IRSG Sustaining

Wholesale Financial Markets

Day-to-day operations: laying foundations for sustaining growth What do businesses need in the short term from wholesale financial markets?

A range of financial offerings exist to help businesses in their daily operations Short-term financing of the business

and to allow them to grow sustainably.

This paper looks at ways to help businesses meet their daily financing needs (in particular working capital finance and trade finance).

This paper also considers risk

Short-term financial needs Day-to-day risk management

management tools which can remove unwanted risks to short-term business performance.

Figure 1 Short-term financial needs

KEY MESSAGES > To sustain business growth, short-term finance is crucial to the day-to-day business of European corporates. > Companies use wholesale financial markets in the short term to: > Manage their cash flow. Working capital finance is often arranged through major wholesale banks; > Grow through trade. Trade finance allows firms to grow through exporting, with world exports of goods returning to pre-crisis levels at $17tn; > Reduce risk. Wholesale financial markets connect corporates seeking to reduce risk with financial firms specialising in risk management: allowing corporates to specialise in their own core activities and work more efficiently.

1.

Working capital finance 2.

Trade finance

3.

Use of derivatives, swaps, futures, and other instruments to transfer risk

Wholesale Financial Markets: Day-to-day operations: laying foundations for sustaining growth

How do businesses finance their working capital?

UK have signed up to a supply-chain

there can be a long delay between the

finance government initiative, expected

purchase of raw materials and final

The current account of a firm:

to generate £20bn of cheaper financing.

payment of the goods.

A business needs money available for

Firms can also use ‘commercial paper’,

day-to-day trading operations from which

which is a type of short-term bond1.

Banks can help reduce risk: Banks assist by providing short-term bridging loans to

it can fund activity. This is its working capital, calculated as the current assets

“ We need to have a buffer of very flexible

cover the gap, and reduce risk for the

minus the current liabilities. For many

credit through banks.”

companies. For example, the importer’s

companies, this is largely composed of

Vice-President Group Financing

bank may provide a letter of credit to the

trade debtors (i.e. customers who have

major European components

exporter (or the exporter’s bank)

not yet paid for goods and services) and

manufacturer

providing upfront payment upon proof

trade creditors (i.e. suppliers the company has not yet paid).

that the items have been sent. Around “ The impact of the crisis has particularly

80% of total trade transactions, estimated

affected our supply chain and

at $16tn, are aided by financial institutions

Typically financed by banks: Firms often

customer base.”

providing credit, insurance or guarantees

have access to flexible bank credit (similar

Senior Vice-President of Treasury

to the companies involved.

to an overdraft on a current account),

global oil and gas company Trade finance can be flexible to each

which can cover working capital needs in the short term. When there is less liquidity

What is trade finance?

firm: Trade finance can also help

in the wholesale financial markets, banks

International trade can be risky:

companies export by providing

reduce the supply or increase the price of

Companies often grow through trading

guarantees that they’ll get paid,

credit to non-financial corporates.

internationally. However, there are

advance payments of export contracts

significant risks to doing so. For example,

(‘letters of credit’), or provide

Europe’s non-financial corporates

when a good is purchased, whichever

protection against debtor non-payment

depend heavily on banks for short-term

party pays upfront for the product takes a

(‘debt factoring’).

finance; of total non-financial corporate

risk that the transaction will not complete

debt outstanding in 2011, bank loans and

successfully. If the importer pays on order,

European banks are major providers of

other advances accounted for 85% in the

he takes the risk that the goods may not

trade finance: According to a recent

euro-area and the UK. This contrasts with

arrive. If the exporter accepts payment

World Bank study, large euro-area banks

53% in the USA. This suggests regulation

on delivery, then he takes the risk that the

accounted for 36% of global trade

that reduces liquidity to banks will have a

importer will not pay in full. Either way

disproportionate effect on European companies. The EU has tried to mitigate

1 F or more details see paper Growing a business organically through long-term finance.

this through initiatives like the European Investment Fund (EIF). In November 2012 the EIF signed its first guarantee

When payment is at the time of ordering: Trade finance covers the importer’s cash flow

agreement with Spain, which released

Cash

€120m of additional loans to small businesses.

Importer

Trade finance facility

Exporter

Financed through the supply chain, and via the financial markets: Supply chain finance gives the suppliers to companies

Goods

access to immediate credit sometimes at reduced rates. Once the firm has

When payment is on receipt of goods: Trade finance covers the exporter’s cash flow upon proof of shipping

approved payment of an invoice, the supplier’s bank will supply immediate

Figure 2

credit. 38 of the largest companies in the

Trade finance facility

Wholesale Financial Markets: Day-to-day operations: laying foundations for sustaining growth

Engineering risk management

trade finance operations in response to

How do businesses use financial services to manage market volatility?

pressure to consolidate activities in

Corporates can use financial services

major industrial projects. It is a large firm

domestic markets. One reason for

products to reduce risk: Every business

employing over 10,000 people in countries

this is that short-term trade finance is

purchases goods and services to use as

across Europe.

easy to trim in order to meet regulatory

inputs. The price of these inputs can rise

capital requirements.

and fall in relation to the demand and

The business challenge: The company’s

supply for these goods. These goods

major concerns were that some of

could be tangible such as steel or

the recent regulatory developments

and it can cover many different risks;

copper (raw materials for production),

could mean that funds they might be

for example currency risk, political

or intangible such as a loan with a

spending in their primary business for

risk, and trade risk, but liquidity

flexible exchange rate. For corporate

product development, research and

requirements will directly decrease

treasurers responsible for risk and cash

development and job creation, could

the amount of trade finance available

management, avoiding volatility in

instead be either spent on credit charges

to a business.”

input prices is worth paying for.

or tied up in clearing houses as collateral.

