What is Trade Finance?

Contents

    For any company to truly succeed in the global trade environment they will need to provide attractive sales terms that are backed up by appropriate payment methods, this will allow them to compete with other buyers/sellers in the market.

    For each trade, the ultimate goal is to be paid fully and on time.

    Trade financing provides these to exporters and importers, reducing risk and creating a confident relationship between the two parties. 

    What is Trade Finance?

    Trade finance is the financing of goods and services in the flow of international trade.

    It is a term used in reference to the instruments/products used by banks and companies to facilitate international trade; a transaction from a supplier through to an end buyer.

    These financial instruments and products include some of the following:

    Documentary Collections (DC) or Receivables financing

    This is a transaction where the exporter's bank is assigned the responsibility of collecting the payment.

    The remitting bank (exporter’s bank) then sends documents to the collecting bank (importer’s bank) with payment instructions.

    The banks involved in the exchange are also entrusted with handling the funds which involve the remittance from the importer's bank to the exporter’s bank.

    There are two types of DCs, Documents against Payment and Documents against acceptance.

    These are defined by trade contact payment terms:

    • Documents against payment: After the payment has been made for the goods the buyer's bank is authorized to provide documents that certify ownership of the goods.
    • Documents against acceptance: After both the buyer and seller agree to delay a payment, this form of documentation states that the buyer will receive written ownership of the goods on the condition of future payment.

    Letters of Credit (LoC)

    These reduce the risk of global trade and acts as a guarantee given by the buyer's bank stating that the supplier will receive the payment for the shipped goods within a specified time frame.

    The buyer is also protected as the payment can only be made if the terms in the LC are met by the seller.

    Thus the risk is only imposed on the banks.

    Trade Crediting and Political Risk Assurance

    These are offered by private insurance companies with the role of protecting a client from risk of non-payment arising from credit risks such as insolvency and bankruptcy as well as political risks brought about by events such as terrorism, war, and other political violence.

    This also covers the risk of non-payment caused by foreign government actions.

    Invoice Discounting

    This product of trade finance involves the inclusion of a third party which is a Trade finance company.

    They have transferred the ownership of the invoice by the seller which therefore means that payment via the debtor will be directed at the finance company, not the seller. 

    In short, this is how invoice discounting works:

    1. A business sells a good/service to a customer.
    2. The client is invoiced by the seller, has up to 120 days to pay.
    3. The business then sends the invoice to a third party, usually called a financing company.
    4. The financing company buys the account receivable from the business. Funds are made available at a certain percentage of the face value of the invoice (~80%).
    5. When the customer makes a payment, the balance of the invoice is remitted back to the business, minus a service fee.

    Supply Chain Financing (SCF)

    This is the most popular source of funding in international commerce. There isn’t an exact definition for supply chain financing as it can be applied to many different activities.

    This trade finance product is marketed to increase the efficiency of trade activities for the parties involved and better manage a company's working capital by helping to unlock tied funds such as unpaid invoices.

    The supply finance programs introduced by banks include the following.

    Supplier chain finance: This program is aimed at managing the capital between a large, high-rated buyer and a seller (small to large).

    The suppliers are able to get their 30/60/90 day invoices paid earlier via the buyer's bank while the buyer will have extra time to pay for the supplies. 

    Buyer chain finance: This works in a similar way to the supplier chain finance but in reverse.

    Here the buyers will be financed through their bank for the imports from their supplier with the expectation to be repaid in the future.

    Therefore the supplier can secure the payment as well as having their balance sheets managed appropriately due to the reduction in day sales outstanding (DSO).

    Trade financing has been reviewing the global trade and export markets since 1983 and according to the World Trade Organisation (WTO), 80-90% of World Trade relies on trade finance.

    Although international trade has been a thing for ages the introduction of trade finance has truly facilitated its advancement and growth.

    Therefore it could be greatly beneficial to your business if you are not already involved in trade finance.

    How does Trade Finance Work?

    The role of trade finance is to remove payment and supply risks for both importers and exporters, ensuring that each part of the trade is guaranteed.

