What’s stopping technology from solving the trade finance gap?
(with Maria V. Sokolova)
A rising tide does not lift all boats. If it did, the internet-based technologies created over the past decade would have closed the trade finance gap.
Technology is widely expected to improve financial inclusion. Both banks and consumers expect that digitalization will narrow the 2.1 trillion dollar trade finance gap (2016). Circumstantial evidence seems to support this expectation. In 2017 we showed that women are more likely to use fintech; in 2020’s global pandemic, we all discovered remote work and virtual offices and in 2023 banks identified technology as a contributing factor to anticipated increases in trade finance.
But it never actually delivers. Basic financial inclusion (that is, the ability to access digital payments) has improved via non-bank financial institutions like PayPal (stablecoins) and Safaricom (mPesa). However there is another level: the exclusion of banked clients from more complicated financial instruments — like mortgages or trade finance — has moved very little. The trade finance gap is not any smaller today than it was in 2013.
Why has technology done so little for financial access?
Reason 1: The use case is not financial inclusion
The first part of the explanation is that the objective of most internet-based technologies is to increase system efficiency. AI is being integrated into AML procedures and customer chat functions. DLT is shortening settlement times and expanding the number of financial instruments in the system. System efficiency use cases decrease costs within the system, but do not directly impact potential new customers.
Not everyone ignores financial inclusion, so there are notable exceptions where projects deliberately target financial inclusion as a goal.
In the trade finance space, Marco Polo and we.trade both had financial inclusion objectives. Unfortunately, governance problems led to their liquidation by 2023. Another example of financial inclusion as the target use case is in most central bank digital currencies (CBDCs). In this case, it remains as a goal, but one which is unlikely to be met as as adoption is below 0.2% of circulating currency in every economy. The difficulty these two exceptions have had is evidence that financial inclusion is a more challenging use case than we realize, which may explain its relative absence.
Reason 2: Regulations disincentivize inclusion
Stability-focused regulations are the second reason that digitization has not expanded access to higher-level financial instruments. Regulations are critical guardrails for the financial system, but financial stability objective of Basel III complicates financial inclusion in two ways.
The first is that financial stability regulations make the system more internally-oriented. For example, Basel III regulations have decimated the correspondent banking network. Technology can’t improve financial participation in emerging economies if the infrastructure there does not exist.
The second reason regulations do not promote inclusion is that Basel’s increased capital and liquidity requirements reduce the amount of money available for lending to riskier parts of the existing customer base. Much has been written about the unintended impacts of Basel III regulations. A 2020 World Bank study shows “moderately negative impacts” on SME lending. A recent paper also shows that when standards are tight, banks overcompensate by gathering too much information on potential borrowers. Neither of these impacts improves the ability of SMEs to access more than basic financial instruments.
Reason 3: Subsidies don’t solve the underlying problem
Because financial markets are not naturally inclusive, efforts to improve financial inclusion are often limited to subsidies or other monetary incentives to divert services to non-traditional customers. The ADB offers guarantees to banks in emerging economies in Asia to facilitate SME exporters. During COVID, the US Government offered a range of financial incentives to SMEs.
Subsidies and financial incentives are not sustainable, nor do they solve the problem that banks don’t want to onboard higher-risk clients. There is also evidence from the US that most subsidies are captured by the highest income households. This suggests that there needs to be a better solution to inclusion than paying for it.
Someone has already come up with a fix
There is good news. We’re not stuck here. Since internet-based technologies are multipurpose, we can adjust them with deliberate action.
To understand how, we can look to two alternative models in operation today. Each is a financial system with the objective of opening the economy to all interested participants while shifting stability to a secondary role. The first is DeFi, and the second is token-based video games like Roblox or Fortnite, or the older EVE Online.
These financial structures show us that it is possible to run a financial system that offers products to individuals who are not typically served by the financial system. From these models, we can extract two actions that could narrow the trade finance gap.
Lesson 1 is from DeFi. We could adjust Basel III to include inclusion as a measurable objective. This adopts the example of DeFi’s disintermediated markets, which are open to all participants, and which then balance pools using algorithms based on the number of participants in the pool. Basel’s capital and liquidity requirements increase the cost of banking the unbanked, making the exclusion problem worse. By adding minimum commitments to inclusion, every future banking regulation could be valued against the enhancement or loss of the edges of its client base. This would ensure that the costs of compliance do not overwhelm the objective of expanding the client base. This is similar to how central banks have both inflation and employment targets.
Lesson 2 is from in-game token economies. We might invite riskier clients, but increase their supervision beyond what is typical for bank clients today. Supervision is more inclusive than immediate disqualification. Adding in supervision comes from the example of video games that have large groups of younger players — anyone can sign up, but if they might be below the minimum allowable age, the platform undertakes additional supervisory actions or incentivizes them to make age-appropriate choices. Consumer credit already works in this way.
Technology shows us that it is not true that a rising tide lifts all boats when regulation is involved. But applying alternative examples, we can see that it is possible to introduce stability regulation that is not directly in opposition to financial inclusion.
The next step is to identify a set of steps for regulators to remove the artificial zero-sum game that has developed between financial stability legislation and second-layer financial inclusion.
