The FCA issues a ‘Dear CEO’ Letter in respect of Trade Finance Activity

On 9^th September, the latest of a string of recent ‘Dear CEO’ letters was released – this one being aimed at Trade Finance activity. Whilst the letter is primarily focussed on financial crime-related matters, it comes from the Financial Conduct Authority (“FCA”) and the Prudential Regulation Authority (“PRA”), both of which have expectations for Trade Finance (in accordance with their respective remits).

Across the financial services industry, Trade Finance activity is typically viewed as a high risk area for financial crime given that it can be complex, global in nature and the large volumes of trade flows utilising multiple currencies. Within the letter, it is noted that during the past 18 months there have been several high-profile failures of commodity and trade finance firms with significant financial loss, and that firms need to demonstrate that they have taken a risk sensitive approach to their control environment that ensures the relevant risks are effectively mitigated.

Findings

The letter states that the FCA’s recent assessments of individual firms have highlighted areas of concern relating to both credit risk analysis and financial crime controls, exposing firms to risks that are material in both a conduct and prudential context – namely:

Risk Assessment

From a business-wide perspective, firms have not adequately evidenced their assessment of mitigating controls for Trade Finance-related inherent risks, or recorded the rationale to support their conclusions on the level of residual risk to which the firm is exposed.
At a transactional level, there is often insufficient focus on the identification and assessment of financial crime risk factors (“red flags”), such as the risk of dual-use goods or the potential for fraud.
From a Customer Risk Assessment (“CRA”) perspective, assessments are too generic to cover the different types of risk that may exist in Trade Finance relationships, such as the industry or jurisdictions in which the client operates. The FCA expects that the customer risk rating will impact the level of due diligence required for trade finance transactions.
Firms have been failing to appropriately assess and (where relevant) discount these risks, and evidence the checks they have undertaken, which can lead to insufficient due diligence being undertaken (such as pricing checks, vessel tracking, and independent document verification), and exposure to suspicious activity.

Counterparty Analysis

Firms are expected to undertake appropriate credit analysis of all trade finance counterparts prior to formal credit limits being put in place. This analysis should include all parties with an interest in the transaction and not be limited to the borrower.
A firm’s policies and procedures should set out clearly when to conduct due diligence on other parties (for example, counterparty checks can help in identifying related parties or adverse media, and verifying the rationale for the transaction).
Transactions with no sensible business rationale given the jurisdictions, or industry of other parties involved in the transaction could be an indicator of fraudulent activity, collusion, or money laundering.
Firms should consider whether the activity is in line with the expected activity of their client and previous interactions with the parties to the transaction.

Transaction Approval

Firms are expected to determine if further specific analysis is required prior to transactions being approved. This should include, but not be limited to, consideration of the financial and non-financial risk on the end-buyers and the rationale for the transaction.
Firms should conduct a structured assessment of risks and red flags and maintain clearly defined policies and procedures to enable them to identify instances of higher risk which require enhanced due diligence or escalation to the Second Line of Defence.
Adequate oversight is crucial to ensure that policies and controls are operating effectively. This includes monitoring the discounting of red flags, transaction approval rationales, and the quality of escalations from the First Line of Defence.

Transaction Payments

Where the end-buyer is the primary source of repayment under the transaction, it is prudent to obtain formal written acknowledgement from the end-buyer that the amount due under the transaction is payable to the financing firm, and not to the borrower.
For credit insurance arrangements, Firms should seek formal confirmation that they are explicitly identified as a loss payee for risk insurance cover on non-payment of debts by the end-buyers and that the firm complies with any requirements in the insurance agreement.
Firms should ensure that the security is appropriately valued, perfection of security is correctly applied and maintained, including in respect of segregation, and there is consideration of how to realise the underlying security in the event of non-payment.

What should firms be doing?

Ensuring that their Business-Wide Financial Crime Risk Assessments adequately consider the inherent risks to which they are exposed by their Trade Finance Activities, the effectiveness of their mitigating controls, and the level of residual risk which remains.
Conducting an assessment of the relevant risks and red flags for each Trade Finance transaction in order to determine whether the transaction is within risk appetite, what level of scrutiny/due diligence must be applied, and whether there are any unusual or suspicious factors which require escalation.
Ensuring that CRAs are specific and detailed enough to capture the relevant risks for Trade Finance customers, and that they inform not only the level of due diligence applied to customers but also to Trade Finance transactions.
Reviewing their policies and procedures to ensure that there is adequate risk-based consideration of when credit analysis and due diligence measures are required in respect of Trade Finance transaction counterparts.
Ensuring that robust internal governance arrangements are in place in respect of transaction approval and oversight of the adequacy and effectiveness of policies, procedures, systems, and controls.
Reviewing their credit risk management arrangements to ensure that they adequately consider and provide protection in respect of transaction payments, credit risk insurance, and the underlying security to a transaction.

How can BDO help?

BDO’s Financial Services Advisory team work in close partnership with a number of firms which provide trade finance services, obtaining a deep understanding of their business and the specific environment they operate in. We act as a strategic partner, providing clear advice which is both balanced and constructive. We have experience in reviewing and helping firm’s to enhance their Trade Finance AML and credit frameworks, including risk assessments, due diligence measures, and transaction monitoring controls. Therefore, please do not hesitate to contact a member of our Financial Services Advisory team if you have any questions regarding how your Trade Finance control framework can be enhanced in light of the areas of concern highlighted in the ‘Dear CEO’ letter.