidly converging on Ambarli, Turkey’s largest port. Less visible is the liquidity that makes these trips possible. Four-fifths of global trade transactions, worth $15 billion a year, rely on specialized loans or guarantees. This hidden world of trade finance is huge but poorly understood. It’s long been in need of an overhaul, and a nascent revolution promises to unlock trillions in fresh capital. But trade wars put this Big Bang in jeopardy.

Trade finance is one of the oldest banking businesses. Millennia ago, merchants in present-day Turkey traded cloth or copper for engraved tablets promising later payment in silver. Trade credit today may be more sophisticated, but it still tackles the same problem: exporters prefer to be paid at the time of sale (so they can finance more production), while importers prefer to settle after receipt of the goods (so that they can first raise money by reselling them). Each side rarely trusts the other to hold its end of the bargain.

Trade finance puts banks in the middle. Typically, the importer’s bank, when presented with a shipping invoice or other proof, issues a “letter of credit” to the exporter guaranteeing payment. This allows the exporter to obtain credit from a bank and then repay the lender when the end customer pays. Loans are short-term, usually less than four months. And they are safe. Annual default rates on letters of credit averaged 0.08% of transactions in 2008-2017, compared to 1.6% for business loans. When loans deteriorate, recovery is quick.

The work is as indescribably tedious – thousands of similar small transactions – as it is regular. Annual returns for trade finance instruments have an average volatility of less than 0.30%, compared to 4.44% for investment grade bonds. Four-fifths of global transactions are processed by just ten banks, mainly in London, New York or Singapore. Borrowers rarely switch providers. Graduates prefer to work on initial public offerings or multi-billion mergers. The business cards change, but not the cast. “It’s very incestuous,” says a senior banker.

All of this explains why an industry that is global by definition is parochial and antiquated. From banks and insurers to warehouses and customs, processing trade credit requires the exchange of 36 original documents and 240 copies, on average; each of the 27 parties involved spends hours, if not days, researching facts and filling out forms. Less than a quarter of banks use electronic documentation. It is not, as Andrew Colgan of Mizuho Bank notes, “a screen-based market.” Standards and terminologies vary from industry to industry, and even within banks.

Since the financial crisis, regulators have forced banks to reserve more capital against risky or exotic loans. As a result, trade finance is punished, as it often serves small businesses in poor countries. Watchdogs also want lenders to stop bad cash flow, and the cost of vetting customers is making small trade finance deals unprofitable. So most lenders compete for big customers, says Joon Kim of BNY Mellon, a bank. Low interest rates have also crushed margins, which have shrunk by a third since 2014.

In response, the banks backed down. According to Coalition, a data provider, the top ten derived 19% of their transaction banking revenue from trade finance last year, up from 27% in 2010. The Asian Development Bank (AfDB) estimates that $1.5 billion in financing proposals were rejected in 2018. “Country risk” was cited as the reason by 52% of banks. Nearly half of small business applications went nowhere. As supply chains shift from China to poorer countries, discards could reach $2.5 billion by 2025, according to the World Economic Forum. This hurts even large multinationals: many rely on niche providers that banks avoid.

Fortunately, transformation is coming, on three fronts. First, thanks to the Internet and easier international travel, buyers and suppliers know each other better, which builds trust. Many prime importers also want to extend payment terms beyond what exporters can afford. This has fueled the rise of ‘supply chain finance’ (CFS). This usually involves removing several steps in the chain, with exporters depositing their invoices directly with the importer’s bank, who promptly pays them minus a commission. Suppliers should not waste time and money collecting documents. They benefit from the best credit rating of their customers (since it is the buyer who ends up paying the bank). Last year, banks earned $21 billion from FCSup 12% compared to 2017. It now represents 18% of trade-finance transactions.

Second, banks are beginning to sell tranches of the loans they have issued to third parties, while acquiring tranches of debt from others. This helps diversify portfolios and increase lending capacity. Surah Sengupta of HSBCa bank, announces that it will sell more than $30 billion in business assets in 2019, up from $2 billion three years ago.

A profitable business

Banks still represent more than 95% of buyers in this secondary market. But institutional investors are beginning to be attracted, thanks to technology, the third part of the revolution. With its many transactions, trade finance is an ideal training ground for machine learning. Platforms like startup Tradeteq allow banks to repackage short-term bills into scalable debt products. Algorithms analyze data to predict credit risk, so investors know what they are buying.

More transparency and liquidity could lead data providers like Bloomberg to recognize trade finance as an asset class, putting it on the radar of big fund managers. Fasanara Capital, a hedge fund with 750 million euros ($835 million) in assets under management, has already invested in more than 16,000 business deals. Stenn International, another firm, aims to quadruple its trade finance assets to $2 billion in 18 months.

However, the danger looms. Hampered by protectionism and an economic downturn, the IMF predicts that global trade will expand by only 1.1% in 2019, compared to 3.6% in 2018. So far, this has had only a minor impact on the incomes of financiers, in part because the supply chains are being overhauled, bringing new business to global banks. But small lenders are more exposed. And the competition for a decreasing volume of transactions could push all lenders to lower interest rates.

This pool could shrink further as the creditworthiness of borrowers deteriorates. This year, business defaults are expected to increase. Meanwhile, requests for credit insurance are increasing, says Alexis Garatti of Euler Hermes, a company that insures payments to exporters. This will likely mean higher premiums and more lenders fleeing to the safest borrowers, further squeezing margins. “We should expect a moderate version of a credit crunch,” says Francesco Filia of Fasanara.

The trade war between America and China threatens to erase other gains. Growing uncertainty in 2019, for example, has led merchants and lenders to demand more paperwork. This is fueling a resurgence in letters of credit, at the expense of supply chain finance. Change may accelerate as trade war leads importers to source from riskier markets, says Sukand Ramachandran of BCGa consulting firm.

Technological progress, at least, cannot be undone. But it can harden emerging divides. The birth of a single global standard, the 20-foot container, has revolutionized maritime transport. But partly because of tariffs, partly because fleeting consumer tastes demand shorter supply chains, trade is fragmenting into regional blocs. If digital standards also develop in silos, rather than as part of a global effort, this may prove impossible to reverse. Trade finance could still see its container moment slip away. ■