Dynamic Trade Finance in the Presence of Information Frictions and FinTech

Manufacturing & Service Operations Management

Management Science and Operations

Manufacturing & Service Operations Management 2022 In Press

Lee H;Tang C;Yang S A;Zhang Y

S. Alex Yang

2022

The paper focuses on an innovative bank-intermediated trade finance contract, which we call dynamic trade finance (DTF, under which banks dynamically adjust loan interest rates as an order passes through different steps in the trade process). We examine the value of DTF, the impact of process uncertainties and the associated information frictions on this value, and the strategic interaction between DTF and FinTech. As more than 30% of global trade involves bankintermediated trade finance (Bank for International Settlements 2014), examining contract innovation in trade finance (DTF) and its strategic interaction with FinTech is of practical importance. Also, analyzing trade finance in the presence of process dynamics and information frictions complements the existing academic literature. We construct a parsimonious model of a supply chain process consisting of two steps. The duration of each step is uncertain, and the process may fail at either step. Information delay may also occur when verifying that the requisites for passing a step have been satisfied. The seller (borrower) borrows from a bank to finance this 2-step process either through uniform financing (the interest rate remains constant throughout the process) or DTF (the interest rates are adjusted according to a pre-committed schedule as the process passes each step). While lending, the bank faces regulatory capital requirement (the bank is required to hold capital reserve when issuing risky loans) or information asymmetry (the borrower possesses more accurate information about the trade process than the bank). The value of DTF lies in its ability of reducing transactional deadweight loss (under regulatory capital requirement) and screening (separate high-quality borrowers from the low-quality ones under information asymmetry). This value increases as the trade process becomes more reliable or lengthier, yet its ability of screening is stronger when the process is less reliable. The severity of information delay hurts the value of DTF convexly. Numerical results based on calibrated parameters suggest that DTF could lower the borrower’s financing cost substantially. Finally, FinTech that expedites information transmission and verification and enables automatic execution complements DTF, and those that segment customers more efficiently could substitute DTF. Our results shed light on how the underlying trade process dynamics and the type of information frictions involved affect the optimal deployment of contract innovations (DTF) and FinTech in trade finance.

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