Over the last decade, the trade finance and post-trade markets in Europe have seen significant changes. After the most recent economic recession in 2007—2008, it became clear to the European Trade Commission (ETC), that trade reform was necessary.
But what specifically sparked the need for reform? In this article, we will provide a little background on what the trade finance and post-trade markets involve, the benefits and challenges, and what the market looks like today.
Trade Finance vs. Post-Trade: A Little Background
The trade finance market essentially involves both domestic and international trade transactions, including post-trade transactions. By “trade transactions”, we are referring to the purchase and sale of goods and services.
In the traditional sense, a transaction typically involves a buyer, a seller, and a third-party intermediary. The role of the third party is to oversee and mitigate any risks regarding supply and payment.
Trade transactions can involve multiple parties, including the following:
- Banks and financial institutions
- Brokers and brokerage firms
- Trade finance repositories and companies
- Investment firms
- Agencies and service providers
The post-trade market involves transactions that occur after a trade. This process involves the approval or rejection of a transaction based on the legitimacy of supply, available funds, and ownership. Post-trade processing is especially important in unstandardized markets, such as over-the-counter (OTC) markets.
The Benefits of Trade Finance and Post-Trade
Trade finance and post-trade transactions have had a place in the European economy and financial markets for decades. Regardless of economic turmoil, trade finance and post-trade have benefited the European financial market. Here are some of the primary benefits:
Improved Cash Flow and Efficiency, and Streamlined Operations
Various business cases will show that companies, repositories, and financial firms can reduce common risks by implementing and automating a trade verification process. In addition to mitigating risks and increasing efficiency, companies and firms can also improve cash flow.
For example, studies have shown that by adopting best practices and achieving same-day affirmation (SDA) companies and firms can reduce operating costs, increase efficiency, and improve the overall performance of the settlement or “clearing” process.
Reduce Payment Delays
In regards to trade finance transactions, companies that are able to obtain lines of credit or letters of credit are in a better position to plan cash flow and expenses more efficiently since payments are guaranteed. This helps keep costs low and reduce payment delays.
Improve Company Performance
Furthermore, by reducing risks of financial hardships caused by delayed payments, this improves overall company performance. By keeping up with payments, companies are in a better position to retain key customer accounts, which can help pave the way for company success over the long term.
The Challenges with Trade Finance and Post-Trade
Although there are a number of benefits of trade finance and post-trade, including having a positive impact on international trade and the European economic market as a whole, the market is far from perfect.
In fact, there have been numerous challenges and issues over the years. These challenges have included structural changes within the market, changes in political policies, financial stability challenges, and the sharp decline of bank-intermediated trade finance exposures, just to name a few.
When global trade finance and post-trade markets were functional and liquid, they did not attract much attention or require regulation from European policymakers.
However, over time, and as new, younger companies began to enter the market and develop new methodologies and processes, the need reporting for bank capital and the use of balance sheets began to diminish. This then caused huge data gaps, which made it incredibly difficult to monitor and regulate transactions and accurately report on economic growth and stability.
Additionally, derivatives—particularly OTCs—played a key role in the downturn of the financial panic of 2007—2008. As data gaps within the OTC market and stability issues were exposed, it became obvious that data standards and counterparty risk management were necessary. In fact, studies and statistics have shown that reduced trade finance availability may have accounted for up to one-fifth of the decline in trade.
Regulatory Reform in Action: The Introduction and Enforcement of EMIR
The goal of post-trade regulatory reform became to mitigate systematic risks and improve overall transparency in the derivatives market. As a result, several primary legislative frameworks were introduced, namely Basel III, MiFID II, and EMIR. The purpose of Basel III, MiFID II, and EMIR was to set strict rules for the entire financial system to avoid future financial crises and chaos.
Here are several rules that were proposed:
- All standardised OTC derivatives should be traded on exchanges or where available by electronic means.
- All standardised OTC derivatives should be cleared through central counterparties (CCPs).
- Both OTC derivative contracts and listed derivatives should be reported to trade repositories (TR).
- Non-centrally cleared derivatives contracts should be subject to higher capital requirements.
The introduction and enforcement of EMIR is expected to drastically change how companies, investment firms, banks, and trade repositories operate and report transaction data as well as to increase visibility and transparency in the derivatives market.
As we look ahead at the EMIR enforcement timeline, CCPs will be required to provide clearing members with an example model or tool to help them to determine the appropriate initial margin that the CCP may require when clearing new transactions by the end of 2019 (December 18th, 2019).
By June 2020, FCs will be responsible for reporting all details of OTC derivatives contracts on behalf of NFCs. This applies to those that do not exceed clearing thresholds.
Finally, by June 2021, clearing members that provide clearing services to other entities will be required to provide these services under fair, reasonable, non-discriminatory, and transparent commercial terms.