Trade finance is a set of financial processes, products and instruments that assist with international trade. For businesses to trade with other companies abroad, they generally need access to finance and insurance to minimise the inherent risk of global commerce. It is estimated that around 80% of world trade relies on trade finance.
Trade Finance, Explained
Imagine you import textiles. You find a supplier from another continent with materials you want, all at an agreeable price. You negotiate a bulk order with the seller and ask them to ship the items. From there, you will receive the items and sell them to your clients.
Now, within this trade, there are several risks for both you and the seller. Unless you are swimming in capital, paying for these materials upfront is not possible. Additionally, in most cases, it’s not preferable either. Until you are sure that the shipment has arrived, committing capital to them might not be wise.
For the seller, this is the end of a cycle that involves sourcing raw materials and paying for labour. For the seller to sell and ship these materials, their production cycle will have to begin anew, which means they will require payment — or guarantee of payment — to send the items.
A bank or financial institution can provide the trade finance needed to close the deal to fill this cash-flow gap. This will take the form of a certificate that guarantees payment to the seller. This money then allows the agreement to go ahead, which benefits both the importer, exporter and other businesses along the supply chain.
How Does Trade Finance Work?
International trade exposes importers and exporters to non-payment and supply risk. Businesses can employ a third party to guarantee some or all of the payment for the transaction to mitigate these risks.
Trade financing should be considered distinct from more conventional financing methods. Methods of funding or credit assurance — like a business loan — help a company with liquidity. However, trade finance is frequently used by exporters or importers who have enough cash reserves but would like to protect themselves against the uncertainties associated with international trade.
International trade carries several risks for both importers and exporters. Opening lines of credit with companies you don’t know or paying upfront for goods that might never arrive are genuine concerns that companies need to consider. Likewise, securing specific goods or materials might require an importer to deal with an exporter in a region marked by political unrest or upheaval. Additionally, currency fluctuations can change the complexion of a deal overnight.
Because of these risks, importers and exporters can involve various intermediaries to ensure their transaction doesn’t run into problems. Some of these third-parties involved in the trade finance process might be:
- Banks or financial institutions
- Trade Finance companies
- Export Credit Agencies (ECAs)
- Insurance companies
What Types Of Trade Finance Products Are There?
To facilitate trade finance, some of the types of trade finance products commonly used are as follows:
Letter of credit: These letters work as a commitment from the importer’s bank to pay for the shipment once the transaction is complete.
Bank guarantee: To ensure both importer and export are protected, a bank will act as a guarantor if one of the parties fails to fulfil the trade contract. For example, if an importer fails to pay for the goods, the bank will pay a sum of money to the exporter.
Factoring: Factoring helps exporters improve their cash flow by selling their invoices to a trade financier. This can allow the exporter to receive up to 80% of the value of their export.
Forfaiting: Forfaiting is a means that allows exporters to sell the amount an importer owes them for immediate cash.
Insurance: Insurance can be bought to cover delivery and safe passage of the goods and to provide protection in case of non-payment
Export credit: Export credit is another facility that exporters can access to bridge the financial gap between exporting and sales invoicing
Lending: Banks can extend lines of credit to either exporters or importers
PO financing: In some cases, a financier may accept a purchase order from an exporter and open a line of credit on the strength of repayment from the importer
Why Is Trade Finance Important?
Global trade helps local economies and employs many millions of people. It allows countries to purchase goods they can’t produce and enables specialist businesses to grow and expand. However, the logistics alone carry a level of risk that would be uncomfortable for many enterprises, so trade finance is required to encourage and facilitate these transactions.
Simply put, the non-receipt or non-payment of goods could jeopardise or even bankrupt a business. There are far too many intangibles that companies cannot control when dealing with imports and exports. International trading could be seen as an unattractive business without the insurance of payment or protection against loss of revenue.
Without these insurances and guarantees, importers and exporters would be less incentivised to engage in global trading. As an exporter, you expose yourself to a loss of materials by shipping them to an importer. To mitigate this, you could demand payment upfront. However, this puts the burden of risk on the importer, who has to hope their shipment arrives safe or they’re out of money. And so, you reach a deadlock.
Providing a solution to these deadlocks is an example of the importance of trade finance.
What Are The Benefits?