A range of tools are available:

Variety of risks covered: Some of the

Financial tools which are used by

underlying business risks (actual or

corporate treasurers to achieve a stable

forecast) that this firm either currently

cash flow include derivatives (e.g.

hedges, (or has considered hedging), are:

finance in 2011. However euro-area banks have been cutting back their

“ Trade finance is very important,

A multinational engines manufacturer produces large engine components for

Chief Executive Officer French consultancy

forwards and options), and swaps (e.g. for interest rates and currency).

> Foreign exchange risk on cash flows;

These are defined and described in the

> Commodity price exposures;

Wholesale Financial Markets paper,

> Energy price risk;

The engine-room of economic

> Credit risk, for example the purchase of

recovery; helping European companies

a credit default swap (CDS), or other

set up and grow.

similar instrument;

Other

■ Commercial letter of credit 44% ■ Standby letter of credit 9% ■ Guarantee 18% ■ Collections 19% ■ Open account 8% ■ Other 2%

■ Commercial Open account letter of credit 44% ■ Standby letter of credit 10% ■ Guarantee 21% Collections ■ Collections 18% ■ Open account 6% Guarantee ■ Other 1% Standby letter of credit Commercial letter of credit

Other

> Employee share scheme liabilities; > Emissions Open account trading scheme liabilities; > Inflation risk; Collections

> Pensions scheme liabilities.

Guarantee

Other non-financial firms will have their Standby letter of credit own set of specific risks that they may wish Commercial letter of credit

to hedge via derivatives, such as the risks of the weather, or property prices.

“ We hedge risk using derivatives, the most Figure 3 Global export transactions volume

Figure 4 Global import transactions volume

% Share

% Share

Commercial letters of credit are by far

Bank guarantees are more

the most popular form of trade finance,

popular when importing compared

their business, and reduce risk.”

with 44% of the volume.

to exporting.

Deputy Chief Financial Officer, materials

Source: ICC Global Survey 2012

Source: ICC Global Survey 2012

manufacturer

common for us being foreign exchange risk; these products are absolutely necessary for companies to manage

Wholesale Financial Markets: Day-to-day operations: laying foundations for sustaining growth

Key question: Why is the derivatives market so large?

Conclusion Businesses require a range of options for short-term finance and to ensure

The size of the market: Various figures are

derivative based on it. There may be

sustainable growth, and European

given to indicate the size of the

multiple derivatives on a single security,

financial and professional services firms

derivatives market, and views have been

some of which may expect the value of

provide them. Corporate banks with

expressed that it might be out of

the underlying asset to rise, and some of

deep pools of liquidity help manage

proportion with the bond and equities

which expect the value of the underlying

working capital and trade. Tools are

markets. For example, the European

asset to fall.

available in the financial markets for financial risk specialists to purchase

Parliamentary Commission estimated the OTC derivatives market volume at

The ‘Gross market value’ nets out all of

business risks from corporates.

$605tn in 2010, which is equivalent to

these to produce an aggregated net risk

This allows the risks to be managed

approximately ten times the size of

position, which is significantly lower. The

effectively. Firms can then focus on

world GDP.

estimated gross market value of all

their own core activities, to help them

derivatives outstanding is €19.5tn, which is

grow in the long term.

Terminology is important: Any lack of

a fairer direct comparison with the equity

clarity is often a result of the terms used.

and bond markets, which have market

‘Notional amount outstanding’ adds up all

capitalisations of €55tn and €95tn

the value of every security that has a

respectively.

Authors The Wholesale Financial Markets Papers are compiled by Accenture Research for

About IRSG

About MEDEF

About Paris Europlace

About CBI

The International Regulatory Strategy Group (IRSG) is a practitioner-led body of the financial and professional services industry, dedicated to shaping the international regulatory regime so that it promotes open, competitive and fair capital markets and supports economic growth.

It is an advisory body to the City of London Corporation and TheCityUK.

MEDEF is the leading network for entrepreneurs in France, with over 780,000 member firms, 90% of whom are small or medium businesses with less than 50 employees.

Paris Europlace represents the major players in the financial markets of France. Its role is to promote Paris as a financial market.

The CBI is the UK’s leading business organisation, speaking for some 240,000 businesses that together employ around a third of the private sector workforce.

Other papers in this series www.cityoflondon.gov.uk/business www.TheCityUK.com

Starting a business Growing a business organically through long-term finance Combining forces for growth: acquisitions, mergers, buy-outs Growing a business through alternative finance