As has been well publicised, on the 9th September all CEOs of trade finance firms received a letter from the UK’s two banking regulators, setting out the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) expectations for firms undertaking trade finance activity.
The letter makes reference to several high-profile failures of commodity and trade finance firms resulting in significant financial loss, and is a clear indication that the regulators want more to be done by trade finance providers to demonstrate a risk-sensitive approach. It calls out four specific areas of concern related to both credit risk and financial crime, including Risk Assessment, Counterparty Analysis, Transaction Approval and Transaction Payments.
The regulators are watching: impacts to trade finance arrangements
Indeed, such a blunt letter from the regulators referencing financial crime and Anti Money Laundering (AML), sends a serious message to the market and a clear indication that regulators will be watching closely.
The letter itself is generic in its references to “Trade Finance”, but the common themes are that more focus must be placed on the risks inherent in each transaction and that risk assessments have been too generic.
The regulators say that companies should undertake “a holistic assessment of the associated financial crime risks. These risks include money laundering, sanctions evasion, terrorist financing and fraud”.
Expanded Needs for Fraud Review and Credit Analysis
Alongside financial crime, the letter also calls firms out to ensure they undertake appropriate credit analysis of all counterparties, including all parties with an interest in the transaction. The regulators state that they have identified examples where firms had facilitated transactions with no sensible business rationale given the jurisdictions, or industry of other parties involved in the transaction. This could be an indicator of fraudulent activity, collusion, or money laundering. Firms should also consider whether the activity is in line with the expected activity of their client and previous interactions with the parties to the transaction.
There is a fine balance to be taken between ensuring that the industry continues to move forward, supports international trade and release capital to those in the supply chain that need it whilst ensuring that robust processes are in place to appropriately monitor and accept risks.
Supply Chain Finance:
Whilst the letter itself is generic in addressing “Trade Finance Activity” the applicability of it could be far reaching including for Supply Chain Finance (SCF). Whilst SCF remains outside of the regulated boundaries there are still obligations on firms to assess the risks associated with the transaction, namely with respect to Financial Crime and AML.
SCF is based upon the concept of purchasing a receivable at a discount from a supplier in return for early settlement of that receivable. Alongside this, the buyer will also provide a payment undertaking to the funder for the relevant amount. It is the dichotomy between a payment undertaking and a receivable purchase that gives rise to the debate around supplier on-boarding and the level of Know Your Customer (KYC) and Customer Due Diligence (CDD) that is required.
Banks are the beating heart of the heavily regulated financial markets. Traditionally, in a bank led SCF programme, the bank will enter into a bilateral agreement with the supplier to purchase their receivables. In return, the bank will make payment direct to the supplier at a small discount to the receivable value.
As such, all bank-led SCF programmes will involve some level of KYC and CDD on the suppliers onboarded to the programme. Each bank will have determined its own rules and procedures as to what is required and whilst this can slow the supplier onboarding times down, banks have come to the decision that they require some degree of KYC and CDD on each of the suppliers. In fact, many banks can’t rely on third party partners to undertake the checks but require their own internal teams to do so.
As the SCF market grew, FinTechs were born, with an ambition to differentiate themselves from banks. Where better than to set your sights than the onboarding times of supplier and the requirement for supplier KYC and CDD.
But with the collapse of Greensill, the market has never been under so much scrutiny. Indeed, the letter from the regulator clearly references the failure of Greensill and whilst the UK Treasury Committee report ultimately reflected that they “do not believe that the failure of Greensill Capital has demonstrated a need to bring supply chain finance within the regulatory perimeter for financial services”, they do go on to discuss the risks around the emergence of the non-bank sector into areas of financial intermediation.
An Inflexion Point
With the increased scrutiny, it could well be an inflexion point for the UK market and perhaps the market globally. The impressive supplier onboarding times quoted are certainly a compelling reason to join one FinTech provider over another, but it is now more important than ever to understand precisely how such fast-onboarding times are really achieved.
- The FinTech partners with a third-party KYC and CDD provider in order to instantly validate details of the suppliers; or
- Neither the FinTech nor the funders are undertaking any form of KYC or CDD on the suppliers and perhaps relying on reps and warranties provided by the buyer; or
- The oft quoted times are simply how long it takes to sign up to the platform, but not have the funder complete their KYC and CDD process.
A major factor in the slow uptake of supply chain finance by banks is the difficulty associated with the supplier onboarding process. It is often a manual and paper-based process, with requirements varying from country to country. Furthermore, the multi-jurisdictional basis of multinational corporations’ supply chains will also require banks to be familiar with the laws of different jurisdictions, for example in relation to laws on receivable purchases.
So, whilst it is the buyer that is the ultimate obligor and has provided an Irrevocable Payment Undertaking (IPU), banks must still undertake their checks on the suppliers. Furthermore, normal practice does not currently allow banks to outsource KYC or CDD procedures.
As the SCF market grew and banks couldn’t or chose not to keep up, FinTechs started to enter the market with a proposal to differentiate themselves from banks. With this came a focus on disintermediating the banks and significantly increasing supplier onboarding times.In order to do so and achieve the fast on-boarding times, the introduction of an intermediary by the FinTech was established to acquire receivables direct from suppliers. This intermediary is in the form of a bankruptcy remote Special Purpose Vehicle (SPV) that funds itself via the issuance of notes or participations.
The funding of the SPV, which has entered into contractual relationships with suppliers and pays them directly removed the need for the funders to undertake any KYC or CDD on the suppliers. This allowed for both bank and non-bank funders to enter the market with a far reduced burden of perceived responsibility.
But not all FinTechs have utilised the SPV model. Through a combination of technology that simplifies and streamlines the supplier onboarding journey coupled with a a bank agnostic solution that allows the buyers and FinTech to select the most appropriate banks for each jurisdiction, there are other ways to run supply chain finance programmes. In fact, such a model can allow SCF to deployed in a wider range of countries due to regulatory compliance, but also by carefully selecting the appropriate banks, supplier onboarding times can be significantly reduced to days.
To KYC or Not to KYC
As the acquirer and contractual counterparty of the supplier, the decision to undertake KYC and CDD on the suppliers sits with the SPV and its management. It is at this point that we see a divergence in risk acceptance levels amongst the various operators, with some providers undertaking supplier KYC and CDD at the SPV level and others not.
The regulators letter will invariably cause all trade finance companies to review their risk practices, but perhaps more importantly, the risk functions, including the MLRO of the bank and non-bank institutions that purchase the notes or participations will raise significant questions.
Ultimately it begs the questions as to whether the SPV model obfuscates the risks highlighted in the letter and whether more attention needs to be placed on those contractual and financial relationships between regulated entities such as banks, SPVs and the Suppliers obtaining early payment.
To learn more about what these new regulatory recommendations and advice means to you and your business, contact Kyriba’s Working Capital experts.