Not quite sure what trade finance is?
Perhaps you’re new to global trade as an importer/exporter, or you stumbled on the phrase “trade finance” and are just curious about how it works. Either way, you’re in the right place.
Because today, I will explain what trade finance is in simple words.
Key Insights
1. Trade finance facilities global trade by providing financial instruments that reduce risks for importers and exporters, ensuring payments and deliveries occur smoothly. It allows businesses to expand internationally without fear of fraud or non-payment.
2. Various trade financing methods exist to suit different business needs, including letters of credit, purchase order financing, factoring, and supply chain financing. These methods help businesses secure capital, reduce costs, and manage cash flow effectively.
3. Key players in trade finance include banks, non-bank lenders, trade finance agencies, and logistics providers, all of whom facilitate transactions, ensure compliance, and reduce risks. Without these intermediaries, global trade would be significantly more challenging.
4. Challenges in trade finance include regulatory barriers, non-payment risks, and accessibility issues, especially for SMEs in developing economies. However, technological advancements like blockchain and digital trade platforms are improving efficiency and expanding access to financing.
What is Trade Finance
Trade means buying and selling. Finance means providing funds for a business to carry out its activities. In line with that, trade finance is simply making funds available for international businesses to buy and sell.
A document by the International Trade Administration of the U.S. Department of Commerce defines trade finance as “A set of techniques or financial instruments used to mitigate the risks inherent in international trade to ensure payment to exporters while assuring the delivery of goods and services to importers.”
In essence, trade finance ensures that businesses have all the funds they need to produce, package, and transport goods from their country to buyers across the globe, while also protecting both parties (buyers and sellers) against fraud, failure to deliver goods, or non-payment for delivered goods.
Trade finance is also known as export finance, import finance, or supply chain finance.
Example of Trade Finance
An example of trade finance is seen in the video below.
A company in India (let’s call it Raj Medicals Ltd) wants to sell medications to a US-based company (John and Jones Medical Corporation). This is an international trade and both companies have never done business with each other. But they’ve reached an agreement on the deal.
All that’s left is to settle the payment and ship the goods. But that is no small matter because there are trust issues.
John and Jones Medical Corporation is thinking “What if I pay for the meds and this Indian company doesn’t deliver the goods? How do I get my money back?” So they’ll prefer to receive their goods before making payment. Raj Medicals Ltd, on the other hand, is thinking “What if we ship these goods and this American company fails to pay us our money? How do we recover our goods?” Therefore, they’d prefer to receive payment before shipping.
Which of these companies will make a concession and bear the risk?
That is the problem trade finance solves. It simplifies international trade by reducing the associated risks and ensuring both parties fulfill their end of the bargain.
In the scenario above, there are different ways to go about it. One of these is the use of letters of credit. A letter of credit is a document in which the buyer’s bank guarantees that payment will be made, provided the goods are shipped. So, while Raj Medicals Ltd may not trust John and Jones Medical Corporation, it can trust a reputable bank in the US to remit its money.
Key Components of Trade Finance
There are many actors involved in the trade finance process and the industry at large.
Some include.
- Banks and lending institutions
- Trade finance agents
- Suppliers and exporters
- Import and export specialists
- Insurance companies
- Export credit agencies
- Shipping and logistics agencies
These key players facilitate the creation and transfer of necessary documents, smooth delivery of goods and services across borders, and timely payment.
Why Trade Financing is Important
Trade finance is important because it helps businesses expand their customer base beyond the shores of their country without the fear of getting ripped off by bad actors. Small and medium-sized businesses can now compete in the global market and drive economic growth.
According to a Trade Finance Global PDF titled SME GUIDE FOR IMPORTERS AND EXPORTERS, “80-90% of global trade, worth $10 trillion per year, is reliant on trade and supply chain finance.”
That shows the vital role that trade finance plays in the world economy. Without it, many businesses will lack the resources and the courage to bear the risks associated with trading with companies from different parts of the world, companies headed by people they barely know and trust.
Benefits of Trade Finance for Importers and Exporters
Here are the many ways importers and exporters can benefit from supply chain finance.
1. Access to Capital
Exporters who lack the capital to produce goods and ship them to buyers can get export loans from banks and lending institutions.
This helps small and medium-sized enterprises take on larger orders and expand their operations.
Also, exporters don’t need excellent credit scores since goods can serve as collateral.
2. Reduced Costs
Unlike debt financing, which comes with high interest and little to no consideration of the completion of orders, trade finance gives businesses a less risky option of financing their manufacturing and sales operations at a lower cost.
Instead of taking a traditional loan from a bank to finance a sale to a new party they don’t trust, businesses can use export loans.
