Trade finance: why trade finance is an important form of finance and how recent policy changes can strengthen it

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The past decade has witnessed tremendous development in the trade finance industry, including the complexity of transaction structures and the increase in transaction volume. This has become possible thanks to a number of legal changes, including new legislation. There is no doubt that trade finance will be an important form of resource mobilization for the foreseeable future, for both large enterprises and micro, small and medium enterprises (MSMEs). This article focuses on two important changes related to trade finance that will come into effect in 2021. The first is the expansion of the scope of trade credit insurance, and the second is the amendment of the law of 2011. on the regulation of factoring (Factoring Act).

Trade credit insurance
Simply put, trade credit insurance protects manufacturers, traders and service providers from the risk of non-payment for goods and services by buyers. Trade credit insurance typically covers the risk associated with buyer’s insolvency, prolonged buyer defaults, or certain geopolitical risks due to which the buyer is unable to make payments.

To date, a limited form of trade credit insurance is permitted in India. From a trade finance perspective, the current regulatory regime does not allow the benefits of trade credit insurance to banks, letter carriers, financiers or lenders (financiers). Even if the trade receivables are assigned, the benefits of trade credit insurance cannot be passed on to the financiers. This in effect means that trade credit insurance can only be taken out by sellers when they have no intention of assigning these trade receivables.

It is important to note that in general trade finance products are unsecured and the non-availability of trade credit insurance means more risk for Financiers. This leads to some reluctance on their part to provide financial solutions to sellers. This is even more true when the seller is an MSME because his risk profile is considered higher. Even on the government-recognized TReDS platform, this functionality is not available.

The problem is amplified by the fact that all kinds of trade finance products are not considered “financial debts” under the Insolvency and Bankruptcy Code of 2016 (IBC). Trade receivables if they are sold without recourse will be classified as “operational debt” according to the IBC. Since operational creditors rank lower than financial creditors in a liquidation scenario, in effect, Financiers bear the risk of little or nothing of the liquidation proceeds.

In March 2020, IRDA authorized credit insurance for the TReDS platform and commercial credit insurance for the MSME sector under a regulatory sandbox approach.

In April 2021, IRDA published draft guidelines on trade credit insurance. In accordance with the draft guidelines, credit insurance will cover suppliers as well as banks and other financial institutions. In particular, it provides that the cover will be available to factoring companies, banks and financial institutions. Credit insurance is not available for “reverse factoring” and “financial guarantee”. This is understandable because reverse factoring and financial guarantees are financing transactions and may not be asset-backed in the true sense of the word.

The scope of credit insurance has also been broadened under the draft guidelines. Previously, this was only offered on the basis of overall turnover. Now this can be offered to cover individual buyers in the case of MSMEs. Single invoice coverage will also be authorized on the TReDS platform.

The maximum indemnity for financiers has been maintained at 60% of the trade receivables of each buyer. The limit in other cases is up to 90% of each buyer’s trade receivables. While the reason for this difference is unclear, it can be argued that financiers are more sophisticated clients and therefore in a better position to assess risk.

The benefits of trade credit insurance that have been taken out in case of cross-border transactions will undoubtedly be possible for onshore transactions as well. This is sure to give the sector a boost and take trade finance transactions to a different level in the near future.

Amendment of the factoring law
The Factoring Law was passed with the aim of addressing late payment and liquidity issues faced by all businesses, including MSMEs. While the Factoring Act has reached a certain stage, it is still a long way from achieving the success it was aiming for. Therefore, the Indian government has decided to make significant changes through the amendment law. Some key changes / amendments to note are:

· According to the Factoring Law, a non-bank financial corporation (NBFC) can undertake factoring activities if it meets the specified threshold of income and assets and is registered as a factor with the RBI. This has led to ambiguity whether other NBFCs can provide factoring products or not. The amending law removes this registration threshold. Subject to clarity from the RBI, it appears that most NBFCs will be able to provide factoring services.

· The definitions of “assignment”, “factoring activity” and “receivables” have been amended to provide clarity and to align them with internationally recognized definitions.

· The concept of Trade Receivables Discounting System (TReDS) has been explicitly included in the factoring law. This was important from the point of view of the functioning of the TReDS platform. It will therefore be possible for the TReDS platform to file the details of the allocation with the central register on behalf of a factor.

· The deadline for filing with the central register has been removed and separate notifications will be issued in this regard. The intention of the legislator is to reduce the filing deadlines in order to reduce the double financing backed by the same receivables.

· The RBI has been given broad powers to develop regulations concerning (a) the granting of a certificate of registration; (b) filing transaction details with the central register on behalf of letter carriers; and c) any other matter to be specified by regulation.

Both of the aforementioned changes show a roadmap, but the actual picture would be clear once the guidelines are released by IRDA and RBI. Expanding the scope of trade credit insurance and including all kinds of NBFCs to undertake factoring transactions would surely increase market participation and give this much needed source of funding a boost. Clarity on the functioning of the TReDS platform would be beneficial for financiers as well as for the MSME sector.

This article is co-authored by Pratish Kumar and Anish Mashruwala, partners at J. Sagar Associates.


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