What is Trade Finance?
Trade finance refers to the financing of goods and services in the flow of international trade and commerce.
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.
How Does Trade Finance Work?
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.
This is where trade finance comes in. For each trade, the ultimate goal is to be paid fully and on time. Trade finance offers exporters and importers reduced risks on international trade, creating a confident relationship between the two parties.
The goal of trade finance is to remove supply and payment risks from deals by bringing in a "third party".
While the importer may be given credit to complete the trade order, trade finance provides the exporter with receivables or payment following the arrangement.
There are several stakeholders engaged in trade financing, which may include:
- Trade finance firms
- Both exporters and importers
- Agencies and service providers for export credit
Trade financing stands apart from traditional financing or credit issuance methods.
💭 Interesting Fact: Short-term trade finance, including trade credit and insurance/guarantees, plays a crucial role in facilitating approximately 80-90% of global trade.
5 Financial Instruments Used in Trade Finance Transactions
Trade finance presents a feasible solution for reducing the inherent threats that ensue from global trade, covering but not being restricted to currency fluctuations, political instability, non-payment predicaments, and the creditworthiness concerns of the involved parties.
Here are the primary financial instruments employed in trade finance:
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)
LoC reduces 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 LoC are met by the seller.
Trade Crediting and Political Risk Assurance
These are offered by private insurance companies with the role of protecting a client from the 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.
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.
Supply Chain Financing (SCF)
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 can 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 similarly to 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 have their balance sheets managed appropriately due to the reduction in day sales outstanding (DSO).
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.
How Does Trade Financing Reduce Risk?
There is no question that there are many risks imposed during trade finance for both the exporter and the importer, especially for international trade.
But what are some common trade finance risks?
- The risk is imposed when the importer does not pay for the goods shipped, or;
- The risk involves an exporter refusing to make the shipment after accepting the payment.
- Country-related risks in the transaction, including exchange rate, political and sovereign risks.
- Risks involving a country's political situation, economic status, and others can be deterring factors for certain exporters and instil 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.
To explain how trade financing reduces the risk we will use Letters of Credit (LoC) as an example as this is the most common instrument for short-term trade financing.
A Letter of Credit (LoC) 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, the exporter has to fulfil the request.
- With LoC, the responsibility for payment to the seller is on the buyer's bank.
- There can be a third party involved within the transaction, which is usually the confirming bank that is typically in the same country as the exporter, and its role is to confirm the LoC provided by the importer's bank.
- Once this is confirmed, it will guarantee that the buyer's payment must be delivered on time with the correct amount to the seller.
The process will of course differ depending on the trade finance product/instrument used but the main premise can be easily understood with LoCs.
📖 Recommended: We have another article that goes into detail about other common types of trade finance products and how it works.
What Are The Benefits of Trade Finance?
Trade finance is an essential means for companies to improve their effectiveness and strengthen revenue, while also mitigating the risks of non-receipt of goods and nonpayment.
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.
💡 Tip: Companies can request larger quantity orders and get discounts offered by suppliers through trade finance transactions.
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.
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 to truly succeed in the trading market, building up connections and relationships with the parties involved and perpetuating your revenue.
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What is trade finance?
Trade finance is the financing of goods and services in the flow of global trade and commerce. The term is used to reference trade finance products used by banks and companies to facilitate international trade.
Who are the main parties involved in trade finance?
What are the 4 pillars of international trade?
What are the main types of trade finance?
What are some trade finance benefits?