3. Reduced Risks of Non-payment or Unfulfilled Orders
Third-party institutions like banks and trade finance agencies act as middlemen, ensuring buyers and sellers fulfill their end of the trade. This reduces the risks associated with trade finance.
For example, a bank can receive deposits on behalf of a seller but only release the funds to the seller when the buyer approves that the goods have been delivered as expected. If, for any reason, the contract terms were not met by the seller, the money will be sent back to the buyer after the goods are returned.
4. Prevents Fraud
Due to the nature of trade finance, only registered businesses with verified owners can engage in it. This protects international businesses against fraudsters who are posing as legit business owners.
Over the internet, people have been victims of scam companies. They paid for goods yet never received their order. Neither was their money refunded.
That’s because there wasn’t a third party to validate the claims of both parties. The buyer bore the risk alone without verifying whether the seller was capable of delivering or if they even existed.
With trade finance, such fears are allayed.
5. Builds Trust
Naturally, many business leaders would be wary of dealing with strangers from a different country. Especially when it promises returns beyond typical market offerings.
For example, a new supplier of raw materials may be offering a deal at a lower cost than its competitors in the global market. That can raise suspicion in the minds of key players. But with reputable institutions like banks and established trade finance agencies acting as middlemen, risk-averse entrepreneurs can take hold of global opportunities.
Because trade finance reduces the likelihood of fraud, buyers and sellers are more open to trading with new businesses outside their country.
6. Access to a Larger Market
It goes without saying that when trust and financial barriers are no longer an issue, businesses can expand to other regions.
The reason why many businesses are limited to a particular state or country isn’t because other people elsewhere don’t need their products. It’s usually because they don’t have a physical presence in those areas or they lack the funds needed to transport their goods. Not having a physical presence weakens trust; buyers are thinking, “How do I know this company is real if I can’t see them? Who do I walk up to if something goes wrong?”
However, with a reputable agency or bank acting as an intermediary, skepticism is reduced. A software development company in India can create software for companies in the UK. A French luxury brand can export its goods to other parts of the world.
Types of Trade Financing
Trade financing comes in various forms to suit the unique needs of businesses. Here are the main methods of payment in international trade.
1. Cash-in-Advance Payment Method
In this method, the importer pays the exporter in full before the goods are shipped. While it minimizes risks for exporters, it places the burden of trust and financial risk on the importer. This can be used by businesses that have been trading with each other since they’ve built trust over time.
2. Purchase Order Financing
In purchase order financing, a business reaches out to a lender to borrow funds so they can complete unfulfilled orders.
For example, let’s say you sell glass cups, and you usually import them in bulk. In your business model, customers pay on delivery. So far, you’ve been selling five thousand pieces each month, using that revenue to import more after taking profits. Then, in a certain month, you noticed a spike in orders. Suddenly, businesses need 20,000 glass cups. You didn’t anticipate that, and now you don’t have the funds to fulfill those orders.
Instead of missing the opportunity, you can use purchase order financing. So you go to a lender, most likely a bank, apply for financing, and once it’s approved, they’ll pay your supplier. When buyers receive their goods, they pay the lender directly. Then, the lender takes their cut and gives you the balance.
3. Factoring
Factoring is similar to purchase order financing. But instead of using purchase orders to get the funds needed to fulfill orders, the business uses its account receivables to get faster payment on already fulfilled orders.
Account receivables are money you’re expecting. Say you managed to deliver 20,000 cups like in our previous example, but your buyer hasn’t paid you and could take up to 30 to 60 days to complete payment. If you need cash flow urgently, perhaps to pay workers or fulfill new orders, you can use your account receivables to secure finance from a bank at a discount.
So, let’s say you’re to get $20,000 in 60 days’ time. You can sell that to the bank and get $17,000 within 3 to 5 days. When the due date comes, your buyer pays the bank directly.
4. Supply Chain Financing
Supply chain financing is also called reverse factoring. Here, the buyer and seller are connected to a financial institution that has the technology to support supply chain financing.
But instead of the supplier to sell his account receivables to the bank at a discount for immediate cash, the buyer is the one to negotiate with the bank and initiate early payment.
It’s like telling the bank that “I’m supposed to pay my supplier $20,000 in 60 days. Pay him $18,000 now, and I’ll pay you $21,000 in 60 days.”
5. Trade Loans and Lines of Credit
Trade loans are specific loans given to finance trade. Unlike traditional loans that can be given for any purpose e.g. taking a loan to buy a house, buy a car, or start any business, trade loans are given for specific purposes.
