Supply Chain Finance is in No Danger Despite Recent Headlines
The crisis with a large financial services company does not signal that supply chain finance is another exotic financial instrument that could trigger disaster.
The recent unravelling of a multi-billion-dollar financial services entity has propelled the somewhat arcane world of supply chain finance into the headlines. This is not a repeat of past crises where the complicated nature of financial instruments was a factor in a financial meltdown, however.
There is no parallel between supply chain finance and something like collateralized debt obligations, the complicated structures whose use are blamed by some for helping to tip the financial world into crisis in 2008.
Instead, what appears to have happened has more to do with the companies involved than with the underlying form of financial transactions being used.
On March 8, Greensill Capital filed for administration in a court in the United Kingdom, saying it could not pay back loans. The company began in 2011 as a supply chain finance provider, although it has since diversified into other financial services.
What is known about the case of Greensill appears to have little application to the world of supply chain finance, for reasons we will touch on below. Still, it is worthwhile to consider why this particular form of financial product is so unlikely to be the focus of a crisis.
Supply chain finance exists to solve a few simple problems.
When companies are involved in buying and selling goods to each other, whether they are part of a supply chain or not, buyers need assurances that they will get what they pay for and sellers need to know that they will get paid for what they make.
In its simplest form, supply chain finance exists to cover those moments in the process of trade when goods are in transit. Essentially these financial arrangements cover one of two risks: the risk that the buyer won’t receive the goods; or the risk that the seller won’t be paid.
Supply chain finance can extend to production, allowing a buyer to support a seller in the production of goods. Otherwise, a seller might have to wait until payment is received for one shipment before beginning work on the next. That would not be good for either the seller or the buyer, since it would lead to a stop-start production schedule as funds needed to be banked before production could begin on the next shipment.
Once the goods are received or the seller has been paid, the risk is over. That means supply chain finance, is a short-term financial instrument.
The risk involved in the transactions is usually shared between the parties involved and banks and/or insurance companies, who take a fee for the service. Since supply chain finance is such a safe instrument, those fees are relatively low compared with other banking and insurance services.
Where trouble can happen is when supply chain finance is made to do things it isn’t designed to do or when it is used as cover for more exotic transactions.
How low is the risk? The Trade Register, which ADB established some 10 years ago and housed at the International Chamber of Commerce, looked at two years of supply chain finance data covering $133 billion in exposures and found that the default rate was around 0.13%. The Asian Development Bank’s Trade and Supply Chain Finance Program has done more than 3,100 transactions since 2015 and has never seen a default.
For the most part, supply chain transactions are very standardized, with the same instruments used over and over. Bankers for the buyers and sellers transact the deals routinely.
Still, there are reasons why multi-lateral development institutions like ADB are involved in supply chain finance. Despite these transactions being low risk, they do rely on a solid regulatory base and relatively mature financial system to work properly.
All parties, including regulators, have to legally recognize the instruments used and agree on things like dispute settlement processes. This can be a problem in some of ADB’s developing member countries, where supply chain finance does not have the track record that it does in other parts of the world. Where the traditional finance providers—banks and insurance companies—need some help to share the risk, institutions like ADB can help.
The risk we speak of here is minor and disappears at the end of each transaction. It is not the sort of risk that can topple companies or be a danger to the financial system itself.
Where trouble can happen is when supply chain finance is made to do things it isn’t designed to do or when it used as cover for more exotic transactions.
There is an argument to be made that the 2008 crisis was not caused by complicated financial instruments but rather by those who put them to uses for which they were not intended. Any financial instrument is just a tool and markets and those who supervise them need to watch for the warning signs when those tools might be misused.
Both then and as now, greater transparency in business models and use of financial instruments, fit-for-purpose risk and governance structures and effective regulatory oversight are the key pillars to ensure that financial institutions remain strong and markets remain stable, however complicated or simple the financial tools they use.