Aside from solving the deadlock that could occur between importers and exporters about who should take on the risks involved with global trading, trade finance facilitates operations and productivity in several ways. Cash flow is a serious consideration for many businesses, especially when dealing with materials purchased in bulk. Companies can use trade finance to access opportunities that would otherwise be impossible due to risk.
Operational Cash Flow
An import or export business will often be just one part of a larger supply chain that involves several entities. Raw materials, production and manufacturing of goods might require payment before they are ready for export. While on the import end, the goods will need to be sent out for further manufacturing or sales.
Whatever the specifics, it can take a long time for the money to come downstream from the end consumer. Unnecessary delays in this process could be felt by any of the components in this chain, which is why credit facilities are vital to ensure the day-to-day survival of companies.
Trade finance prevents these blockages by helping companies obtain the finance needed for business. Additionally, it can also work as an extension of credit. You can use trade finance products like letters of credit or factoring to generate cash flow when you need it.
For example, the market is crying out for a particular good or product. You’ve located a supplier, and they are ready to ship the items to you. This is an excellent revenue opportunity for you. Using trade finance, you can guarantee protection against non-delivery and use this shipment as collateral for financing growth.
Increased Revenue Opportunities
Trade financing gives companies the latitude to increase their revenue opportunities through importing and exporting. For a company to grow, they need to take on more ambitious orders or projects. Export financing from private or government institutions is designed to help domestic companies feel more secure when selling to global markets.
Using the loans or insurances provided by ECAs, a business can leverage its expertise in a broader range of markets, helping them expand and grow.
Reduced Financial Risks
As we’ve mentioned, global trade carries with it a significant amount of risk. Any delay along the supply chain can have repercussions like a loss of revenue or clients, resulting in existential danger.
Trade finance products like factoring or revolving credit lines could be the difference between survival and extinction for many businesses.
The History Of Trade Finance
Trade finance has a long and storied history dating back to the Renaissance Era. Italian mercantile companies were among the first people to provide trade finance via their network of correspondents. These early agreements were called bills of exchange.
The exporter would issue a bill of exchange and sell it to a bank or a remitter. The goods would be shipped; the banker would send the bill of exchange to his correspondent. When the goods arrived, the correspondent would present the bill to the importer, who would provide payment, which would then work its way back to the banker who had issued the original line of credit to the exporter.
With a few minor changes, this was the model that persisted up until the 18th Century. By then, London was the centre of global trade, and they established several acceptance houses that controlled and regulated international trade. Because these traders accepted bills of exchange in London — and sold and traded by them — this created a very liquid market for global financing.
The disruption caused by World War I caused London’s grip on the global trading market to loosen as New York emerged as a significant player. However, the great depression hit the global trading market hard, and subsequent tight governance and regulations limited trading.
The collapse of Breton Woods in 1972 led to an easing of these restrictions, and the increase in global trade meant demand for credit firms was high. Thus emerged the modern system of trade finance that takes place between the importer and exporters bank.
The one consistent throughout these changes is the recognition that trade finance, credit and insurance have always been financial tools required by importers and exporters to facilitate trade.
How Can Trade Finance Be Made More Efficient?
Global trade has come a long way from issuing bills of exchange in 13th Century Italy. The volume of exported goods and trade routes has exploded, with whole economies deeply reliant on imports and exports. This growth has meant banks and companies must be efficient to stay competitive.
Recent years have seen trade finance become far more complex. Rising tariffs, coupled with increased market and geopolitical volatility, pose considerable problems for trading relationships. On top of all this, enhanced regulations have made it harder for banks to open up lines of credit to traders.
Regulations, KYC and compliance checks have become additional costs that banks and financial institutions have to bear that provide little revenue. To counter this administrative burden, better tools are needed to drive down compliance spending. Below are three key areas that can power trade finance modernisation.
RegTech is one of the fastest-growing areas inside corporate finance. Highly regulated areas like trade finance can benefit from using dedicated tools to meet compliance and manage risk. With a particular government focus in recent years on money laundering and fraud, a technology that facilities KYC and AML processes — while reducing risk — is essential for surviving in this landscape.
Trade finance is one of bankings oldest functions, and it has shown a resistance to move away from pen and paper. However, digital signatures and electronic documents are increasingly used by operatives. The benefits of this connectivity are huge, with AI and machine learning tools ready to streamline and automate many of the processes.
Cross-Border Payments Software
Cross-border payments are complex and can lead to severe delays. Automating these processes with software that manages foreign currency and transfer activity improves the supply chain and increases productivity.