For example, some financial institutions focus on giving trade loans to finance agricultural trade. Others may only give trade loans to import specific kinds of goods or raw materials.
A line of credit is a type of loan that gives business owners the flexibility of borrowing multiple times within a set limit but only paying interest on what they borrowed eventually.
For example, you can get a line of credit with a limit of $300,000. But you don’t have to get all the $300,000 at once. You can borrow $50,000, $20,000, and $80,000. If you don’t exhaust the $300,000 in your line of credit, you wouldn’t pay interest on the amount you didn’t use. You only pay interest on the actual money you spend.
6. Letter of Credit
A letter of credit is a document created by a bank assuring a business or individual that money will be paid at a particular date, provided all parties meet the terms of agreement.
I talked about this earlier when I was giving an example of what trade finance is. With a letter of credit, a trustworthy financial institution or service provider assures the seller that he will be paid the agreed amount if the goods are delivered.
This takes the risk off the seller and puts it on the financial institution.
7. Consignment
Consignment is an agreement between a buyer and a supplier that payment will be made after the end user has purchased the goods. For example, say you imported 20,000 cups from a company abroad.
In a consignment, you’ll only pay the supplier when you’ve sold those 20,000 cups to your customers.
8. Forfaiting
Forfaiting is similar to factoring. The major differences are;
1) Forfaiting deals with mid to long-term account receivables. While Factoring sells account receivables that are expected within 30 to 90 days, forfaiting deals with account receivables expected in 6 months to a year.
2) Forfaiting has lower limits, usually around $250,000. That is, your account receivables must be at least $250,000. Factoring, on the other hand, doesn’t have lower limits.
Types of Lenders
1. Banks
Corporate and/or commercial banks are the most used lenders in trade finance. Some banks have a rich history and are seen as trustworthy trade finance providers.
Banks usually have stricter rules and regulations guiding who can get trade finance. There may be rules like minimum years in business, minimum annual turnover, credit score range, etc.
Processes may be slower due to bureaucracy.
2. Non-Bank Lenders
These include trade finance agencies and corporate bodies.
Non-bank lenders can be more flexible in their approach to trade finance and may be willing to take on more risk.
They could also process deals faster.
But the likelihood of exploitation by bad actors could be higher.
How Businesses Secure Trade Financing
After two parties have agreed on a deal, one of them must take key steps to kickstart the process.
Generally, a simple trade finance transaction goes like this;
- Application: Depending on the method of trade finance, the buyer (importer) or seller (exporter) approaches the lending institution and applies for funding. E.g. An importer can apply for a letter of credit from a reputable international bank.
- Evaluation of Application: The lending institution looks at the application to ensure that both business entities are real, have been registered in their respective countries, and are compliant with trade laws. They could also look at the creditworthiness of the businesses involved.
- Negotiation: If the lending institution sees the deal as something worth pursuing, it invites the applicant for negotiation. They agree on fees to be paid, discount or interest rates as the case may be.
- Approval and Documentation: When the applicant and the lender reach an agreement, the lender approves the trade finance deal and keeps a record. Necessary documents are created, with copies given to all parties involved.
- Fulfilment and Disbursement of Funds: Depending on the method of trade finance, the funds are either released to the applicant or the other business entity after the delivery of goods.
Challenges and Risks Associated with Trade Finance
1. Availability of Trade Finance
Certain countries may have a less favourable climate for international trade, making it difficult for businesses, especially SMEs, to access it. Things like high costs, complex application processes, and limited financial infrastructure often hinder businesses from securing the funds they need.
2. Non-Payment
Despite the safeguards of trade finance, there is always a risk of non-payment. This could be due to disputes over goods quality, economic instability, or the buyer’s insolvency. To mitigate this, businesses often rely on tools like credit insurance or letters of credit.
What is the Main Problem of International Trade?
The main problem of international trade is the complexity and risk associated with cross-border transactions. This includes trust issues, currency fluctuations, differing regulations, and geopolitical tensions, all of which can disrupt trade.
What are the Three Major Barriers to International Trade?
- Tariffs and Trade Barriers: Import duties and quotas can significantly increase costs and limit market access.
- Regulatory Differences: Compliance with varying laws, standards, and documentation requirements can complicate trade processes.
- Logistical Challenges: Shipping delays, inadequate infrastructure, and border inspections can disrupt the flow of goods.
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Conclusion
Digitalization is transforming trade finance by increasing efficiency, reducing costs, and improving accessibility. Blockchain technology, for example, is being used to create secure and transparent digital trade records. Online platforms are also enabling SMEs to access trade financing more easily, democratizing opportunities in global trade.
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