    This is done by introducing a third party.

    These third parties range from the following:

    • Banks
    • Trade finance companies
    • Importers and exporters
    • Insurers
    • Export credit agencies and service providers

    Trade finance acts as a protection solution against many risks involved in international trade which could be inherent such as currency fluctuations, political issues and instability, non-payment risks, and credit ratings of the parties involved.

    This is what distinguishes trade finance from conventional financing which might involve only solvency or liquidity management.

    How does trade finance reduce risk?

    There is no question that there are many risks imposed during the trade for both the exporter and the importer, especially if these trades are done cross-border and/or between new trade partners.

    On one hand, the exporter has the risk imposed that the importer does not pay for the goods shipped after they have done so, this leads to the need to be paid upfront to reduce this risk.

    However, this does not eliminate the risk as there is still the chance that the exporter refuses to make the shipment after accepting the payment.

    The countries involved in the transaction also creates several risks including exchange rate, political and sovereign risks.

    Things such as the country's political situation, their economic status, and others can be deterring factors for certain exporters and instill uncertainty in deals.

    There are also direct risks with the company (corporate) where the exporter/importer might have a history of non-payment/shipment as well as their credit score.

    This is where Trade finance comes into play and acts as the solution to these risks.

    So how exactly does trade finance reduce risk?

    To explain how trade financing reduces the risk we will use letters of credit as an example as this is the most common instrument for short-term trade financing used.

    A Letter of credit acts as a solution to imposed risks during global trade, this is provided to the exporter's bank by the importer's bank and states that once the importer is provided with the correct substantial documents for the shipment of goods, such as a bill of lading.

    Until this is provided and terms between the two parties have been met will the payment be issued to the exporter.

    Thus with letters of credit, the responsibility for payment to the seller is on the buyer's bank.

    Usually, there is also a third party involved within the transaction which is the confirming bank, this bank is typically in the same country as the exporter and their role is to confirm the LC provided by the importer’s bank.

    The process will of course differ depending on the trade finance product/instrument used but the main premise can be easily understood with LCs.

    Other Benefits to trade financing

    Increases revenue 

    The revenue potential for the company is greatly improved due to trade financing.

    For example, a company might make a deal with a buyer to sell a certain good, however, they might not be able to produce the goods that are needed for the order.

    However, thanks to trade financing solutions such as export financing or aid from trade finance agencies the order will be possible.

    Thus creating new trade relationships and connections abroad leading to the financial growth of that company.

    Also, trade financing allows companies to request larger quantity orders from suppliers which in turn allows them to take advantage of economies of scale as well as discounts offered by suppliers for large bulk orders. 

    Improves the efficiency of operations 

    Trade financing ensures that business operations are as efficient as possible.

    This is because trade setbacks such as delays are reduced for both payments and shipments, allowing businesses to more confidently and efficiently plan cash flow and future operations.

    Non-payment and non-receipt of goods are reduced with both the payment and shipment guaranteed.

    Prevents financial hardships and stunts business growth

    Without the help from trade financing, companies may not be able to follow through with certain deals which could then lead to them losing out on a vital client or supplier which in turn stunts their business growth.

    Companies that may not have the best credit rating or capital standings will now have the option to take part in international trade to build up and improve their businesses by taking advantage of trade financing solutions

    Strengthen the relationship between the buyer and the seller

    Another important factor that inevitably leads to the success of a business is to have strong connections and relationships with your client or supplier.

    Confidence and trust between the two main parties are advantageous to facilitate growth and will lead to increased frequency of transactions, profit margins, and competitiveness. 

    To sum things up

    Trade financing might not be much of an easy term to define as there are many different forms of trade financing but as a whole, it can be understood that trade financing is a major facilitator in the growth of global trade by reducing the many risks that are brought up from doing cross-border deals.

    For any business it is essential to take advantage of the many solutions that trade financing offers in order to truly succeed in the trading market, building up connections and relationships with the parties involved and perpetuating your revenue.

    Interested in payment solutions to pair up with your trade financing needs? 

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