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What is 'Trade Finance'

Trade finance relates to the process of financing certain activities related to commerce and international trade. Trade finance includes such activities as lending, issuing letters of credit, factoring, export credit and insurance. Companies involved with trade finance include importers and exporters, banks and financiers, insurers and export credit agencies, and other service providers.

BREAKING DOWN 'Trade Finance'

Repayment terms relating to trade finance activities are generally short-term with the majority being used solely for the completion of a particular financial transaction. This financing forms a safety net, helping to protect the interests of buyers and sellers in an international marketplace and assisting in the completion of transactions that may involve multiple currencies.

Although international trade has been in existence for centuries, trade finance developed as a means of facilitating it further. The widespread use of trade finance is one of the factors that has contributed to the enormous growth of international trade. Trade finance is of vital importance to the global economy, with the World Trade Organization (WTO) estimating that 80 to 90% of global trade relies on this method of financing.

Trade Finance, Solvency and Liquidity

General financing may be used to cover an issue of solvency or liquidity, but trade financing may not necessarily indicate a lack of funds or liquidity on the buyer's part. Instead, it may be used to protect against the unique risks present in international trade, such as currency fluctuations, political instability, issues of non-payment or questions regarding the creditworthiness of one of the involved parties.

International Trade Financing

In its simplest form, trade finance works by reconciling the divergent needs of an exporter and importer. While an exporter would prefer to be paid upfront by the importer for an export shipment, the risk to the importer is that the exporter may simply pocket the payment and refuse shipment. Conversely, if the exporter extends credit to the importer, the latter may refuse to make payment or delay it inordinately.

A common solution to this problem in the area of trade finance is through the issuing of a letter of credit, which is opened in the exporter's name by the importer through a bank in his home country. The letter of credit essentially guarantees payment to the exporter by the bank issuing the letter of credit upon receipt of documentary proof that the goods have been shipped. Although this is a somewhat cumbersome process, the letter of credit system is one of the most popular trade finance mechanisms.

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