What Is Trade Finance?
Trade finance represents the financial instruments and products that are used by companies to facilitate international trade and commerce. Trade finance makes it possible and easier for importers and exporters to transact business through trade. Trade finance is an umbrella term meaning it covers many financial products that banks and companies utilize to make trade transactions feasible.
What's Trade Finance?
- Trade finance represents the financial instruments and products that are used by companies to facilitate international trade and commerce.
- Trade finance makes it possible and easier for importers and exporters to transact business through trade.
- Trade finance can help reduce the risk associated with global trade by reconciling the divergent needs of an exporter and importer.
How Trade Finance Works
The function of trade finance is to introduce a third-party to transactions to remove the payment risk and the supply risk. Trade finance provides the exporter with receivables or payment according to the agreement while the importer might be extended credit to fulfill the trade order.
The parties involved in trade finance are numerous and can include:
- Trade finance companies
- Importers and exporters
- Export credit agencies and service providers
Trade financing is different than conventional financing or credit issuance. General financing is used to manage solvency or liquidity, but trade financing may not necessarily indicate a buyer's lack of funds or liquidity. Instead, trade finance may be used to protect against international trade's unique inherent risks, such as currency fluctuations, political instability, issues of non-payment, or the creditworthiness of one of the parties involved.
Below are a few of the financial instruments used in trade finance:
- Lending lines of credit can be issued by banks to help both importers and exporters.
- Letters of credit reduce the risk associated with global trade since the buyer's bank guarantees payment to the seller for the goods shipped. However, the buyer is also protected since payment will not be made unless the terms in the LC are met by the seller. Both parties have to honor the agreement for the transaction to go through.
- Factoring is when companies are paid based on a percentage of their accounts receivables.
- Export credit or working capital can be supplied to exporters.
- Insurance can be used for shipping and the delivery of goods and can also protect the exporter from nonpayment by the buyer.
Although international trade has been in existence for centuries, trade finance facilitates its advancement. The widespread use of trade finance has contributed to international trade growth.
"Some 80% to 90% of world trade relies on trade finance..." – World Trade Organization (WTO)
How Trade Financing Reduces Risk
Trade finance can help reduce the risk associated with global trade by reconciling the divergent needs of an exporter and importer. Ideally, an exporter would prefer the importer to pay upfront for an export shipment to avoid the risk that the importer takes the shipment but refuses to pay for the goods. However, if the importer pays the exporter upfront, the exporter may accept the payment but refuse to ship the goods.
A common solution to this problem is for the importer’s bank to provide a letter of credit to the exporter's bank that provides for payment once the exporter presents documents that prove the shipment occurred, like a bill of lading. The letter of credit guarantees that once the issuing bank receives proof that the exporter shipped the goods and the terms of the agreement have been met, it will issue the payment to the exporter.
With the letter of credit, the buyer's bank assumes the responsibility of paying the seller. The buyer's bank would have to ensure the buyer was financially viable enough to honor the transaction. Trade finance helps both importers and exporters build trust in dealing with each other and thus facilitating trade.
Trade finance allows both importers and exporters access to many financial solutions that can be tailored to their situation, and often, multiple products can be used in tandem or layered to help ensure the transaction goes through smoothly.
Other Benefits to Trade Finance
Besides reducing the risk of nonpayment and non-receipt of goods, trade finance has become an important tool for companies to improve their efficiency and boost revenue.
Improves Cash Flow and Efficiency of Operations
Trade finance helps companies obtain financing to facilitate business but also it is an extension of credit in many cases. Trade finance allows companies to receive a cash payment based on accounts receivables in case of factoring. A letter of credit might help the importer and exporter to enter a trade transaction and reduce the risk of nonpayment or non-receipt of goods. As a result, cash flow is improved since the buyer's bank guarantees payment, and the importer knows the goods will be shipped.
In other words, trade finance ensures fewer delays in payments and in shipments allowing both importers and exporters to run their businesses and plan their cash flow more efficiently. Think of trade finance as using the shipment or trade of goods as collateral for financing the companies growth.
Increased Revenue and Earnings
Trade finance allows companies to increase their business and revenue through trade. For example, a U.S. company that can land a sale with a company overseas might not have the ability to produce the goods needed for the order.
However, through export financing or help from private or governmental trade finance agencies, the exporter can complete the order. As a result, the U.S. company gets new business that it might not have had without the creative financial solutions that trade finance provides.
Reduce the Risk of Financial Hardship
Without trade financing, a company might fall behind on payments and lose a key customer or supplier that could have long-term ramifications for the company. Having options like revolving credit facilities and accounts receivables factoring can not only help companies transact internationally but also help them in times of financial difficulties.