Dynamic Trade Finance in the Presence of Information Frictions and FinTech

Problem definition: 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. Academic/practical relevance: As more than 30% of global trade involves bank-intermediated trade finance, 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. Methodology: 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 the process passing a step. The seller borrows from a bank to finance this two-step process either through uniform financing (the interest rate remains constant throughout the process) or DTF (the interest rates are adjusted according to a precommitted schedule as the process passes each step). When lending, the bank faces a regulatory capital requirement (the bank is required to hold capital reserve when issuing risky loans) or information asymmetry (the seller/borrower possesses more accurate information about the trade process than the bank). Results: The value of DTF lies in its ability to reduce transactional deadweight loss (under the regulatory capital requirement) and screening (separate high-quality borrowers from the low-quality ones under information asymmetry). This value is greater for more reliable or lengthier trade processes, yet DTF’s ability to screen is stronger when the process is less reliable. The severity of information delay hurts the value of DTF convexly. FinTech that expedites information transmission and verification and enables automatic execution complements DTF, and those that segment customers more efficiently could substitute DTF. Managerial implications: 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.

History: This paper has been accepted for the Manufacturing & Service Operations Management Special Section on the Interface of Operations, Finance and Technology.

Funding: This work was supported by National Natural Science Foundation of China [Grant 72201060], London Business School, the University of Hong Kong, and the University of International Business and Economics.

Supplemental Material: The online appendix is available at https://doi.org/10.1287/msom.2022.1102.